The weather report is always ‘cloudy with a chance of regulatory reviews’ in the subprime leasing space. Thorn Group, the owner of Radio Rentals, is the latest to find itself surrounded by storm clouds. This time around it's ASIC penalties and an impending class action spoiling the picnic.
Ordinarily, we view leveraged businesses with great scepticism. Especially those that profit from less financially sophisticated consumers. It’s an area most investors avoid, and for good reason. Just writing those sentences was enough to send shivers down my spine.
A consumer leasing leader
Lower price unrelated to sustainable earnings power
Speculative Buy up to 3%
But that’s the point. This sector is hated so widely that it throws up the potential for bargains, especially when regulatory clouds are at their darkest. This is where Thorn finds itself today. As a result, Thorn now trades around book value. For a market leader, capable of sustaining returns on equity of 15–20%, that’s cheap.
The source of those impressive returns is Thorn's crown jewel, Radio Rentals, which dominates consumer leasing in Australia.
This service is used by customers who are unable to purchase everyday items outright but can manage smaller ongoing lease payments. Most are low-income earners and many are on Centrelink. Credit Suisse estimates that half of Radio Rentals' revenue is received directly from the government, bypassing customers' accounts altogether. As noted in The Thorn Identity, that’s great for reducing bad debts but it adds regulatory risk.
After 80 years of operation, Radio Rentals has become the biggest in the space, with 83 stores and over $163m of assets. This gives it numerous economies of scale that smaller competitors can’t match, especially in equipment procurement, finance and marketing. This means Thorn can charge lower prices to customers and earn higher returns, giving it a durable competitive advantage. That advantage means higher returns, but it also means the business could even benefit from tightened regulations over the long term, as they would have a greater impact on smaller competitors.
Chart 1 shows just how good Radio Rentals is, with rising returns as the business grows, although these would likely take a hit during an economic downturn.
The rats 'n mice
Thorn’s other businesses have been pared back since we last reviewed it. The consumer loans business is being run off, and will generate small profits until $27.6m of net receivables are returned. Thorn also sold its debt collection business to Credit Corp for $22.6m in September last year. Alongside Radio Rentals, the business finance division is all that remains, the part of Thorn we like the least.
Business finance was created organically in 2012 and had grown to $176m of assets by March 2016, funding a diverse range of equipment for small businesses. Unlike Radio Rentals, there's nothing special about this business, and the numbers show it: its return on assets is a shadow of its illustrious sibling.
The only logic for building this division could be diversification. Why else would management direct half the company's assets to its lowest-returning business? Perhaps the institutional imperative for growth has taken hold. We would prefer to see Thorn sell or run down business finance to focus exclusively on Radio Rentals. Investors would have to accept lower growth, but they'd be compensated with a high yield, and management could deal with regulatory clouds with aggressive share buybacks at cheap prices.
With that said, business finance has been growing and its returns have been improving with scale, but it is yet to be tested through a full economic cycle. Thorn is protected to a point by its ability to confiscate equipment in the event of default, but economic conditions are likely to be influential on business finance’s returns.
The risk of regulatory changes is ever-present for businesses like Thorn. Just when investors thought one issue had passed another two surfaced.
Let’s recap. In a consumer leasing review in April 2016, the government recommended caps on the interest rates lessors can charge and restrictions on the total value of leases an individual consumer can enter. If implemented, these restrictions would reduce costs to consumers, but they would also reduce the value of a single lease (or a single customer) to Thorn, and therefore reduce earnings. To stand still, more leases would be needed.
Although the recommendations still haven't been made into law, Thorn has quickly adopted them recognising that, as the low-cost operator, by reducing costs to consumers it could further increase market share at its smaller competitors' expense. We suspect it has already increased market share and think industry consolidation could be an ongoing theme.
The other downside of capped lending rates, with market-driven borrowing costs, is that it introduces the possibility of margin compression from rising interest rates. However, both dynamics have been known, and therefore priced in, for some time.
What’s new is ASIC’s penalties and a class action. This all came to the fore after Thorn conducted an internal review, which showed that it had overcharged a number of customers due to a technology glitch. Thorn promptly notified ASIC, and has improved internal processes to rectify the issue, but that hasn't prevented an ASIC review and a subsequent class action.
Thorn had already provided for penalties but needed to increase them by a further $4m in March this year. Higher provisions mean lower earnings, so this was effectively an earnings downgrade that sent Thorn’s share price to 52-week lows.
Here’s the good part. These recent woes have little to do with Thorn's earnings power. The fear of a $10m one-off penalty knocked $50–100m from its market capitalisation. After this penalty is paid investors get the same earnings power at significantly lower prices. We have little concern for the class action either, as they typically take years to complete and settlements are often funded by insurers. With the leasing review just completed, we think the risk of further changes is low.
At below $1.40, we think the share price compensates for these issues. This is not an investment we expect to rise by multiples over many years, but a decent return is possible as regulatory fears subside. Even though management noted that the final dividend is likely to be reduced, we think the yield is likely to be above average providing a strong foundation for returns.
Thorn is only suitable for investors prepared to accept higher risks and, even then, we'd recommend limiting it to a maximum portfolio of weighting of 3%, but with those provisos, we're upgrading Thorn to SPECULATIVE BUY.