Description

Elevator pitch: Morses Club is a subprime lender in an out-of-favor industry hit hard by covid-19, record customer complaint fees and new government regulations.  Over a third of small lenders have filed for bankruptcy, the survival of the third largest lender depends on approval of a highly-dilutive capital raise and the largest lender has withdrawn from the industry.  As the second largest lender, investors are also wary of Morses Club.  The fears are unfounded.  It has minimal debt,  97% customer satisfaction and the lowest customer complaint rate in the industry.  While peers are struggling to survive, Morses Club was marginally net income positive last year, is poised to take substantial market share from withdrawing competitors and will continue to strengthen whenever the industry is damaged.  As a subprime lender, Morses Club will experience a multi-year tailwind following covid-19 and will further benefit from cost cutting, neither of which is accounted for in the 2.8x EV/(EBITDA-mcapex) base case valuation and 256% expected return in two years.

Brief overview

Home-collected credit (HCC) is a UK subprime loan for low income customers.  Loans are typically for under £1000 lasting a year or less and carry high interest rates.  A distinguishing feature is that the loan agent shows up at the customer's home to collect weekly payments.  As a result of covid-19, in-person contact was severely restricted, making traditional home visits impossible.  At the same time, customer complaints against lenders increased over 200%, leading to record fines.  In 2020, the Financial Conduct Authority (FCA), a government regulatory agency, issued new rules for high interest lenders causing investors to fear severe financial impacts or bankruptcies across the industry.  Due to the financial stress from covid, customer complaints and regulations, the largest HCC lender is withdrawing from the industry, the third largest has petitioned the FCA to limit fines while its survival hinges on an equity raise worth six times its market cap and over one-third of smaller lenders have filed for bankruptcy.  As the second largest HCC lender, investors are also wary of Morses Club (MCL).  The fears are unfounded: Morses Club has near zero net debt, was marginally profitable in 2020 during the height of covid and stands to take significant market share from withdrawing competitors.  In this report I will discuss

   1. fines from customer complaints

   2. how new government regulations affect MCL

   3. how MCL adapted to covid

   4. how much MCL's revenue increases by acquiring customers from withdrawing companies

   5. valuation

   6. risks to the thesis

1. Fines from customer complaints

Section summary

   - Customer complaints increased sharply in 2020, severely damaging many HCC lenders

   - MCL's high underwriting standards and customer satisfaction have limited complaint fees to <4.4% of its FY2021 revenue

   - Complaints have dropped significantly in the past six weeks

     Covid-19 disproportionately hurt people from the lower economic class such as HCC customers since most couldn’t work remotely.  With no source of income and unpaid debt, many customers filed a claim that their lender loaned cash without thoroughly considering whether they could repay their loan.  The claims process works as follows: the borrower files a complaint with the lender.  If the borrower is not satisfied with the lender's response, they can complain to the Financial Ombudsman Service (FOS).  If the FOS determines that the lender is at fault, the lender must return interest and fees it collected to the borrower plus 8% of simple interest.  Regardless of the outcome, the lender must pay the FOS a processing fee.  In recent years, Claims Management Companies (CMC) have appeared to help borrowers file claims.  Borrowers can reach CMC's through their websites or the CMC places an ad on Facebook for example, asking if the borrower is having difficulty repaying a loan.  The CMC helps fill out the paperwork, submits the claim and collects a fee from the borrower if the claim is paid.  High claim fees have severely damaged many lenders.  The largest company in the HCC industry, Provident Financial, says that the number of claims filed in 2020H2 increased 200% over the previous year.  Citing complaint claims and a declining industry, Provident started running off its HCC loan book on 5/10/2021 and plans to finish in 2022.  Provident filed a Scheme of Agreement (an alternative to bankruptcy in an attempt to limit payouts) where they offered £50M to pay off the remaining customer complaint claims.  After the FCA wrote to the judge hearing the case, Provident amended the scheme to contribute any profits earned by the loans remaining in run off.  Other HCC lenders have also filed Scheme of Agreements and Loans at Home, the third largest lender, has petitioned the FCA to limit its customer fines.

