Needing a fix

The first company is Halfords (LSE:HFD). At 165p, the stock is down 6% over the past year. This isn’t a disaster of a performance, but is still at the lowest price over the 52 weeks.

The UK retailer of motor and cycle products posted some strong interim full-year results back in November. Revenue was up 13.9% versus the previous year, with group profit before tax also jumping 15.8% to £21.3m.

I think the slump in the share price recently comes following weaker than expected December trading. This was blamed on the weather, along with customers generally spending less. I think both factors are just blips. In fact, given the amount of the products sold by Halfords for car or bike maintenance, I’d expect demand to be fairly constant going forward.

A risk is that given most products are imported, the company is exposed to the exchange rate between the British pound and US dollar.

I’m considering using this dip to pick up some Halfords shares, as the broader full-year results show good momentum to me.

An off-the-wall idea

Another firm in the mix is Funding Circle (LSE:FCH). With a market cap of £114m, the business is close to being a penny stock. The share price has fallen by a whopping 40% over the past year and is at 52-week lows.

This is definitely a high-risk idea for consideration. One of the reasons for the drop in value is the increase in interest rates. This is because the business focuses on raising funding through loans for small and medium-sized firms. Given that the cost of taking out a loan has increased due to the interest rate shooting higher, it’s no surprise to see demand for this has fallen.

The half-year results highlighted this, with group total income, origination revenue, loans under management, and profit before tax all lower than a year ago.

Yet I believe this could be a great value play on the assumption that interest rates in the UK won’t go any higher from here. If this is correct (and if we see some interest rate cuts), then Funding Circle may have already hit rock bottom.

If we see rate cuts coupled with strong economic growth over the coming year and beyond, demand for loans could increase significantly. I note that this is a risky play but the reward (given the extent of the share price fall) could be large. I’m considering allocating a small amount of money to the stock.

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I’ve been taking a fresh look at this lender, which acts as an alternative to mainstream banks. Should I think about buying Funding Circle shares, or would I do better off by buying a more traditional banking stock such as Barclays (LSE: BARC)? Let’s take a look.

A Covid-19 winner?

Funding Circle’s software enables businesses to apply for loans and receive a decision within seconds. The company says that its machine learning technology uses a “data lake” containing more than 2bn data points to help it make accurate lending decisions.

New lending has increased during the Covid-19 pandemic, as the company put its regular lending on hold and focused solely on UK government-backed CBILS loans. In total, Funding Circle issued £1.7bn of these loans last year — that’s more than 80% of its total UK lending in 2020.

CEO and founder Samir Desai admits that as Funding Circle returns to normal commercial lending this year, he expects to see “some initial reduction in lending”. Even so, Funding Circle expects to report an underlying profit for the full year.

Funding Circle share price: what I’m doing

I think that when support schemes such as furlough finally end, we could see an increase in business failures in the UK. This could probably lead to an increase in loan losses, including CBILS loans.

Funding Circle’s heavy dependence on CBILS loans worries me. Although these loans have a government guarantee, this only covers 80% of the loan. The remaining 20% is at the lender’s risk.

Interestingly enough, Funding Circle’s management increased their estimated average loss rate on loans to 20.5% last year, from 12.9% at the end of 2019. If the company starts to report rising default rates this year, I think Funding Circle’s share price could start falling.

Even without this, I reckon Funding Circle stock is starting to look expensive. The lender’s shares trade at more than two times their book value, even though this business has never reported a profit.

Looked at another way, Funding Circle shares are trading on 50 times 2022 forecast earnings.

On balance, Funding Circle is just too expensive for me.

Why I’d buy Barclays shares now

FTSE 100 bank Barclays isn’t likely to double in size anytime soon. But this business is already profitable and trades at an attractive 30% discount to its tangible book value. That gives Barclays shares a forecast valuation of just eight times 2021 earnings, with a dividend yield of 3.3%.

The bullish argument in favour of Funding Circle shares is that if things go well, this smaller business could grow much more quickly than Barclays ever could. That’s probably true, but I think the risk of serious problems is also much higher at Funding Circle.

I admit that Barclays’ growth has been sluggish in recent years. But this big bank has plenty of surplus capital, a diverse business model, and a cautious valuation. For me, Barclays is a sensible investment that should deliver positive returns.

In contrast, I think Funding Circle looks like a much riskier bet, especially after recent share price gains.

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UK shares to avoid 

The first company on my list is doorstep lender Provident Financial (LSE: PFG). Ethical considerations aside, this lender has some severe problems. It’s currently dealing with a “flood” of complaints from borrowers who claim the business has misled them.

