Description

   

Pitch:

IPF is a unique growth story trading at a bargain price due to a number of interesting yet explainable dynamics.  We believe IPF is trading at 12x 08’ and 10x 09’ normalized 08’ earnings (before backing out excess capital) for a business that should be able to grow earnings > 10% a year on their existing operations.  What gets exciting is there are new unprofitable territories (Mexico, Romania, Russia) that could take earnings growth to 20-30% for many of years that we get as free options.  We believe the new territories, which represent a large market opportunity, will prove to be successful in which case IPF should trade for at least 15x 10’ EPS of ~28-30 pence implying 50-60% upside over the next year or a ~$450 stock price, up from $282 today. 

 

If we are right on the new markets becoming profitable, the company will have proven to the market the business model can be transitioned to new territories and emerging markets that are more than one year away from profitability at that time ((India, Ukraine, Russia) will have a market value placed on it.  In this scenarios the PE multiple could expand to 20 or greater, which would yield a $560 to 600 stock price, or slightly more than a double. 

 

If we are wrong and the business model cannot transition to new markets the company can quickly walk away from all unprofitable territories, return roughly 25 pence per share in excess capital to shareholders and we would own a business trading at 11x 08 earnings that should be able to grow > 10% a year for a number of years.  This strikes us as a value investment with a free growth story that is misunderstood.   

 

Business description:

IPF was written on VIC less than a year ago so please refer to the former write-up for a more thorough business description but to re-cap:

 

IPF is a “home collected credit” lender that was recently spun out of Provident Financial in the UK.  IPF is the “Avon-lady” of finance  It operates a network of mostly female agents that travel door to door offering unsecured, ~ 1yr duration, ~150% APR cash loans averaging $200lbs to sub-prime customers throughout Poland, Hungary, Czech Republic, Slovakia, and most recently Mexico, which is not yet profitable but expected to be in 2009. But, it’s not that kind of sub-prime. 

 

 IPF has ~10 years of operating history in Poland, while its parent (which is public) has offered the same product in the UK for 120 years.  IPF is currently taking the business model into Russia with plans to enter India and other emerging markets.  While the APR seems egregious, IPF serves a niche market that is completely underserved by banks, which do not have the expertise, patience, flexibility, or desire to target this market.  IPF has very little competition.  We spoke with a local online bank in Poland, slightly half of their customers in CE, and he noted that local banks do not compete with IPF, store credit was not a threat b/c it is run by local banks and still required credit history, and that the length of start-up losses and infrastructure required to run the door to door loan business effectively all serve to keep out competition. 

 

A high APR is needed to overcome the high risk of lending to this group.  Agents are paid commission on what they collect, not what they lend, so they are incentivized to lend well.  IPF customers are among the highest in satisfaction rates across the financial industry, as they are simply happy to have access to credit and often develop a personal relationship with the loan agents, both of these characteristics create a strong incentive to repay the loans.  Loans are tied to local debt & interest rates are hedged nearly 100% 12 months out progressing to 35% 24 to 26 months out. Despite troubled credit markets the fact IPF borrows long and lends short improves their access to credit.  They have significant funding secured through 2010, with lots of untapped funding.  

 

We think this is a rather safe form of “low-quality” customer loan lending and a long history to support this view suggesting the current valuation is unjustified and it deserves a growth multiple not a European bank multiple. 

 

What is the market missing:

There are a number of factors we believe are causing the market to greatly misprice IPF.  Some of these include:

1)       International spin-off.  Parent company was a dividend play and IPF is the growth play.

2)       Sub-prime stigma.  Anything credit related is being shunned by the market. 

3)       Unprofitable countries creating a drag on earnings and market unwilling to look through the losses.  14x 08 and 12 09 w/ losses.

4)       Exotic / unique business.  No real comps so IPF is valued like a financial.  Takes a while for people to learn something new

5)       Fear of regulation risk. 

6)       It’s a complicated overall picture but at it’s core it’s extremely simple.  But with lots of moving parts and foreign geographies to get your arms around

 

The list is intimidating but a few anecdotes that confirm these factors are causing the market to knock the multiple are the following: 

1)       We have spoken with mgmt and there are still only a handful of US investors and almost zero UK investors.  As of a month ago there were a handful of large shareholders from the Spin-off that were still selling shares.