     How has MCL fared with customer complaints?  According to the FCA, in 2020, 3.2% of MCL customers filed a complaint and 22% of complaints were approved.  MCL was slightly better than Loans at Home (3.5% filed, 27% approved) and much better than Provident (16% filed, 42% approved).  The results are consistent with MCL's profitability while Loans at Home and Provident suffered losses.  One reason MCL had the lowest per capita complaint rate is their higher lending standards.  In FY2018, they acquired 600 Provident agents and their loan books.  MCL found that the acquired loan books had higher balances, longer terms and higher loan frequency which were considerably reduced to meet MCL lending standards.  MCL has also been using real time verification of customer data for six years, cross checking loan applications with credit and office of national statistics databases.  Customer satisfaction is 97%, leading to fewer complaints.  Given the turmoil complaints have caused to MCL’s competitors, management has focused on maintaining tight risk management and high satisfaction.

     In a discussion MCL's CEO had with the largest CMC, the CMC said it was no longer financially viable to file claims against HCC lenders.  The CMC used Facebook to place ads and find users with difficulties repaying HCC loans.  In the past, the average ad respondent had loans with 10 different lenders, so the CMC could file 10 different claims per customer.  However, many lenders went bankrupt or are filing a scheme of arrangement.  So for each ad, there are now only 1-2 lenders that the CMC could file against, making it economically infeasible to continue filing claims.  During the six weeks from 4/1/2021 -  5/13/2021, MCL saw a significant drop in customer complaints.  CMC's are now also regulated by the FCA which may reduce claims in the future and as a last resort, MCL can also file a Scheme of Agreement to limit claims.

     In FY2021 ending on 2/27/2021 before the drop in complaints, MCL paid £2M in administration expenses, created a £2M provision and suffered a £0.4M balance reduction due to customer complaints, so the maximum total effect is £4.4M or 4.4% of FY2021 revenue (£100.2M).  Going forward, assume a 4.4% revenue reduction due to customer complaints.

2. How new government regulations affect MCL

Section summary:

   - The Financial Conduct Authority's (FCA) new regulations target high cost credit in general, but reading the FCA's own reports, their regulations for home-collected credit (HCC) lenders are quite different and less damaging.

   - Required changes in marketing practices and refinancing will reduce revenue by an estimated 6% and 1.5% respectively.

     The FCA, a UK government organization, has targeted high interest loans including HCC in the past 10 years citing the burden the loans place on lower income residents.  In 2015, the FCA issued a law limiting the total fees and interest a borrower pays for a loan to 100%.  As a result, many established payday lenders filed for bankruptcy and payday loans have since reduced by half.  On 6/2020, the FCA issued a detailed report [1] on changes in relending that it wants high cost lenders, including HCC lenders, to make.  Investors fear that HCC lenders will suffer a similar fate to payday lenders.  I'll run through the report's key points and how they affect the HCC industry and MCL in particular.

   - Increasing levels of debt and repayments

       "The level of debt and repayments can increase significantly, to the point where it is no longer affordable or sustainable for some customers… We are particularly concerned to see behaviour which suggests some customers may be managing financial difficulties through further borrowing."

     In 2019 year end, the average customer receivables for the top three HCC lenders were £285 (MCL), £432 (Loans at Home) and £477 (Provident), indicating that MCL debt and repayments are the most affordable and sustainable.  Also, concerns about increasing levels of debt and repayments are directed at high cost credit in general.  Looking specifically at the HCC industry, another FCA report [2] says lenders do not have late payment fees and they work with customers to adjust their payment schedules, so costs don’t increase even if borrowers take much longer to repay their loans.  According to a 2020 report requested by the FCA on relending in high cost credit markets [3], 34% of HCC borrowers said the amount they borrowed increased since they first started borrowing.  34% compares favorably with the other five types of high cost credit, which range from 30 – 54%.  Rather than imposing restrictions on lending amounts, the FCA says it wants to change how lenders market their products and how relending occurs to decrease the amount borrowed.  I'll discuss marketing shortly.