There were 10,000 complaints to the Financial Ombudsman Service in the second half of 2020. These claims cost the business £25m. 

While PFG is trying to work out a plan to deal with these issues, it’s also facing an investigation from the Financial Conduct Authority. These are two severe headaches for the firm, and they’re unlikely to go away anytime soon. Shareholders may have to foot the bill if claims exceed Provident’s resources. 

That said, the group may turn things around. Its profitable Vanquis credit card and Moneybarn car finance operations are still performing well. If it can dispose of the doorstep lending issues and concentrate on these divisions, Provident’s fortunes could improve. 

Despite this, I’m not planning to include the stock in my portfolio of UK shares any time soon.

Coronavirus lending 

Funding Circle‘s (LSE: FCH) IPO in 2018 caused a stir in the City. The company aimed to revolutionise the lending market, connect borrowers and lenders directly, and remove the need for a bank in the middle. 

Unfortunately, the firm hasn’t lived up to the hype. It’s consistently lost money since 2015. 

However, unlike many UK shares, the group performed well in 2020. The firm’s involvement in the Covid support scheme helped it expand loans under management to a record £4.2bn. Despite this, the business made an operating loss of £106m for the year. Fee income rose 25% to £220m. 

While management believes Funding Circle’s outlook is bright, I’m not convinced. If the firm hasn’t been able to make money in the past five years, when will it make money? If the group keeps losing money, sooner or later it’ll run out of cash. That’s why I plan to avoid the stock at all costs. 

Still, the business could prove me wrong. If the economy roars back to health over the next few months and years, demand for borrowing on the group’s platform could explode.

With interest rates at bottom levels, savers may also be happy to deposit their money with the group. The company is also planning to launch new products over the next few months to help businesses acquire funds faster. 

This could help Funding Circle make more loans, which would generate more fees, which may help the business earn a profit. In this scenario, the stock’s outlook would change entirely, in my view. 

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A new approach to borrowing money

Traditionally, a business loan from a bank is the go-to option for borrowing funds. However, this process can be complicated, as well as time-consuming. To make financing easier for SMEs, Funding Circle Holdings (LSE:FCH) created a new platform which connects borrowers directly to investors.

Providing they pass the credit checks, borrowers gain immediate access to funding sourced from third-party investors operating on the platform. These investors earn returns from the SMEs’ profits as the debt is repaid. Meanwhile, Funding Circle is generating revenue through small transaction fees and annual service fees.

While still relatively unknown, the platform has over 90,000 borrowers, and a network for over 100,000 investors providing the money. In total there is currently £3.7bn of loans under management.

Covid-19 has been devastating for many SMEs. The lockdowns have halted business, and many were unable to keep up with repayments. However, the stock’s management team is fully aware and introduced temporary flexibility options regarding payments. As a result, even with most SMEs shut down, over 90% of borrowers are still making their payments on time – an impressive feat in my eyes.

Lending money always has its risks

The platform is vastly different from traditional money lending systems. However, it is still exposed to the same fundamental risks. If borrowers don’t pay their debts, the investors will run for the hills, making the platform useless in the process.

As previously stated, the fintech stock provided flexibility options for borrowers during this pandemic. But, depending on how much longer the lockdowns continue, these flexibility measures may not be enough.

This is particularly worrying as nearly 50% of platform investors are institutional. Institutional investors do bring stability to the source of funds. But, if one were to lose confidence and withdraw, it could trigger a chain reaction that might significantly impact the business.

The firm is also not yet profitable and continues to lose money each year. It is generating a gross profit, meaning the platform makes more money than is being spent on operating it. However, due to lack of public awareness, the company is investing heavily in its marketing department to attract more borrowers and platform investors.

Is the Funding Circle fintech stock worth owning?

This new moneylending approach certainly sounds intriguing to me. And while it could be many years before the business turns a profit, the aggressive marketing budget appears to be working. Over the last five years, revenue has grown by 51% annually.

And even with this impressive growth, it has only captured less than 1% of the addressable SME debt market. Combining the platform’s advantages, with a substantial room for growth, makes Funding Circle just the kind of stock I like to have in my portfolio. The risks are still quite high, but I believe the potential returns justify having the share on my watchlist.

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Who funds Funding Circle?

Small and medium-sized businesses apply for loans, and Funding Circle takes small sums from the accounts of hundreds or thousands of investor accounts to match the loan amount. Funding Circle charges a transaction fee on the principal balance of newly generated loans, which is deducted from the proceeds that borrowers receive, and collects a servicing fee on outstanding principal balances of loans under management from investors.

