QUALIPORT
No Credit For Provident Financial

By Maynard Paton (TMFMayn)
July 2, 2001

Carburton Street, London -- Following the revival of the Qualiport's watch list, today's feature will review one of the candidates mentioned as a possible watch list member -- Provident Financial (LSE: PFG). While high margins and low fixed asset requirements make Provident an attractive business, it's negated by a dreary and somewhat questionable cash flow performance.

The business

Provident is the UK's leading doorstep moneylender. The company is said to have to half of the country's 3m customers who rely on this particular type of borrowing. Customer loans are advanced, and repayments collected, via a 12,000-strong agent network. Loans are relatively small, typically less than £500, unsecured, and usually repaid over a year. With many Provident customers seen as poor credit risks, APRs are high. For a £500 loan, £810 is reportedly collected over the subsequent twelve months.

There are two important points to note with Provident's agent network. Firstly, agents' remuneration is based on a percentage of money subsequently collected rather than the amount borrowed. This obviously limits the risks of bad debts, which are, perhaps, more prevalent in Provident's type of operation than in more mainstream areas of lending. (Bad debts ran at 8.1% of credit issued for Provident during 2000).

Secondly, Provident's agents tend to generate customer loyalty. The personal nature of Provident's doorstep lending ("if she's got enough time, she'll stop and have a cup of tea" claims one UK customer in the Provident Annual Report) can help prevent other sources of credit luring the customer away.

Provident is also taking its lending skills abroad. The group has recently started ventures in Poland, the Czech Republic and South Africa, although these operations are loss-making at present. Away from moneylending, Provident also has a UK motor insurance division. This business focuses on low-risk drivers, principally women drivers, drivers of second and older cars, and low mileage drivers. During 2000, 20% of group operating profits came from insurance.

The financials

Here's Provident's five-year record:

To December 31st            1996    1997    1998    1999    2000

Turnover (£m)                430     444     506     583     728
Operating Profit (£m)        104     127     144     151     165
Pre-tax profit (£m)          119     137     146     155     161

Earnings per share (p)      29.3    34.4    39.8    42.8    47.4
Dividend per share (p)      16.5    19.5    22.5    24.8    27.3

The above table doesn't really do justice to Provident's longer-term record. Earnings and dividends per share have compounded at around 20% since 1991. That said, growth has noticeably slowed of late as the UK lending business has gradually matured. Indicating the high mark-up on its loans, Provident's operating margins are a very healthy 24%.

Tangible assets and return on equity

One very welcome feature of Provident's accounts is the company's complete lack of fixed assets. Just £26m worth of fixed assets was needed to generate £165m of operating profit during 2000. Indeed, with an operating profit to tangible fixed asset ratio of 6.2, the company has the lowest requirements for fixed assets within the FTSE 100.

Unfortunately, calculating a sensible incremental return on equity figure is impossible for Provident. After paying a £94m special dividend in 1998 and initiating share buybacks totalling £82m during 1999 and 2000, the company's asset base is now smaller than it was in 1997.  Increasing profits on a shrinking asset base -- what a great business! For the record, return on average equity employed during 2000 was a very impressive 42.1%.

Cash flow

This is where things become decidedly cloudy. Accounting profits are not entirely backed up by cash.

To December 31st            1996    1997    1998    1999    2000

Group Operating Profit (£m)  104     127     144     151     165

Change in (£m):
Working capital              (34)    (57)    (64)    (47)    (97)
Unearned insurance premium   (26)     (7)     11      22      43
Insurance claims provision    10      (4)    (11)    (7)      25

While I recognise that speciality finance companies do generally have large working capital cash outflows (anyone for Independent Insurance (LSE: IIG), Versailles or Helphire (LSE: HHR)?), it is difficult for the ordinary investor to obtain any reassurance that all is well when faced with such inherently "poor" cash flow characteristics.

In the above table, the "working capital" is the line to focus on. The line highlights the cash movements relating to the money lending businesses and shows anything up to two-thirds of group operating profits subsequently absorbed into the debtor ledger.

Another point to note is the restrictions placed on the cash flow generated by Provident's insurance operation. While throwing off plenty of cash lately, the performance flatters Provident. During 2000, out of the £56m generated by the insurance business, £47m was set aside to meet capital adequacy requirements and thus not readily available to benefit shareholders.

But the most worrying cash flow issue surrounds the embryonic international operations. Relatively huge amounts of working capital have been absorbed into these ventures for little incremental gain.

To December 31st            1996    1997    1998    1999    2000

International
Operating Profit (£m)          -      (1)     (5)     (8)     (7)

Change in
Working capital (£m)           -       -      (4)    (19)    (50)

To plug the general cash flow gap, Provident has taken on greater debt. Since 1997, borrowings have doubled to £370m, part of which helped fund the aforementioned special dividends and buybacks.

Summary

While being a Provident customer is perhaps a little unFoolish, there are definite investment attractions to the company itself. Its money lending operation is a steady and stable industry-leading business that exhibits high margins and low capital expenditure requirements.

In terms of a sustainable competitive advantage, it's Provident's agent network that is key. Overall I'd say that the "personal lending" nature Provident's network, given that there appears to be a high retention and referral rate within its seemingly price-insensitive customer base, is a major and not-easily-replicated asset. However, one big question is whether Provident's customers will remain with their friendly agent when an increasing number of mainstream alternatives (notably, the Post Office's Universal Bank) continue to emerge. Turning to the group's insurance operation, I'd be very hesitant to say this particular business has any worthwhile competitive advantage.

But my main fear with Provident concerns its cash flow, especially that of its overseas businesses. I can't really square the size of the international cash outflows with the associated profit performance. I could be wrongly interpreting Provident's overall cash flow, but a favourite motto of mine is "if in doubt, stay out".

And another disconcerting sign is the forthcoming retirement of Provident's Chief Executive in September. Given the company is at a critical operational stage with expanding its fledgling overseas businesses, I'd really prefer to see some boardroom stability over the short to medium term.

Overall, cash flow question marks and an involvement in insurance, an area that I've never felt comfortable with, means I can't really justify giving Provident a place on the Qualiport watch list. Don't get me wrong -- Provident appears to be a fine business in many ways. But there are plenty of other fine companies that have far more understandable and appealing cash flow and working capital characteristics too.

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