   - Relending accounts for a high proportion of business and drives profitability in many firms, which gives rise to customer harm

       The FCA states: “We are concerned that some customers may be suffering harm because of over indebtedness and we expect firms to review their lending practices and operations.”  However, the report the FCA issued [3] says “reborrowing had a relatively low impact on [HCC] customers day to day."  In [2]: “We do not consider that [repeat borrowing] is harmful.  Providing creditworthiness assessments are carried out effectively, weekly repayments should be affordable and sustainable.”

       The problem the FCA has with HCC is that a small core of customers borrowed over an extended period because their lending agents frequently suggested that they could borrow more.  The FCA concluded that “requests for borrowing should be initiated by consumers, not firms.”  In other words, marketing, which I discuss in the next section, needs to change.  MCL also started to directly address relending this year, when it introduced digital (online) loans with terms up to four years at lower interest rates than HCC for qualifying customers.  Longer terms reduce the need for relending and 2.6% of digital loans are longer term as of 2/2021.

   - Marketing activity and customer behaviour

     Many guidelines centered around marketing and disclosure:

          “Customers do not always know the total amount of their debt to the lender (and the overall cost of borrowing)”

          “Marketing material does not prompt a customer to think about how they will manage repayments.”

     Altering marketing is an easy fix that will have a limited impact on HCC lenders.  In the FCA requested report [3], after customers were told how much they spent on their loans over the years, “there was no sense that they would or could have done anything differently... The net effect of this was that the reborrowing had a relatively low impact on customers day to day and most thought they would borrow again.”

     The FCA also “expect[s] to see marketing strategies and operations which put customers in control of their decisions to apply for additional borrowing when it is in their best interest, without adverse influence from firms.”

     Marketing is not relevant 74% of the time when the customer initiated contact to get additional credit [3].  For the 2% of cases where the borrower was unsure who initiated contact, assume it was the borrower half of the time, adding 1% and bringing us to 75%.  For the 24% of cases where the provider initiated contact, how often would the borrower request credit at a later time?  Most customers are in the lower income bracket and have little savings.  In the case of seasonal events like Christmas or the start of the school year, customers would need money and initiate borrowing on their own.  Customers are also aware that they’re eligible for new loans after about half of the current loan is paid off.  Assume that if the lender had not contacted the borrower, the customer would eventually contact the borrower half the time.  0.5 * 24% = 12%, so adding 12% to 75% where the customer initiated the loan brings us to 87%.  Before the pandemic, an HCC agent would show up once per week to collect payment.  Even if the agent were not directly pushing for the client to take a new loan, the agent's weekly presence would be a regular reminder to the client that he could borrow more.  Coupled with a sudden need for cash for repairs or other pressing events, it's hard to see the client not asking about borrowing more.  Under new guidelines, the lender can still offer new loans, he just needs signed permission beforehand.  Assuming marketing raises borrowing more than halfway from 87% to 100%, 93.5%+ of the original amount is lent even with restricted marketing.  Assume a 6% revenue reduction due to changes in marketing.

   - Refinancing is more expensive overall than concurrent lending and customers should be able to make informed borrowing decisions

       In addition to changes in marketing practices, the FCA wants to reduce costs associated with repeated borrowing.  It's not currently concerned with the high interest rate HCC lenders charge because the lenders charge few if any fees for late payments and payments are usually made weekly so borrowers who aren’t great at saving don’t suddenly owe a large amount at the end of the loan which they can’t repay.  The FCA believes that the cost for HCC loans accumulate because of how customers refinance loans.