On, average Funding Circle collects 4.86% of the total amount of new loans generated annually as transaction revenue and 0.82% of the annual principal balance of loans under management in servicing fees. Increasing the amounts of loans originated, above and beyond the number of old loans that have been repaid, will increase loans under management and both revenue streams.

Stunted growth

By 2012, Funding Circle had £52m of loans under management in the UK. After growing by an average of 149.41% each year, it had £3,148m under management in the UK, US, Germany, and the Netherlands in 2018. This is a company that is investing heavily to grow so I am not surprised when I see that it has made a net loss of more than £30m every year since 2015.

Losses can be acceptable when growth is rampant, and share prices can go up in spite of continuing losses as shareholders expect juicy profits further in the indefinite future. But Funding Circle is seeing rates of growth moderating, so I want a reason to believe that it can at least start to move towards breaking even at the operating profit level because it looks like we are dealing with a late-stage growth company moving towards maturity.

Can’t catch a break (even)?

By regressing Funding Circle’s reported transaction and servicing revenues against operating expenses, I got an equation that I can plug forecasts of both revenue components into, get a prediction of future operating expenses, and then estimate operating profits. Assuming growth rates in both loans originated and those under management continue their short-term trend, and using the average percentages for servicing and transaction fees, I am forecasting that operating losses will continue for the foreseeable future and not move towards breakeven.

I have made a lot of assumptions in my analysis, and I could be completely wrong, but for now, I see Funding Circle as being in the later stages of its growth phase, and not moving towards making an operating profit. This could mean more bank borrowings, further equity issues, and dilution of shareholder claims, or worse.

It is also worth mentioning that Funding Circle has never operated through a recession, when businesses are not eager to lend and investors are put off by rising rates of defaults on their loans, nor has it dealt with historically normal interest rates. This, along with my outlook for profitability and growth, means I will be looking for another smaller UK company to invest in for now.

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Unfortunately, it doesn’t look as if the company’s performance is going to improve any time soon. According to its half-year report, Funding Circle’s business performance actually deteriorated during the first six months of 2019, even though revenue expanded 29%. 

Rising losses

According to the report, group revenue increased by 29% to £81.4m during the first half of 2019, but increased costs pushed adjusted earnings before interest tax depreciation and amortisation down to -£19.7m, from -£13.9m in the same period a year ago.

The adjusted EBITDA margin declined from -22% to -24%. The loss before tax for the period hit £30.8m, up from £27.1m last year. 

Still, despite this performance, the company continues to believe that its adjusted EBITDA loss margin for 2019 will be better than in 2018. I’m doubtful Funding Circle can achieve this performance, especially with Brexit looming at the end of October. City analysts are also sceptical. They’re expecting a full-year loss of £51m, up from last year’s loss of £49m. 

And even though the City is expecting revenue to grow around 45% by 2020, losses will hit £54m by 2020, analysts believe.

With losses set to grow over the next two years, I would sell Funding Circle today, as it doesn’t look as if the company’s share price performance is going to improve anytime soon.

On the other hand, I am much more positive on the outlook for Cineworld (LSE: CINE).

Debt paydown

Cineworld’s acquisition of its larger US peer Regal in 2018 lumped the group with a tremendous amount of debt, which seemed unsustainable at the time. 

However, the company has surpassed all expectations since the deal. It is on track to achieve merger synergies of $150m and, according to Cineworld’s results for the first half of 2019, the business’s debt reduction is ahead of schedule.

Cineworld took on $4bn of debt to buy Regal, but by the end of June, borrowings had fallen to $3.3bn (excluding lease liabilities), primarily thanks to a massive sale and leaseback transaction.

Dividend champion  

Declining debt is just one of the reasons why I think Cineworld could be a great addition to your portfolio. It is also a dividend champion. At the time of writing, the stock supports a dividend yield of 5%, but with earnings per share set to increase by 17% this year, analysts believe the company has scope to increase the payout by 30% to $0.19. If this comes to fruition, it will leave the stock yielding 6.5%.

At the time of writing, the price for this level of income is just 9.4 times forward earnings, which looks to me to be a steal considering Cineworld’s projected earnings growth.

So, if you’re looking for a cheap income play with tremendous growth potential, then I highly recommend taking a closer look at Cineworld today. 

The post One FTSE 250 turnaround stock I’d sell and one I’d buy right now appeared first on The Motley Fool UK.

