Small Caps | Jul 13 2017
Canaccord Genuity has initiated a Buy recommendation on ASX-listed Scottish Pacific Group, saying the debtor finance company could grow steadily once it beds down recent acquisitions.
-Scottish Pacific has potential to grow faster than competitors
-Scottish Pacific needs to satisfactorily integrate recent acquisitions
-Peer-to-peer lending not seen as a genuine threat
By Nicki Bourlioufas
Small caps specialist Canaccord Genuity has initiated coverage of Scottish Pacific Group ((SCO)) with a Buy recommendation, accompanied by a price target of $2.94. The stock currently trades around $2.77.
Valuation and outlook
Scottish Pacific listed in July 2016 at $3.20 per share, but missed its prospectus earnings forecast and has drifted to $2.77 after a guidance downgrade in November.
Canaccord Genuity values Scottish Pacific at $3.13 a share using a discounted cash flow methodology but it notes any future re-rating by the market will depend on the company’s ability to increase revenue and to satisfactorily integrate recent acquisitions. With these factors in mind, the maiden price target was set at $2.94.
The one broker in the FNArena universe that also covers the stock is Citi, which is currently rating the shares Buy with a price target of $3.50.
Debtor finance Industry
Scottish Pacific is the leading independent debtor finance company in Australia, holding about 20% of the market. The Debtor and Invoice Finance Association says the market has total turnover of about $65m a year.
Debtor finance is attractive to SMEs, companies with short trading histories, and those experiencing rapid growth or needing working capital. Companies pledge their receivables as collateral, so property is not required as security. A facility acts like revolving line of credit, automatically adjusting to the value of the client’s invoices on issue. The major business risk Scottish Pacific faces is fraud by clients and their debtors.
Scottish Pacific background
Scottish Pacific has about 1,750 clients, with about 60% of its leads coming from its broker network and accountant contacts. It turns over 20% of its client base every year, so constant business development is imperative.
The business has operated for about 30 years and broking analysts highlight its executive ranks have a considerable depth of management experience in the industry.
Scottish Pacific securitises its clients’ receivables by selling them into special purpose funding vehicles. Each of its three facilities has a senior lender that contributes 85% to 90% of the funding, plus a group of mezzanine lenders. Two of the senior lenders have provided funds for more than a decade.
Scottish Pacific also offers trade finance, which helps importers manage their long working capital cycle, based on its purchases of Tradeline in 2012 and Sterling Trade Finance in 2017.
During the eight months before it listed, Scottish Pacific bought competitor Bibby Financial Services and the debtor finance businesses of GE Capital Finance and Suncorp.
“Integrating Bibby proved problematic: Scottish Pacific tweaked some of Bibby’s unique products to match its credit policies, prompting higher than usual levels of client attrition. The market is watching to see whether Scottish Pacific can complete the integration process smoothly and increase revenue to offset the costs of adjustment,” said Canaccord Genuity in its first report on the company.
Some of the larger clients from the GE and Suncorp books also reduced borrowing, prompting the company to issue a guidance reducing its forecast of Earnings Before Interest and Tax (EBIT) by – 9% below the prospectus forecast.
In the wake of the acquisitions, and cuts to employee incentives after it missed the prospectus forecasts, Scottish Pacific is facing an employee cost of about $3m.
However, Canaccord Genuity maintains Scottish Pacific enjoys strong growth potential. “The recent onboarding of clients from the GE and Suncorp portfolios should improve its ability to pitch for larger accounts, and wider marketing of new products inherited from Bibby offers the potential of better margins and new client wins. Earnings translate strongly into operating cash flow, facilitating a high dividend payout ratio which should provide share price support.”
New products to expand opportunities
Scottish Pacific is developing a range of niche products that could appeal to a broader range of clients. One example is selective invoice financing, which provides loan funds against specific debtors rather than a client’s entire portfolio of receivables.
Another is bad debt protected facilities, under which the company takes out insurance against the risk of debtor default and agrees not to recoup most of the cost of any bad debts from the client.
Progress claim finance makes debtor finance available to companies in the construction and contracting sector.
Scottish Pacific inherited several such products from its Bibby acquisition, and it expected to increase marketing once it has structured them in a manner consistent with its existing credit policies.
Downside risks
Like all debtor finance providers, Scottish Pacific is exposed to fraud events. As protection, the company relies on its underwriting experience to identify risks, implement proper credit process and diversify its exposures.
The company’s acquisitions from GE Capital Finance and Suncorp have given rise to some client concentration, with its largest client having a facility of $80m. However, this concentration risk is lessened slightly by the 12-month contracts and three-month notice periods for terminating debtor finance facilities.
Canaccord Genuity says Scottish Pacific is highly dependent on its senior lenders, which provide up to 90% of the capital it advances to clients.
To preserve these relationships, as well as its reputation, the company must guard against any deterioration in the credit quality of the receivables portfolios it sells into the special purpose vehicles.
As the provider of first loss capital, Scottish Pacific is also in the front line – along with other mezzanine lenders – in the event of any defaults.
At least half a dozen fintech entrants are active in the Australian debtor finance market, using peer-to-peer platforms to link borrowers with sophisticated investors.
Several players require clients to link their accounting data via accounting software providers such as MYOB ((MYO)) and QuickBooks.
“While we believe these businesses are small at present, the ability to provide businesses with a fast and flexible form of financing is likely to be an attractive proposition to SMEs.
“The establishment of sustainable market share is dependent on increased liquidity on their respective platforms, which will require maintenance of strict credit processes to minimise investor losses. Should any of the online models experience high levels of losses, this may sour broader support for P2P debtor financing as an investment class.”
As a result, true disruption to Scottish Pacific’s business remains unlikely, Canaccord Genuity concludes.
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