       When a customer wants to borrow more before paying off an existing loan, they typically roll the principle on the existing loan together with the newly borrowed amount into a new loan (refinancing).  A less common alternative is to pay off the original loan as planned and concurrently start a new loan (concurrent lending).  In the refinancing option, principal on the original loan is typically paid off over a longer period, so total interest paid is higher.  Advantages of refinancing are that it's simpler because there's only one loan and initial payments after rollover will be lower.  The FCA wants to steer customers towards concurrent lending instead of refinancing to lower the total interest paid, so it mandated that lenders explain the different lending options available to customers. Pg 33 of the FCA document [2] shows a typical case where the customer saves 13% in interest payments by choosing concurrent loans over refinancing.  Assume 13% is the average savings when choosing concurrent loans.  The FCA also says ~30-40% of HCC loans are refinanced with additional borrowing.  Taking the midpoint of 35%, assuming refinanced loans and non-refinanced loans have the same average value and all formerly refinanced loans become concurrent, interest payments are reduced by ~0.35*13% = 4.5%.

       The FCA says HCC credit users often have limited or irregular incomes, so they may prefer lower initial weekly payments.  Lenders also believe that having a single loan makes it easier to budget for because weekly payments are consistent.  As a result, borrowers may continue refinancing even when concurrent loans save money.  Assume that 1/3 of customers who chose to refinance would choose concurrent lending if offered the option, so interest payments are reduced by 1/3 * 4.5% = 1.5%  Assume revenue decreases by 1.5% when customers become widely aware of the refinancing option.

   - Early settlement charges should not be charged when a customer refinances their loan

       Morses Club doesn’t charge for early settlement.

3. Adapting to covid-19

Section summary:

   - During covid-19, the subprime population grew 20% and MCL performed multiple job functions online while payment rates didn't drop noticeably

   - In the bull case valuation, I'll assume that the larger subprime population and online efficiencies increase revenue by half of their estimated values to 10% and 4.6% respectively.  Base and bear cases are unchanged.

   - A prolonged covid-19 pandemic with restrictions like those experienced in 2020 would strengthen MCL by killing weaker competitors

     A defining feature of HCC is face to face contact to collect payments while covid-19 has severely limited in-person contact.  In response, MCL accelerated the roll out of online features.  All staff worked from home and they closed 90 of 91 administration branches and offices.  67% of customers now lend completely remotely (17% last year) and 80% of cash collections are done remotely (39% last year).  Independent lending agent commissions were reduced by £7M in FY2021 and are expected to reduce a further £1M this year.  Non-payment rates showed little change since remote transactions increased, so the savings may be permanent.  In the bear and base case valuations described later in this report, I assume no savings.  In the bull case I reduce agent commission by £4M (half of the estimated £8M in savings)  for every £86.4M (FY2021 traditional HCC revenue) in revenue, or 4.6%.

     Looking at the industry, as a form of subprime lending, HCC does better when the country is under financial stress.  The FCA estimates that the subprime market grew 20% from 10M people in 2/2020 to 12M as of 11/2020.  I'll assume no revenue increase due to the larger subprime population in the bear and base case valuations and a 10% increase (half of 20%) in the bull case.

     If covid variants develop that cause the UK to lockdown again, HCC lenders may once again be unable to physically reach customers, hurting earnings.  However, as long as the lockdown eventually ends, another lockdown like 2020 lasting 1-2 years would benefit MCL.  During 2020, MCL was marginally profitable and cash burn was manageable, while at least 35% of smaller competitors went bankrupt, the largest lender decided to withdraw from the industry and the survival of the third largest lender depends on approval of a highly-dilutive capital raise.  Another lockdown would kill more competitors while MCL treads water, leaving MCL as the strongest remaining player to take even more market share.  Covid should reach a manageable state within a few years since the UK doesn't suffer from vaccine hesitancy like in the US.  As of 7/23/2021, 88% of UK adults received at least one dose vs 69% of the US.  For reference, the 1918 flu pandemic took two years to resolve with 100-year-old medical technology.  It's hard to imagine lockdowns continuing beyond a few years.

4. How much will MCL's revenue increase by acquiring customers from withdrawing companies?

Section summary:

   - Assume that if MCL has x% market share among healthy companies, it can take x% of the customers from companies leaving the market.

