HOW TO UNDERSTAND THE BUSINESS MODEL OF A SUBPRIME LENDER

If you follow Provident Financial, a subprime lender you would know the share price took a battering, due to the admission that staff recruitment has affected their CCD division with collection rate falling from 90% in 2016 to 57% thus far, this year. They also mentioned problems with their operating systems. But, if things weren’t bad enough, their Vanquis division is facing an investigation into their “Repayment Option Plan”. And this would lead to tens of millions in compensation.

The share price stands at £7.70 from a peak of £35, a fall of 80% in market value. But, if you believe in Neil Woodford that in two years, the shares will return to making pre-tax profits in excess of £300m then you got to understand the business model.

Therefore, I outline a three-step process to understanding Provident Financial.

Step one: Their business model and how it works.

Step two: The positive side of their business.

Step three: The game plan, how will things likely to play out in the next six months, and whether you should or shouldn’t invest from two different scenarios.

Let’s do this.

 

STEP ONE: The Business Model of a payday lender

 

 

Illustration – Simple

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);

£450 (Interest).

This means Provident Financial report gross interest income of £500.

Remember Provident Financial incurs expenses from these loans. Let say the £1,000 lend cost them the following in expenses:  

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.

N.B.: The above is for illustration purposes only and not based on Provident’s financial accounts. 

So, annual operating costs total £250. Therefore, Provident Financial makes £250 in profit from this arrangement.

 

Illustration 2 – More business like

Illustration 1 explains the lenders model and how it makes money. One thing missing from that is the default rate or the non-performing loans or the impairment charge (whichever name you chose). And is 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).

(How much 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)

(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.

 

Hope this gives you an idea of how Provident Financial works.

 

STEP TWO: The Optimistic Reason for Provident Financials

Judging by their latest trading statement, any possible turnaround is likely to be around early 2018, so don’t expect quick results! The only thing you are getting is the new CEO appointment.

 

That gives us ample time to figure out if Provident is a good business.

In my previous post, I covered Provident’s profitability and mentioned their improving return on assets and return on equity.

Return on assets = 9%, up from 10-year average of 7.6%.

Return on equity = 57.4%, up from 10-year average of 43.5%.

The reason for the extra return is the increasing use of retail deposits, which has grown from £0m in 2010 to £1bn today. When you pay out 2-3% on these deposits, instead of 5% to 6% borrowing from the market, Provident gets to earn an extra 2-3%.

Also, as more of Provident’s borrowings come from retail deposits than they get to enjoy the extra margins.

 

 

STEP THREE: HOW WILL THINGS PLAY OUT

The lender can start to rebuild if the FCR ends their investigation into Vanquis’s ROP scheme and start improving their collection performance. But, one thing appears certain that 2017 will be their biggest washout.

But their late admission sounds alarmed for shareholders and investors because of its severity and the last CEO resignation is confirmation of this.

That leads to two scenarios.

 

Scenario One: The positive outcome

By late 2017, Provident will issue stating that their CCD showed an improvement in their collection rate of 67% from 57% with further improvements in 2018, but the FCR is still investigating their ROP scheme. However, the company makes a provision of £40m for any eventual fines it will pay if found guilty.

That’s the sort of news you want to hear. And should your initial investment. For example, if you plan to invest a total of £3k, then invest the first £1.5k.

Unless there is news of a financial crisis brewing or Brexit is causing the UK borrowing costs to rise (i.e. 10-year gilts up at 3.5%-5%). This should make you hold off your investment because higher borrowing costs mean mortgage monthly payments will shot up by 200%-300%.

 

Scenario Two: The negative outcome

If there is further deterioration (i.e. performance collection to fall to 50%) is forecast and other divisions experiencing weaknesses, especially Vanquis Bank. Harmed by the FCR investigation.

Then, don’t invest.

My reasoning is simple. It confirms that the experienced sales agents have left and Provident has to re-train their new workforce which requires time. Also, the FCR investigation prompted their Vanquis Bank division to adopt rules which benefit the borrowers, and that leads to lower margins.

That will re-rate the shares back to £4 per share, even causing it to fall to £3.

There is also a third scenario, where Provident’s retail deposits start to get withdrawn, though I find it unlikely due to the government guarantee scheme.

 

Where is the share price heading?

 I mentioned in my other Provident’s post that their shares are heading towards £6 per share in the next three months.

It gives the patient investor to wait for further news before assessing if this business is ripe for investment.

 

More on Provident Financial

A look at Provident Financial fundamental business and an interpretation of what their latest updates mean can be found HERE and HERE.

 

If you like this post, please share and subscribe to my blog.

 

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.

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