Tuesday 28 February 2017

Giving Money3 a wide berth

I recently took a quick look at ASX-listed Money3 (MNY AU). A well-known NZ-based small-cap outfit own it and have labelled it one of their top picks, and Ray Malone, of AMA Ltd fame (AMA AU), is also the (non-executive) Chairman. I have followed AMA for a long time and admire the company and what Malone has achieved with it, and made good money on the stock in the past (although I am long out of the stock now - I bought at 5c but sold way way too soon, at about 15c). MNY has also been growing quickly and the stock has done well over the past five years, and trades at superficially modest earnings multiples (a low teen forward earnings multiple, although closer to 2x book).

What I found horrified me, and it suffices to say that I won't be investing.

Who are Money3?

Money3 is a leading player in Australia's rapidly-growing non-conforming lending market, focused on sub-prime secured automotive lending, as well as unsecured personal loans to non-conforming borrowers. The company has been growing like a weed in recent years, and has continued to issue bullish earnings growth guidance to the market.

Red flags abound

A cursory analysis of this company immediately raises a number of red flags:

*Firstly, in the company's results commentary and presentation materials, there is absolutely no reference to asset quality trends. Quite shockingly, in the company's recently-released fiscal 2017 interim accounts, there is absolutely no disclosure on asset quality trends whatsoever - even in the footnotes to the accounts. The only disclosure proffered relates to bad debt expenses, which, according to the company, fell (paraphrasing) 'from 3.5% to 2.5% of the book YoY'. However, this relates only to what the company elected to write off in the P&L, and says nothing about how conservative or aggressive this election was in light of underlying asset quality trends.

*Secondly, the above omission comes in spite of the fact that the company's full-year fiscal 2016 disclosures (which mandated the inclusion of some asset quality information in the notes to the accounts) exhibited a fairly stark increase in overdue loans as a percentage of the company's total loan book (see below). More specifically, current and less than 1mth overdue loans (aggregated, so we don't even know what percentage of the book is current) fell from 80.1% of the book to just 65.9% of the book in 2016, while 1-3mth, 3-6mth, and >6th overdue loans all increasing very significantly, with faster growth in the more significantly overdue categories. Furthermore, this occurred despite rapid continuing loan book growth, which means that the seasoned book likely performed even worse. There was not even a passing reference to this rapid deterioration in asset quality in the company's 2016 result commentary and presentation materials.

By comparison, provisioning was woeful. For instance, at fiscal 2016 year-end, the company had provisioned for only 28% of its greater than 6 month overdue loans. Six months overdue! This appears very aggressive to say the least - particularly because (1) not all of MNY's loans are secured; and (2) for secured auto loans, the cost of repossession and disposal of collateral is typically very high - particularly lower-priced cars which sub-prime borrowers likely disproportionately purchase. If MNY had adopted a more conservative approach to provisioning, it is likely it would have fallen well short of its 2016 earnings guidance.

*Thirdly, the company's investor communications have focused purely on trends in loan book growth, and growth in 'EBITDA' and earnings. EBITDA growth is a wholly irrelevant number for a lending institution, and indicates that this company is being run like it is an industrial company, rather than a financial institution. This is a big red flag. Ray Malone has a strong track record with AMA, but I worry that he lacks experience in the financial sector and is presiding over a much riskier business model than he may be presently aware (and is putting his hard-won reputation at risk as a result).

Financial stocks are not like industrial stocks

Inexperienced investors in the financial sector focus on headline earnings and balance sheet growth, ROEs, and PE ratios, in a similar manner to industrial companies. Experienced investors, however, know that in isolation, these metrics are irrelevant if not downright dangerous for financials. This is so for a number of reasons:

*Firstly, unlike industrial businesses, financials get paid for taking risk, so a high ROE may be less a sign of robust operations & a strong competitive position (unlike what is usually the case for non-financial businesses), and more a sign of high leverage and/or excessive risk-taking. This is one reason why financial investors usually focus more on multiples of book than multiples of earnings, because you can juice your earnings and ROE by taking more risk.

*Secondly, unlike for most industrial businesses, you do not find out if the profits financials are reporting are real for many years. It is easy to grow reported profits fast by making a lot of new loans or writing a number of insurance policies quickly, and then reserving for bad debts and future claims optimistically. You only find out later if the provisioning & claims reserves taken against these loans today are adequate or not. If they are not, the profits booked in prior years can prove illusory and have to be completely reversed/written off in subsequent years as loss development emerges.

Because of this, the P&L results of a financial cannot be sensibly evaluated without a concurrent analysis of asset quality trends; the conservatism of reserving; and an analysis of the level of risk that is being taken to deliver those earnings. The lack of any such disclosures by MNY is therefore a truly shocking omission, and is symptomatic of either incompetence or of an active intention to obfuscate (I'm betting more on the former, although it may morph into the latter if asset quality keeps deteriorating - particularly because the company has committed itself to aggressive earnings targets).

*Thirdly, very rapid growth of any financial is usually a red flag. Financials should be run not by marketing people, but by capable and prudent risk managers. Rapid growth is usually a sign that a financial is being run by marketing folk. That usually results in great growth and optical returns during the bull phase of the cycle, but it almost always ends badly when the cycle turns.

A broader issue

There is also a broader issue to consider with MNY's rapid growth and its high level of claimed profitability. Automotive lending is a mature industry in Australia. It has been around for a long time, and levels of car ownership in Australia are already high. Why is it that suddenly organizations like MNY have sprung up and are able to grow so fast and so profitably?

There are two potential reasons:

*Firstly, tightening banking regulations have resulted in traditional banks/lenders retreating from the sector, creating a vacuum for outfits like MNY to fill. If this is the case, MNY will probably do ok for a while, until the space becomes crowded and/or a recession hits.

*Secondly, more experienced institutions with better data sets may be aware that the types of customers MNY is lending to are bad credits, and so have avoided lending to them. If this is the case, MNY will likely fare very poorly - particularly because Australia is very late cycle at present and is overdue a fairly severe recession & housing downturn.

Recent trends in MNY's asset quality suggest that the latter explanation is more likely the case than the former. Every cycle, a new batch of naive and aggressive go-go lenders and financial engineers emerge that make the same mistakes as the former crop during the prior cycle (which all invariably went bust). As the carnage of the prior cycle is forgotten, investors begin to fund re-birthed organizations that rediscover and rush in to fill the putative voids left by the prior wave of second-tier lenders. MNY appears to be singing from this song-sheet.

The best that can be said of the company is that they have kept their leverage relatively low (to date), financing their growth primarily (but not exclusively) via equity issues. That is a good thing and reduces the risk of a complete wipe out. However, at 2x book, with aggressive guidance having been put into the market, it will only take one profit downgrade to send this stock down 50%.

I wish MNY holders good luck. They will need it in my view.


*The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.