   - Use the above point and customer counts for each company to estimate the potential number of customers MCL can acquire

   - MCL has higher underwriting standards than the companies withdrawing from the market, so it won't lend to all potential customers

   - Assuming MCL lends to 25% (bear case) and 50% (base and bull case) of potential customers, future revenue increases by 35% and 69% respectively

   - If MCL has x% market share of healthy companies, it can take x% of the customers from companies leaving the market

       To estimate how many customers MCL can acquire, first break companies into those healthy enough to take market share (as measured by customer counts) and those companies leaving the HCC market.  I'll assume that if MCL has x% market share of healthy companies, it can take x% of the customers from companies leaving the market.  The reasoning is that companies primarily gain new customers through friends and family of current customers [3].  The more customers the healthy company has, the more likely the company can recruit customers from companies leaving the market.

   - Estimate the current number of customers from healthy companies to find MCL's market share among healthy companies

       The HCC industry consists of 3 large companies that provide annual customer counts, Provident, MCL and Loans at Home, and ~400 smaller companies that don't.  I'll make various assumptions to estimate small company customer counts, then discuss which companies are healthy and which will withdraw.  The FCA said that the industry had 1.6M customers as of 2016 year end, so we can determine that small companies collectively had 428K customers.  Provident's customer count dropped sharply from 2016 - 2019 due to restructuring, while Loans at Home declined slightly and MCL increased.  Since Provident was unusual, assume small companies were more similar to Loans at Home and MCL and customer counts didn't change.  Provident, MCL and Loans at Home collectively shrank customer count by 20% in 2020 during covid-19, but are all still operating.  Assume that the smaller companies would also shrink by 20% to 342K if all of them were still operating, however 35% went bankrupt by early 2021.  The bankruptcy rate is likely higher today, so let's assume 40%, leaving 205K (342K * 60%) customers with small companies which didn't go bankrupt.

       MCL (180K customers near 2020YE) has no problem taking market share from bankrupt smaller players.  Loans at Home (72K) may not be able to take market share due to its parent company's financing issues, but I'll assume they can as a conservative assumption and because Loans at Home itself is healthy.  Provident tried to sell their HCC unit on 3/15/2021, but couldn't find a buyer, so they started running off their book on 5/10/2021.  Assume Provident runs off their HCC loan book and among the smaller players who didn’t go bankrupt, only half of them are healthy enough to take market share.  The other half suffer from customer complaints, new regulations, no infrastructure to electronically transfer funds during covid, etc. and are too busy surviving.  This means that healthy companies that can take market share have (180K [MCL] + 72K [Loans at Home] + 205K * 0.5 [smaller players]) = 354.5K customers.  MCL has 180K / 354.5K = 51% market share among healthy companies.

   - Find the potential number of customers MCL can acquire by estimating the number of customers from companies withdrawing from the market

       I assumed earlier that if MCL has x% market share of the healthy companies, it can take x% of the customers from companies leaving the market.  So MCL can take 51% of customers from companies leaving the market.  Assume that in two years, demand for HCC loans returns to the pre-covid 2019 level.  In 2019, Provident had 522K customers while smaller companies that are presumed bankrupt had 171K customers (40% that went bankrupt * 428K customers).  MCL can take 51% of (522K + 171K) = 352K customers.  As the market leader with the highest customer satisfaction, MCL should be able to take a larger share, so 352K is a lower estimate.

   - Estimate MCL's increase in revenue from taking market share

       For the base case, assume that only 50% of the acquirable customers meet MCL’s underwriting standards, so MCL acquires 176K customers, a 69% increase over MCL’s 2019 customer count.  Further assume that revenue is proportional to customer count, so revenue also increases 69%.  For the bear case, I'll assume that only 25% of customers meet MCL’s underwriting standards, so MCL revenue increases 34.5%.  While a 69% increase in customers is a large amount to absorb, MCL routinely acquires a few smaller companies per year and has in the past merged with another company many times larger than itself.  New customers will also be absorbed over two years, MCL has not fired any staff during covid and 82% of independent lending agents remain.  Existing lending agents can take new clients with low marginal effort given MCL’s network density and the recent shift to collecting some payments electronically.