Since then, the situation has eased. The latest FCA data provided by research-tree.com indicates that short interest in Metro stock has halved to 6.3%. But that’s still enough to make Metro the 19th most heavily shorted stock in the UK.

Short sellers sometimes get a bad name, but shorting a stock carries a lot of financial risk. If the price rises, your losses are theoretically unlimited. A fair amount of research usually goes into such decisions.

I’m worried too

I share the short sellers’ scepticism towards this business. In January, the company revealed that a chunk of its loans were more risky than it had previously thought. This contributed to the bank’s decision to raise £350m in fresh cash from shareholders in May. Such misjudgement is a warning flag for me.

I also have some concerns about the bank’s rapid expansion of its branch, or ‘store’ estate. Most banks are closing branches. Are Metro’s really so different that they will be more profitable than those of other banks? I don’t know, but I do note that new store openings are now being slowed.

Analysts’ forecasts for Metro’s 2019 earnings have been cut by a staggering 83% to 19.8p per share over the last 12 months. That leaves MTRO stock trading on 25 times forecast earnings.

In my view, that’s too much to pay for a bank that’s only been marginally profitable in each of the last two years. I’d stay away.

How profitable is P2P?

Peer-to-peer lending has exploded in popularity in recent years. One of the biggest players is Funding Circle Holdings (LSE: FCH), which dropped straight into the FTSE 250 when it floated on the stock market in September.

However, there may be trouble in paradise. In its half-year update, the lender said that it now expected 2019 revenue growth to be 20%, down from previous guidance of 40%. Demand for new loans from small and medium-sized businesses is said to have weakened. And Funding Circle has decided to tighten its lending criteria, in response to an increasingly “uncertain economic outlook”.

Losses are expected to continue for at least the next two years. Analysts’ forecasts indicate that an after-tax loss of £42.7m is expected on revenue of £175.4m this year.

Should we be worried?

I’m not suggesting that there is anything amiss with the performance of Funding Circle’s loans or with the credit quality of its customers. But I would note that the peer-to-peer lending model and this company’s high-tech credit scoring system have not yet been tested in a recession.

Looking at the latest data from the company, I can see that the expected loss on the firm’s loans has risen from 1.3% in 2012 to between 2.1% and 4% for the first half of 2019.

The FCH share price has now fallen by more than 70% from its IPO level of 440p, last October. This has reduced the group’s market cap to £425m, but that’s still a slight premium to its last-reported book value of £402m.

In my view, that’s not cheap enough for a loss-making lender at this point in the economic cycle. This is another stock I’d avoid.

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Losses

Just this week, the growth projection for the company has been slashed, with the lender announcing that it now expects revenues to grow by 20% this year, down from its previous forecast of 40%. That hit the share price hard. When it comes to profits, Funding Circle expects the annual loss for 2019 to be less than in 2018 – so moving towards profit, but still a long way from being profitable. However, it reported an operating loss of £51.6m last year, 40% wider than the year before.

It could be argued that it’s prudent for the lender to invest for growth and expand into international markets, even before it turns a profit, in order to maximise market share and therefore hopefully achieve bigger profits down the line. This is the strategy of many other tech companies – notably those based in Silicon Valley. That’s all very well if there’s enough demand for the product and eventually, costs can be cut and a profit turned. The big worry comes if investors think that can’t be achieved or if the economy takes a downturn, which would most likely disproportionately hit loss-making companies.

Overpriced IPO

Funding Circle joined the London Stock Exchange in October 2018. Right from the off the shares seemed overpriced and the promises to investors too hard to turn into reality. And so it has proved. Analysts have expressed concern at the lack of clear information from the company and investors need to know the management team has their interests in mind. 

What next?

Do the shares now look like fair value given the huge fall in the share price? In my view, no. The halving of predicted revenue growth, the increasing losses and the relative newness of the business model all combine to make me shrink from picking up the shares. I think there are much better value listed companies out there that are able to make a profit. At the end of the day businesses survive and prosper on cash and profit.

Going back to tennis just to finish off, Funding Circle seems to me to be like Nick Kyrgios – a bit love it or hate it. It could be brilliant, but too often underperforms. However, the market has many Roger Federers, slick operators that continue to outperform effortlessly. Shares in the latter are the ones to back for long-term wealth creation. The former are good for excitement which may ultimately end in failure and therefore, in my eyes, are best avoided.

