Subprime lender Provident Financial (the owner of Vanquis Bank) made a stunning admission that caused their share price to crater by 66%. The shares did recover by 100% to £8.60 after falling as low as £4.20 per share. As of right now, the company is stating they are having internal issues such as turning self-employed employees to full-time workers. But we don’t know how many are new to the job or were previously self-employed and was happy to convert to full-time agents. Also, we don’t know if they have lost a lot of talented and experienced people through this conversion.
Based on the latest trading statement, this job status transition has caused the collection of debt to fall from 90% to 57%. That can only suggest talented agents have left. For more on the latest news on Provident with analysis, click HERE.
In this post, we need to understand the basic concept of Provident’s business model that involves asking the following critical questions, such as: –
What is Provident’s business model looks like?
How much is the average amount loan to people?
What are the typical interest rates charged on those loans?
The average borrowing costs on Provident.
Does Provident borrow short-term money or long-term money for their business?
Do they hold retail deposits, and what is their borrowing composition looks like?
What is the historical change of their impairment charges?
How leveraged is Provident Financial really?
How the change in fundamentals affect their share price?
What is their cost of equity?
These are the type of questions that needed answers before you commit to investing in any pay day lenders. So, if things go wrong you know why it happens, and how to proceed going forward.
Provident’s business model
Provident is a sub-prime lender. Their business is to borrow money from the market (usually at rates of 4%-5%) and lend it to people by charging annual interest of 30%-40%.
The borrowed money is the lender assets.
A simple reason why this is possible because they can’t borrow from traditional banks or they require arrangements that the banks can’t provide.
If you go to one of their subsidiary, the Vanquis Bank website, a typical customer pays 39.9% APR, but the amounts lend is small like £150 to £1,000, but there are fines if payments are missed. Here is an illustration of how Provident does business.
P.S. The ILLUSTRATION BELOW goes into detail, so if YOU ARE familiar with their business model then skip to the next section.
Let’s say a customer borrows £1,000 at 45% APR and has to pay a £50 fee for this arrangement. Assuming the person pays it back in one year (keeping it simple), the payment is as follows:
£1,000 (Original amount borrowed);
£50 (Arrangement fee);
This means Provident Financial report back gross interest income of £500.
Remember Provident Financial incurs expenses from the loans as well, which includes:
Borrowing rates at 5% of £1,000 = £50;
Staff costs at 15% of £1,000 = £150;
Other costs like system upgrade, utility bills, insurance, auditor fees, bonuses, etc. make up for another £50 from £1,000.
So, annual operating costs total £250. Therefore, Provident Financial makes £250 in profit from this arrangement.
Illustration 1 explains the lenders model and how it makes money. One thing missing from that is the default rate, non-performing loans or impairment charge. That means the % of customers unable to afford to pay back their loans and interest.
Let’s say Provident’s impairment rate is 15% meaning out of 100 customers, 15 of them are unable to meet their obligations (fully or partially).
Step 1: (How profit does Provident makes if every customer pays?)
So, if Provident lends out £1,000 to 100 customers, then total lent is £100,000 and profits made comes to £25,000. (See illustration 1)
Step 2: (How does 15% impairment rate affect profits?)
Well, 15 customers equal to £15,000, so it will reduce profits to £10,000. The impact is substantial because instead of a profit margin of 25%, it now makes 10%.
To add more layers, what if, out of the 15 customers, seven was able to pay back half the loans, £500. It adds £3,500 to the existing £10,000 profit.
Now, we got that out of the way, let’s move on to the task at hand.
Provident Financial Ratios
This section explains the leverage, impairment rate and revenue generation.
Using the asset to capital ratio, which is:
Total Assets divided by Tangible Capital (Tangible Assets minus Total Liabilities), Provident Financial has a low leverage of between 4 and 5 times. This is below the 15 to 25 times from UK banks.
The traditional measure of the asset to ‘regulatory equity’ ratio showed leverage of 5 to 6 times. The reason for this prudence approach is the riskiness of their customer base. And that level of riskiness is stopping Provident from leveraging higher.
According to the IMF, UK non-performing loans to gross loans is roughly 2%-2.5%, that why tradition banks can leverage 15 to 25 times and inverting this means banks will lose their entire equity if they see 4% to 6.5% default rate.
For Provident, it has a much higher default rate known as impairment charge which ranges from 14% to 25%, hence the low leverage.
Meaning if we divide the traditional banks’ non-performing rate from Provident’s non-performing rate you will see a multiple difference of 7 to 10 times.