5. Valuation

Section summary:

   - Bear case (only 25% of acquirable customers meet MCL's lending standards): EV/EBIT = 5.4; EV/(EBITDA - mcapex) = 5; estimated return by comparing EV/EBIT with peers = 95%

   - Base case (50% of acquirable customers meet MCL's standards): EV/EBIT = 3; EV/(EBITDA - mcapex) = 2.8; estimated return = 256%

   - Bull case (50% of acquirable customers meet MCL's standards, revenue increases due to a higher subprime population and online efficiencies): EV/EBIT = 2.1; EV/(EBITDA - mcapex) = 1.9; estimated return = 422%

   - 2.8x EV/(EBITDA - mcapex) is too low for a good quality company with dominant market share which is resilient to covid-19, customer complaints and government regulations and is about to benefit from a multi-year tailwind

       Previous sections estimated how MCL could benefit from withdrawing competitors, cuts in lending agent costs from digital efficiencies and a larger subprime population following covid-19.  I also estimated losses from customer complaints and government regulation.  I value MCL by starting with FY2020 and applying estimated gains and losses under different scenarios to estimate income in two years.  I chose FY2020 because it’s the only year where MCL was heavily invested in the digital platform and because FY2020 ends on 2/29/2020, before covid had begun to strongly affect the UK economy.

   - Base case

     I apply the following corrections discussed earlier to the FY2020 income statement (pg 20):

69% increase in revenue by taking share from small bankrupt companies and Provident as it withdraws from the market

6%, 1.5% and 4.4% decreases in revenue from changes in marketing, refinancing and customer complaint fees respectively

Omit covid-19 impairment and exceptional items which MCL won't see in two years

Assume impairment, agent commission, depreciation, amortization and funding costs scale 1 to 1 with the new revenue after applying all adjustments except for complaint fees. (e.g. - if rev increases 50% then impairments increase 50%)

Administration expenses for the traditional HCC unit decreased 17% from FY2016 - 2020 despite a 28% increase in customer count, so assume that administration expenses remain fixed.

Tax rate doesn't change

     The vast majority of capital expenditures were for growing the digital unit and MCL has no plans to decrease spending.  It's also unclear if the digital unit will be profitable, so I replaced mcapex with capex when calculating EV / (EBITDA - mcapex). Capex is limited to £5M per year due to a new funding arrangement, so set mcapex to £5M.  For EBITDA, subtract acquisition cost since it's a cash cost.  EV adds back two weeks of revenue held as cash in order to make quick loans.

     EV/EBIT = 3

     EV/(EBITDA-mcapex) = 2.8

     P/FCF = 3.3

   - Bear case - fewer potential customers meet MCL's lending standards

     Similar to the base case, but only 25% of customers leaving Provident and bankrupt smaller companies meet MCL's underwriting standards vs 50% for the base case.

     EV/EBIT = 5.4

     EV/(EBITDA-mcapex) = 5.0

     P/FCF = 6.6

   - Bull case - subprime population growth and lending agent cost savings

     Similar to the base case, but assume revenue increases by only 10% due to a 20% increase in the subprime population and revenue increases by 4.6% due to the realization of half the estimated cuts in lending agent commissions from digital efficiencies.

     EV/EBIT = 2.1

     EV/(EBITDA-mcapex) = 1.9

     P/FCF = 2.2

     Given the uncertainty surrounding MCL and HCC lenders in general, DCF is not appropriate.  Instead, I estimate gains in share price by comparing EV/EBIT with peers in 2019.  The closest peers were Provident and Non-Standard Finance (NSF), the parent company of Loans at Home, where 30% and 33% of revenue respectively came from HCC in 2019.  EV/EBIT near 12/31/2019 were: 11.9x for NSF, 8.5x for Provident, and 13.8x for MCL (excludes exceptional items in the calculation).  MCL was higher because they sharply increased digital capital expenditures while digital had yet to generate income.  Provident had a lower multiple due to many years of losses and restructuring that was winding down in 2019.  I’ll use the average of the lower two values, 10.2x EV/EBIT, as a more conservative reference value.

