Brace yourselves for the Scottish independence vote. Small cap investors here should barely feel more than a few ripples from an event that happens 15,000 kilometres from our shore – unless you’re a shareholder in ThinkSmart (TSM).
The consumer and business equipment financing company is solely focused on the UK market since it sold its Australian and New Zealand operations to FlexiGroup late last year.
If Scotland chooses to carve a separate path to England, it will likely be a blow to consumer and business confidence – and that could put the brakes on retail spending. The question is how much of a danger does this pose for ThinkSmart’s Australian investors?
The outcome of the historic referendum on September 18 is too close to call. The only thing we know is that the undecided will be the deciding factor. That could be a good thing for the opponents of Scottish independence, or the “no” camp, because voters who have yet to make up their minds often choose to stick with the devil they know instead of risking their economic wellbeing.
Deep in our hearts, we are all born risk-averse. Just ask Québécois (residents of Quebec). Their last referendum on sovereignty in 1995 came down to the wire (this was their second attempt), and a little more than half voted to stick with Canada.
The Scottish vote could well follow the same path but if the “yes” vote come out on top, brace for a knee-jerk reaction from consumers. I suspect this shock could last three months or so before sentiment recovers. The fact is England and Scotland will have 18 months to plan the divorce and separation of assets. Scotland accounts for less than 10% of the UK’s gross domestic product (GDP), according to economists.
Under that scenario, I assume no new leasing agreements are signed for the December quarter. This is significant because the Christmas holidays are the most important period for consumer related companies.
If originations (new leases) come to a grinding halt for three months before recovering over the next two quarters, we could see ThinkSmart’s 2014-15 operating revenue drop to $13.7 million, which would represent a 30% drop over the 12 months to June 30, 2014.
The good news is that its bottom line would still be in the black, but by not much. Even under that conservative scenario, my discounted cash flow (DCF) based price target comes in at 35 cents, roughly where the stock is trading now.
Perhaps more importantly for risk averse investors is that ThinkSmart is protected by walls of cash – $38.5 million to be exact. This equates to two-thirds of its market cap. Most of this came from the asset sale to FlexiGroup, although its UK business is generating operating cash flow of $2.5 million in the six months to end June 30 this year. If business came to a grinding halt, ThinkSmart can last for three years, if not more.
However, it is not easy to appreciate the potential of the stock even without the Scottish independence overhang. While ThinkSmart has jumped close to 44% since I first flagged its re-rating potential in February 2013, the stock struggled to stay above 40 cents despite my fair value estimate being well north of that and last month’s better-than-expected full year result.
There are a few reasons for this. First, the change in its financial year end to June 30 from December 31 makes comparing results confusing. On the surface, revenue for the 2013-14 year has fallen 39.5% to $11.5 million while normalised net profit has crashed 40% to $1.6 million.
However, the “full-year” result only reflects the six months from December 2013 to June this year. If we took that into account, the 2013-14 result would be comfortably ahead of my original sales and net profit forecast of $19.3 million and $2.9 million, respectively.
On the other hand, the lack of a capital return may have overshadowed the good result. Investors were hoping that management would return some of the proceeds from ThinkSmart’s asset sale but management has decided to hold on to the cash as it explores acquisition opportunities in the UK market.
I believe ThinkSmart is closing in on a potential target and a deal could happen in six months. Otherwise, some capital return plan is likely to be announced at the February reporting season.
The third thing that might be hanging over the stock is the change to “lease accounting”. This means that sales from new leasing agreements won’t be booked in the period of the origination but spread out over the life of the lease agreement, which is typically two years.
The move to lease accounting for its Australian operations forced the company into a net loss position in 2012 and caused a de-rating of the stock. ThinkSmart’s chairman, Ned Montarello, had to work very hard to rebuild investor trust and he will be hoping that investors will be more understanding this time round as the company moves to lease accounting for the UK business.
The move doesn’t concern me. The change in accounting practice for both occasions is due to a change in the way ThinkSmart funds the leases. The new funding package for its new consumer leasing product “Upgrade Anytime” will lower interest costs for the company and provide extra capacity to expand its solution offering.
However, the move means I have to cut my sales forecast for 2014-15 by 13% and 2015-16 by 14.5% to $21.3 million. Given the relatively high operating leverage of the business, net profit falls more substantially by over 40% in each year. This has a material impact on my DCF price target, which falls to 50 cents from 68 cents a share.
While that is disappointing, there is still considerable potential upside for its share price given the potential size of the UK market. Further, the valuation doesn’t take into account potential acquisitions or a capital return. For these reasons, I reiterate my “buy” call on ThinkSmart.
To see ThinkSmart's financial summary and forecasts, click here.