Purchase #1: Thorn Group Ltd (ASX:TGA)
My first purchase for the portfolio was Thorn Group Ltd (ASX:TGA), a financial company that primarily provides leases to retail and some business customers.
It is an ugly company, with an unspecified regulatory penalty from ASIC hanging over its head (although they have set aside $4 million in provisions for this), recent regulation which capped the amount of profits they can earn going forwards, and now a class action against them alleging improper conduct.
I have bought it primarily because it is cheap and because I think the business is more sustainable than the market is expecting. Here are some quick stats:
Thorn Group Ltd (ASX: TGA)
- $213 million market capitalisation
- 8.5% trailing dividend, fully franked
- $1.17 per share in Net Tangible Assets
- Priced at ~8.5 times forecast earnings of $24-$26 million for the current full year. This is after a $4 million impact from provisions.
In this situation, funnily enough, I’m not overly interested in how the business runs – as long as it keeps running. It’s almost a ‘special situation’, although I envision holding Thorn for years. Here are the 3 biggest concerns that I think the market is seeing with the business:
- ASIC penalty and the provisions Thorn is taking for it
- Regulation capping profitability
- Class action
I was looking at Thorn before it first mentioned a ‘contingent liability’ in response to the ASIC enquiry. At the time I mentally budgeted for around $14 million, based on not much other than some comparison with penalties that SACC lenders like Money3 and Cash Converters have paid in the past.
Either way I think the $4 million in provisions taken is lower than will be required, but it does mitigate some of the uncertainty. In the end, the penalty will be a one-off hit and I think today’s prices provide plenty of cushion.
There will be a cut to this year’s dividend – if it stays in line with profit the dividend will fall to 10 cents or so, maybe a little less.
Regulation capping profitability
After a good read of the Small Account Credit Contract review (which also investigated consumer leases) and the proposed changes, I am uncertain of the exact size of the impact to Thorn. I am however, very certain that the changes will not legislate Thorn out of business. Thorn’s pricing (even before it updated its pricing in accordance with the recommended SACC changes) was at the lower level of that investigated by government.
I actually think that the changes to the sector could be a positive, by putting unscrupulous and/or smaller operators out of business. This is an industry where scale is important, and high fees are the only way to make money – especially if you are a smaller player.
By way of illustration, imagine that you are a sole trader leasing out 1 fridge per year. You need to lease that fridge for like $70,000p.a. just to pay your costs. So how many fridges do you need to lease every year to have a viable business? 100? 300? The advantages of scale are obvious and I think Thorn could be a net beneficiary over time if price caps put higher-cost competitors out of business.
In terms of ongoing profitability (excluding one-offs like ASIC and class action), my base case scenario for Thorn assumes that the 15% hit to profit this year (caused by the reservation of provisions for ASIC) will be sufficient to cover the impact of the pricing caps. I.e., I assume that this year’s forecast profit of $24 million will be able to be maintained into the future.
Worst case scenario figures a 33% hit to profit – i.e., the impact of pricing caps is greater than expected (perhaps due to operating leverage), and profits per year drop to $20 million. Even then Thorn is priced at around 11x earnings, which would be reasonable if there were no ASIC penalty/class action. The real worst case scenario involves more ‘cockroaches in the kitchen’ but that is a bridge whose existence is uncertain, and which I will have to figure out a way to cross when I get there.
Best case scenario figures a hit to profitability of around 15%, but with some growth in revenues following the redirection of NCML (debt collection business which was divested) resources into the leasing segments. Business leasing in particular looks to be a possible source of further growth.
Since I first drafted this post, I have received an email response from Thorn CEO Peter Forsberg. He was unable to say much due to the class action, and would not be drawn into speculating on possible reduced competition. However, he did confirm that Thorn was priced at the lower end of the industry, and that the impact of the pricing caps on Thorn would be approximately $2 million next year (~8%) and would compound from there (as old leases roll off and new ones are written at lower prices).
This makes my 15% calculations appear conservative as, indeed, I hoped they were. It’s possible that the class action and noise about predatory leases will hurt demand for Thorn’s business. I have no mechanism for evaluating that however and will have to wait and see what happens.
This is the big uncertainty. A $50 million judgement would be an investment ruiner. I have not read the filing yet as I have been unable to find it on the web. Based on statements from lawyers I think the real value of the class action will be less, although it could still be weighty as it may include customers from 3 or 4 years worth of trading.
I think lawyers will have real difficulty proving that Thorn has been predatory in its pricing, although the company does seem to have a case to answer regarding the misleading advertising and automatic rolling over of contracts at the end.
The improvements in Thorn’s compliance regime (with the appointment of a Chief Risk Officer and the current regulatory attention) will likely have the intended effect of seeing the Group improve its standard of behaviour. The company has generally been proactive at responding to problems and I think this will work in its favour.
My concern is that Thorn has also been pinged previously for having inadequate controls in place to evaluate customer income and a few other things. Given that this is all in the past and difficult to quantify (since you have several years of possible wrongdoing) it is hard to value the possible impact to Thorn. I have made a preliminary decision that if the judgement was found against Thorn and was less than $25 million or so, I can live with that without it breaking the investment thesis.
This is a wait-and-see concern, although I have not been inspired with Thorn’s response so far. They have not denied the allegations nor said that they would defend them vigorously, which is par for the course for a company so accused.
Thorn is not flush with cash so the ASIC penalty or an adverse class action ruling would likely require additional capital or greater debt. However, I think that the long-term earnings ability of the business will be unaffected.
The plus side is that Thorn’s compliance regime (with the appointment of a Chief Risk Officer and the current regulatory attention) will likely be much improved from now on.
There are plenty of other things to look at about Thorn, including its Net Tangible Assets, the quality of credit on leases (which is reasonable and has acceptable impairments etc) and so on. However for me, the primary concerns and the dealmakers/breakers are the points mentioned above.
I am assuming that:
a) regulatory changes/pricing caps are not a big deal and Thorn will maintain approximately its present level of profitability, dividends, and cash generation
b) that the ASIC penalty will not be a big deal besides a one-off hit to earnings
c) that the class action may take up to 2 years to resolve, during which time I and Thorn will have plenty of warning either to exit the investment (me) or prepare itself financially for penalties (Thorn).
With this year’s forecast profits, Thorn will pay out around 9-10 cents per share in dividends, which is a 7% yield or so. I really only need 3% price appreciation per annum to earn a respectable 10% per annum on Thorn shares.
I haven’t bothered with constructing an IV or doing a DCF in this case because of all the unknowns hanging over Thorn’s head. However, I think it would be fair to think that, in normal circumstances, the company would be fairly priced at around 12x earnings, or $1.80 per share based on this year’s forecast profits of $24 million. There is the possibility, if Thorn performs better than expected and significant events aren’t as significant as the market expects, that Thorn would change hands for maybe 16x earnings – which would be awesome – but that’s a ‘lottery ticket’ and not part of my investment thesis.
On 30/03/2017 I bought 400 Thorn shares at $1.28 each, plus $14.95 brokerage, for a total of $526.95, or $1.317 per share, which I round up to $1.32 per share.
Thus my estimate is for a ~36% upside to ‘fair’ value combined with an attractive 7% fully franked dividend. Over the next 5 years that could be a decent market-beating return.
Thorn is not a multi-bagger, more like a ‘single’ in cricket terms. The uncertainties also limit me to making it just a 5% position, but I think I have a good chance of beating the market with this one.
Disclosure: I own shares in Thorn Group.