     Bear, base and bull case returns were 95%, 256%, 422% respectively.  MCL performs well even in the bear case which doesn't benefit from a larger subprime population or lending agent cost savings and MCL only writes loans for 25% of potential customers due to weaker underwriting standards.

     Let's see if MCL is a good business to determine if the 10.2x EV/EBIT is reasonable.  Base case ROE is 25.6%.  Good companies often have barriers to entry.  The HCC industry has stringent regulatory requirements to become a lender and you need expertise to assess credit risk as well as high quality customer data (MCL has over 100 years of data and the second largest customer count).  A strong agent network like MCL's is necessary to reach customers in a cost-effective manner and since most new customers come by way of referral from friends and family of current customers, trust built with customers is crucial for good advertising.  MCL doesn't give customer retention figures, but retention is likely high given that 97% of customers are satisfied with the company, 97% of customers are likely to consider using MCL in the future and 94% are likely to recommend MCL to friends and family.  Finally, MCL is shareholder friendly, having distributed 47% - 89% of pre-tax earnings as dividends from FY2018 - 2020.  Overall, company quality is above average.

     Looking at valuation in another way, in two years, MCL will be the dominant competitor with 33% market share which is 2.6x larger than the next largest peer, MCL has minimal debt,  97% customer satisfaction and the lowest customer complaint rate.  Covid-19, customer complaint fees and government regulations bankrupted over 1/3 of smaller peers and caused the largest company to exit the industry.  Meanwhile, MCL experienced limited impact, can take 51% of customers from competitors who are withdrawing from the market and will continue to strengthen whenever the industry is damaged.  There are moderate barriers to entry and the company is shareholder friendly.  As a subprime lender, MCL will experience a multi-year upswing following covid-19 and will further benefit from cost cutting in lending agents and fewer offices, neither of which is accounted for in the base case valuation of 2.8x EV/(EBITDA-mcapex).  While there is uncertainty around the valuation, covid-19, customer complaints and future regulations, it's hard to see 2.8x as fair value.

6. Risks

Section summary:

   - New regulations won't come for a few years and as the strongest company in its sector, MCL is well-positioned to cope with them

   - The digital unit (online lending) may be unprofitable for years, but its small size and large improvements in the rest of the company will mask its losses

   - Provident is highly likely to finish running off its HCC unit

   - In general, alternatives to HCC are either more expensive and harder to repay or are not available to the typical HCC customer

     - New government regulation

       The latest guidelines were issued in 2020, so new regulations are unlikely for at least a couple years.  When they are issued, HCC is the least harmful of all types of high cost credit and MCL is the strongest among HCC companies, so new regulation will affect MCL the least.  New regulations will make it harder for smaller competitors to adapt, leaving MCL to take more market share.  While government regulations can be unpredictable and can harm MCL, MCL's conservative underwriting, financial strength and dominant market share leave it well positioned to cope with if not benefit from regulation.

     - Digital unit continues heavy losses

       With the digital unit (primarily online lending) playing an increasing role, let's see what effect the unit has on valuation by breaking apart the digital unit and the traditional HCC unit (agent shows up at the customer's doorstep).  For FY2021 (ended 2/2021), traditional was 86% of revenue, operating income was £12.5M, ROE was 18.5% (30.1% in FY2020 ending 2/2020) and impairment as a percentage of revenue was 15% (typically ~23%).  ROE is profit after tax divided by rolling 12-month average of tangible equity where tangible equity is net assets less intangible assets less acquisition intangibles.  Digital was 14% of revenue, operating income was a loss of £9.7M and impairment as a percentage of revenue was 55% despite tightening lending standards (49% in FY2020).  Digital capex was also 125% larger than traditional capex.  While digital is clearly a drain on overall results, one advantage is that it offers longer term, lower interest rate loans to traditional HCC customers with good payment records, addressing regulatory concerns about excessive relending and growing loan balances.  Also, the digital and traditional HCC units overlap in remote payment collection and performing other services online, so the digital unit is useful even if it isn't profitable.  Still, the large digital loss is a severe handicap and there's a risk that digital continues to expand and underperform traditional.  