But, when you multiply the 7-10 times to Provident’s leverage multiple of 4 to 5 times, then their “TRUE leverage risk” can range from 28 times to 45 times! That debunks Provident’s conservative leverage.
Now, we look at the gross revenue ratio. This is revenue from loans divided by tangible capital (tangible assets minus total liabilities), expressed as a percentage. Provident generates revenue that exceeded “per pound of capital” for the last ten years but has fallen to under 200% from 300% during the financial crisis. The lower the %, the more prudent it becomes.
Compare this to the UK banks, it is still 3 to 4 times greater.
P.S. Some of the ratios like the gross revenue ratio and the asset to capital ratio is devised by John Kingham of UK Value Investor blog.
Provident has improved their return on assets to 9% from their 10-year average of 7.6% and their return on equity has risen to 57.4% from their 10-year average of 43.5%. That was the past, as Provident is likely to report an operating loss for 2017.
But, according to Neil Woodford, Provident is experiencing an operational issue, not a business cycle issue. (He still believes the company will post a £80m profit.) But Woodford fails to mention whether this is adjusted profits or normal profits because there will be some exceptional charges likely relating to CCD Division and Vanquis Bank. He also states that within two years, Provident will produce profits in excess of £300m, despite Brexit concerns and peak employment numbers, not to mention tougher regulation. At the moment, investors should view this as “conflict of interest” opinion post, which could turn out to be true!
On a historical basis, doing a historical analysis helps you to project how much profits the company would make if their operations were back to normalcy.
A Business that requires the “Art of Persuasion”
Staff costs at Provident have become risen from £87.5m to £185.9m.
Given the drastic change in staff in their home credit division, it would be unwise to analyse the cost per employee and other data. Investors need to understand that half the company’s sales are reliance on knowledgeable staff in this division. It requires the “Art of Persuasion.” Unlike the traditional banks, where people go to ask for loans. Subprime lenders need to persuade people to borrow for things they will likely to purchase for tomorrow, today.
Given that profits have tripled since 2006, the increase in wage costs seems justified. But, that if you use accounting net profits. If you use net cash flow it is a different story.
Using 10-year averages, Provident’s net profit comes to £138m, while its net cash flow amounts to a measly £32m giving an operating cash conversion of 23%! Plus, in 2006 Provident made net cash flow of £43.7m, higher than their average.
Like I said earlier, financial services view debt as an asset and that is part of their operation to create a return. Don’t be alarm if loans are rising.
What we should be asking is the availability of funding and the costs of borrowing. So, you are analysing borrowings facilities and changes to borrowing costs.
Another factor is having retail deposits because unlike short-term financing via wholesale and overdrafts (the cause of Northern Rock collapse) they can count on deposits to fund their business since savings rate is below that of borrowing rates.
Provident has been paying out 2-3% on deposits, whereas borrowing rates are between 4% and 6%. Looking at the chart, Provident has Another advantage is if short-term financing dries up, it can always rely on retail deposits. As long as the next financial crisis doesn’t cause a run on Provident Financial.
P.S. Provident only took in retail deposits since 2011, the subprime lender is untested when the financial sector becomes stressful.
When fundamentals deteriorated this fast, causing the share price to fall 70% in one day and down 87% from peak to trough it becomes hard to value. Also, there is this uncertainty of how it changes the business going forward.
Using earnings power value, you can understand how small changes in fundamentals change the narrative and sentiment, which affected their share price. I’m that low profits could be a one-off and isn’t the only factor responsible for the share price adversity.
That is why we take the severity of the share price decline down to the dishonest reporting of their 2017’s interim results, along with not giving investors data on the severity and the effects of transitioning self-employed staff to full-time workers.
Only when the CEO has resigned, they drop the bombshell by revealing that collection on consumer loans is at a rate of 57% from 90% and sales intake is averaging £9m per week lower than 2016!
Back to the chart and I give Provident the benefit of the doubt of reporting normalising profits at £70m for 2017. The reasoning is that they cancel their dividends saving them £200m. But, I increased the required rate of return from 9% to 11% reflecting the increase in risk.
That saw the fundamental valuation of Provident Financial fell from £19 to £4. This explains the 70% share price crash in one day.
USING Neil Woodford is forecasting a return of pre-tax profits of £300m, then the fundamental’s share price would have risen to £22 per share or 180% upside.
Hope this gives some historical background on Provident Financial. If you find this useful, please subscribe to this blog and share the post.