2)       It took us ourselves a long time to get comfortable with the product and that it was a different kind of sub-prime customer

3)       Few street analysts actually highlight what normalized profits look like if you back out the unprofitable countries

4)       Recent analyst downgrades highlight their reasoning as being the “premium multiple to comparable European banks.” 

5)       There has been regulation in the past and on the surface it does look like a consumer gouge

 

What gives us comfort in the investment?

1)       Management is highly committed and very methodical on their plan to open new markets. 

a.        They spend a few years studying each new market and after the evaluation decide to take the plunge

b.       They are prudent about how quickly they want to grow, with only a few test markets at any given time and after that market turns profitable reinvest those cash flows into new territories

c.        Insiders bought 2.4m GBP at a $260 stock price and mgmt incentive plan does not strike till the stock is at least a 30% return above 217GBp, slightly above today’s price which serves as a nice floor on the stock

2)       The business is simple and recurring in nature.

a.        Outside of a few small cultural issues and day to day methods of running the operations if the market is financially underserved then this product is needed and it’s only a matter of finding the right customers and the right agents to serve those customers

b.       70% of the business is repeat and ~45% of new customer come from referral.  The business builds itself. 

3)       IPF was spun-out of Provident to take advantage of new emerging markets, which require years of start up losses before building a customer base to cover fixed infrastructure costs, build a network of good agents who can judge the credit worthy customers from the defaulting peers, and grow the avg. loan size to a level profitable level. 

a.        It takes roughly 4-6 years to achieve this.

b.       Reason being IPF has to create a credit worthy customer base through trial and error over the 4-6 years

c.         Loan losses on customers 3^rd loan and beyond are extremely low and this is the real bread and butter of the business

d.       But again it takes a while to groom the customer base to this level.

e.        Once a core base is achieved mgmt can take up the risk levels and focus more on finding new customers

f.         You can see how the business is more a matter of time and patience than success or failure

g.        Once the fixed costs are overcome and the business turns profitable there is a lot of leverage in the model

h.       We are happy to see some Provident mgmt moved over to IPF 

4)       There was initial fear the Central European operations were running out of growth but recent results are proving the mgmt can continue to improve the business and earnings for years to come. 

5)       In reality, IPF has 10 years of operating history in Central Europe and the same door to door credit product has 120 + years of history in the UK at the parent company, Provident Financial.  Provident has had very little variation in EBT over the last 7 years, and is in fact a high yielding dividend stock in London. 

6)       We’ve spent a lot of time studying Mexico, currently unprofitable but seems ahead of plan and will turn a profit in 09

a.        New markets working more a function of time, ethics, culture, and market need rather than execution risk

b.       Senior management who has been with the company for 15 and 25 years respectively just made the move to Mexico in the last year to head it up.  It sounds ahead of schedule

c.         We think Mexico is the key to the investment thesis.  If it can work the market will likely be willing to value new territories

d.       A peer, Financiera Independecia, has good things to say about IPF and considered partnering with them but IPF wanted to go at it alone. 

e.        Financiera Independecia also sports a 800m USD market value for ~800-900k customers with an EBT / customer roughly equivalent to IPF’s Central European operations ~40-45 / customer.  IPF has 300-350k customers in Mexico today, but is growing at 20% annually, and was recently throttled back so IPF could focus on profitability.  Serves as a good comp to value these operations.  Trades at 15x LTM.

7)       Mgmt has navigated regulatory risk extremely well in the past:

a.        When Poland implemented an APR cap a few years ago IPF suffered in the short haul, but was able to reduce the APR to the cap and instead charge a service fee for agents visiting the person’s home.  This change allowed IPF to keep the effective economics in place, appease public image, and abide by the new laws.  The only country to have looked through to the total economics of the loan is Japan, many years ago , and we do not expect other countries to follow suit

b.       Given the history and conversations with industry experts we feel the regulatory risk is low and even if it surprises in the near future IPF has the experience to navigate it with minimal impact to the economics

8)       The unique nature of the product, flexibility of the payment process, and other factors allow for excellent loan loss management:

a.        The relationship an agent builds with the customer is a strong element in growth and keeping impairments low. 

b.       Agents speak with neighbors, visit the customer’s home, and use environmental clues such signs of substance abuse - no other financial institution has access to in deciding whether someone is likely to re-pay a loan. 

c.        The agent also has the ability to create a flexible payment schedule the client can afford over the course of the loan, which adds psychological willingness to repay.

d.       If a customer misses a payment, the agent can adjust the payment schedule as needed. 