       New funding arrangement limits capex to £5M per year, so cash burn from digital capex will be limited.  Management also said during the earnings call in 5/2021 that the digital unit is on schedule to achieve run-rate profitability by the end of FY2022, which would have increased total operating income by 78% in FY2021 and 37% in FY2020.  While digital losses improved in all cases of the valuation work done in a previous section, EBITDA was always negative, so it remains to be seen what management can do.  In any case, large improvements over the next few years in the traditional HCC unit should mask digital losses, but digital should be monitored carefully.

     - Provident doesn’t run off its HCC unit

       Provident announced on 3/15/2021 plans to sell its HCC unit or place it in managed run off.  The unit was subsequently put into managed run-off on 5/10/2021 after only receiving one offer to help wind down the division – Provident opted to manage the run off by itself and expects to finish in 2022.  Also, the FCA agreed to Provident's request to not allow it to offer more loans.  Provident will contribute any profit from the remaining loans to the Scheme of Arrangement to pay off customer complaint fines.

       Provident is unlikely to find a buyer given that no credible offers have been made in three months, the run off already started two months ago while most new loans are for a year or less.  A potential acquirer also wouldn’t receive profits from the remaining loans and uncertainty remains over customer complaint fines and any future regulations.  A buyer is very unlikely at this stage and becomes less likely every day.

     - Switching to alternatives to HCC

       I haven't considered that HCC borrowers might switch to other forms of credit in this report because other credit is less favorable or difficult to obtain. In a report commissioned by the FCA [3], among six types of high cost credit, HCC came out as the most favorable towards consumers.  For example, 21% of HCC users had to cut back on spending to meet repayments vs 35-75% for other forms of credit and 21% of HCC users regret borrowing vs 28-63% for the others.  While HCC customers do use multiple products, it's hard to see customers making a large scale shift to more expensive or less convenient products.

       It's also hard for HCC customers to obtain lower cost credit as detailed in a 2019 FCA report [4]: “It was very clear from the qualitative interviews that very few if any alternatives to home collected credit were being considered... Of the small number that had considered alternatives, none of these [alternatives] appeared to have been feasible."  Lower cost credit often requires higher incomes, better credit scores and longer credit histories.  Credit decisions are also not made on the spot and customers need to go to the lender rather than have the lender come to them.  MCL plans to develop lower cost digital products, but the variety of currently available products and uptake are low.  Given the lack of better options, an HCC user whose lender has left the market is most likely to find another HCC lender rather than to try another type of credit.  HCC users who do switch are just as likely to be replaced by other credit users switching to HCC.

References

[1]  Relending by High Cost Lenders https://www.fca.org.uk/publications/multi-firm-reviews/relending-high-cost-lenders

[2] High-cost Credit Review: Consultation on rent-to-own, home-collected credit, catalogue credit and store cards, and alternatives to high-cost credit Discussion on rent-to-own pricing

https://www.fca.org.uk/publication/consultation/cp18-12.pdf

[3] Relending in the high cost credit market

https://www.fca.org.uk/publication/research/relending-high-cost-credit-market-narrative-report.pdf

[4] Alternatives to high-cost credit

https://www.fca.org.uk/publication/research/alternatives-high-cost-credit-report.pdf

Catalyst

Financial results over the next two years show large improvements from taking market share, an increasing subprime population and cost cuts which dwarf losses from covid-19, customer complaints and government regulations.