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Credit crunch all over again

The basic concept of the company is that it matches small businesses that need funding with private individuals who are happy to lend their money. For the borrowers, who were perhaps unable to source cash elsewhere (red flag), they were able to raise money and generally get better loan rates than offered by traditional lenders. For the individuals lending their money, the same was true, their ‘investments’ generally getting better interest rates than regular saving options on offer.

In order to mitigate the risk of these borrowers defaulting – they are, after all, not always able to meet the standards required by established lenders – the company pools lots of loans together in one big pot. Some of these pots (officially portfolios) are deemed riskier than others perhaps, but the premise is that if you collect enough loans together, the one or two that default are not relevant to the portfolio as a whole.

This is exactly how asset-backed securities and mortgage-backed securities work, and is a concept that proved to be flawed when it turned out that subprime loans had been making up a far larger portion of these securities than anyone realised, triggering the credit crunch and subsequent financial crisis.

People who couldn’t afford mortgages were getting them, these were then packaged together to make them ‘safer’, and then these packages were offered to others (in this case as bonds) as entirely different, and supposedly safer, securities. Sound familiar?

Default position

The similarities have perhaps, already started to show. Funding circle has had to revise-up its expected default rates twice this year, and in April announced it would be winding down its sister fund – Funding Circle SME Income – due to a period of “lower than expected returns”. This entity helps provide funding for its loans.

That said, Funding Circle does seem to be making some efforts to get ahead of things. Over the past year it has moved away from the peer-to-peer model and now seeks to fund much of its lending via other financial institutions. It has also said that it is tightening its lending standards, particularly to riskier businesses.

This could be a prudent course of action, but unfortunately for investors it has also led to the company reducing expectations on Tuesday, cutting its 2019 growth forecast from 40% to just 20% due to these tightening standards and “economic uncertainties“, causing the share price to drop almost 27% at the time of writing.

I feel this shift also raises another question though – if the company is no longer going to be a peer-to-peer lender, then what is it? I am not convinced it will work as an institution-to-individual middleman, and if its lending clients are seeing lower returns and higher defaults, how long will they use the platform? I for one want to know where my money goes when I lend it.

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However, one area where the bank disappoints is its lack of growth. While the group recently reported a healthy 18% year-on-year increase in profits for 2018, analysts are expecting a more subdued performance going forward. The City has pencilled in earnings per share growth of just 3.6% for 2019.

So while I still believe that the Santander share price presents incredible value for investors and income seekers, I think growth investors will be disappointed. 

With this being the case, I’m considering the outlook for UK fintech startup Funding Circle (LSE: FCH) instead.

Explosive growth

Compared to Funding Circle, Santander looks as if it’s standing still. Today, the peer-to-peer lender reported a 55% year-on-year increase in revenues to £142m which, according to CEO Samir Desai, is another “record-breaking year for the firm.“

However, while revenues hit a record, pre-tax losses also surged, climbing 40% from £36.3m to £50.7m.

Looking forward, management expects this trend to continue. It’s forecasting more revenue growth, but losses are expected to continue for the foreseeable future.

Funding Circle’s management thinks revenues will rise above £200m in 2019, and adjusted operating losses will fall, with the firm remaining loss-making overall. City analysts have pencilled in a net loss of £32m for 2019, a slight improvement on 2018’s figures, although this is based on revenues of £199m.

As the company now expects to beat this top line estimate, I wouldn’t be surprised if we see a number of analysts revisit and reduce their loss estimates for the group this year over the next few weeks.

Different companies 

At first glance, Santander and Funding Circle couldn’t be more different. Santander is one of the largest established banks in Europe that earned €7.8bn in net profits last year. Funding Circle is still losing money and in its early stages of growth.

But despite its losses, I think Funding Circle could be the better long-term buy. One of the reasons why the company is losing so much money is because it’s reinvesting 41% of revenues back into marketing and building the brand. Over time, this marketing spend should fall as the business’s customer base grows.

Indeed, according to the company, in 2018 43% of group revenues came from existing customers, up 67% year-on-year, while 74% of lending also came from existing investors. As existing borrowers and investors are cheaper to acquire, (the cost is virtually zero) Funding Circle makes the bulk of its income matching these lenders and borrowers.

What I’m really excited about is the firm’s potential around the world. Last year, it only generated revenues of £48m from its US and international operations. This is just a snip of these multi-trillion pound lending and borrowing markets. So the opportunity for Funding Circle in these markets is tremendous and, if the enterprise gets it right, the sky’s the limit for the firm’s growth.

So overall, if you own Santander and are you’re wondering what to do with your investment, I reckon it could be worth selling a small percentage of your holding and investing the proceeds in Funding Circle today.

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