9)       Specific new market commentary:

a.        Mexico is a few years in the making and expected to turn profitable in 2009.  They recently implemented a new customer profiling database that has helped them prune out weak customers but also dramatically reducing loan loss impairments. 

b.       Romania was launched in early 2006 and is targeted to reach profitability in 2010.  Given mgmts knowledge of the Central European markets we see little reason why Romania should not meet their long term targets, which are pre-tax profits of 20m.  Although, Romania does seem to have a weaker macro outlook than other CE countries.

c.         IPF recently bought a Russian Bank Dec 07’ and will be expanding into Russia in Early 2008 and is investigating expansion into India. 

 

 

 

Capital Structure in GBP:

Price: 282 pence

Shares: 257.5m

Cap: 720m

 

Street EPS, pence a share, targets:

08’ = $18.5

09’ = $22.2

10’ = $26

 

Our EPS targets:

08’ = $19-20

09’ = $23-26

10’ = $28-31

 

EPS backing out unprofitable countries

08’ = ~23, or 12x

09’ = ~27, or 10x

10’ = ~37

 

Excess capital:

Mgmt stated in 2H07 conference call their LT target for tangible equity to receivables of 25%, which implies 28 of excess capital we discount to $25 pence / share. 

Investment risks 

1)       Credit / Macro related.  Our biggest concern is the difficult macro backdrop.  But management is fully aware of the risk and has not seen any problems yet as their customers typically don’t have other debt outstanding (they don’t have credit history, remember) so this would mostly be a problem if unemployment spikes dramatically and eats into the IPF customer base.  Specifically:

a.        Eastern Europe is essentially the Mexico of Western Europe with a large part of exports tied to western Europe.  While Eastern Europe does have some potential macro issues looming, in general these are tied to consumer who have made poor mortgage loan choices in foreign denominated currency.  Exposed to Hungary and Romania mostly. 

b.       Central Europe looks better off.  In particular Poland which is the biggest CE operation for IPF seems to have the least problems whereas Romania where IPF is starting up operations seems to have the most problems along with Hungary, which is currently a small contributor to profit.  None of the problems seem to be impacting IPF yet and probably won’t absent a very large macro problem in those economies.

c.         Mexico.  A key market b/c investors will look for Mexico execution to value the rest of the business.  Mexico has been surprisingly resilient so far and we continue to believe that if Management does a good job executing they can avoid problems or sense them before they come problematic. Specifically, management has taken steps to proactively prune the customer base hereto ensure higher quality customers in the roster in case of a slow-down.  This pulled away from customer growth near term but demonstrates how dedicated management is to the business and taking the right steps for the long haul. 

2)       Slowdown good – but moderate downturn in economies would hurt IPF.  Non-performing loans being the primary negative impact, but market size would also grow as customers are cut off from traditional forms of credit in a slowdown.  Non-performing loans quickly offset this benefit in anything more than mild slowdown.

3)       Regulatory risk.  Mostly political / consumer oriented pressure on regulation as high-APR loans are seen as taking advantage of poor.  Reality is regulators know it is a necessary product and have made regulation to appease public interest while at same time having a small impact on home-loan business.

4)       Emerging market risk.  Branching into new markets has risk and takes a few years to reach profitability.  IPF failed in South Africa many years ago, but that seems like an isolated event where agent fraud and entering too quickly were the main culprits. 

 

In conclusion, the reward outweighs the risk and we see clear catalyst to drive revaluation over the next year including profitable Mexico and investors beginning to value the new territories which are not being ascribed any credit currently.  The macro backdrop is intimidating but this is not the same type of sub-prime and IPF customers, by their nature, should not have other forms of debt outstanding.  It’s more a matter of making sure unemployment does rise to risky levels than anything else and the IPF agents visit with customer frequently enough (weekly, monthly) to spot risk before it gets out of control. 

 

 

DISCLOSURE:  We and our affiliates are long IPF LN, and may long additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of IPF LN.  This is not a recommendation to buy or sell shares. 

 

 

Catalyst

Earnings. Mexico. Investors realizing this isn't a bank in the traditional sense and will grow through this cycle and should trade at a growth multiple not a bank multiple.