This morning we have received another profit warning from Provident Financial, a core holding in the CF Woodford Equity Income Fund and the CF Woodford Income Focus Fund, which has led to a substantial share price decline.
The problems that Provident Financial has faced in recent months concern its household consumer credit division (which extends small, short duration loans to households in non-standard credit markets), and in particular, the company’s recent decision to fundamentally change the way that the division operates. Earlier this year, management announced that it would transition from a self-employed agent model to one in which lending is conducted by full-time employees. The rationale for this move was partly operational, as it should ultimately allow the company to more effectively manage its customer relationships, but it also reflected the changing regulatory landscape in which the company operates. As such, we supported the change and trusted management to execute it successfully, given the track record the team has built at the company over a very long period of time.
In June, it became apparent that the transition was not going as smoothly as anticipated, in a profit warning which reduced guidance for that division’s current year profitability from c. £110m to c. £60m. I spoke at length to management about the issues that were being experienced and was reassured that the business knew the causes of the problems and what to do to rectify them. I assumed that the company was guiding towards a worst-case scenario for the additional cost of executing the transition effectively.
Today’s announcement undermines that assumption with a further significant reduction in profit guidance – the consumer credit division is now forecast to post a loss of between £80m and £120m during the current financial year. Operational disruption has continued, with the newly organised sales force seemingly failing to collect existing debts to the extent that had been anticipated or create as much new business as had been forecast. Importantly, this is not a credit quality problem – it is an operational issue which has been self-inflicted by the company. Credit quality across all of Provident’s divisions remains very good. Indeed, across the UK, I believe that credit trends are improving, as evidenced in the recent bank reporting season.
Nevertheless, this is an extremely disappointing announcement today and I am surprised that the transition has failed so significantly. Long-standing chief executive, Peter Crook, is standing down with immediate effect to be replaced on an interim basis by executive chairman, Manjit Wolstenholme.
One other issue was announced this morning which is worth noting. The FCA is investigating a repayment option plan product offered by Provident’s Vanquis division. This is effectively a forbearance product which gives customers with volatile financial circumstances the flexibility to manage their credit and maintain their credit rating very effectively. The FCA asked the company to stop selling the product last year and conduct a consumer contact exercise which has now been completed. The FCA investigation continues and has exacerbated the negative market sentiment towards the company this morning. The company is co-operating fully with the FCA and maintains a good relationship with its regulators. My view is that the profitability of this product may be impaired in the future but this does not appear to be a redress issue. Vanquis customers value this product – that is why they buy it.
The coalition of these issues has, however, resulted in a significant hit to profitability this year, and a cancellation of the interim dividend that it was planning to pay. It is also unlikely to pay a final dividend as it prudently moves to maintain the capital base of the business.
Before we turn to the stock market’s reaction to today’s news, it is worth reminding investors that the rest of Provident Financial is unaffected by today’s announcement. Vanquis Bank, Moneybarn and Satsuma are all trading in line with management’s expectations, which is important from a fundamental perspective, when considering the stock market’s reaction.
Despite today’s profit warning, the company is still expected to post a profit at the group level of at least £80m this year. Looking into next year, there is still a lot of uncertainty around forecasts but if we assume some stabilisation in the consumer credit division with a smaller customer base, along with other conservatively-struck assumptions about the rest of the business, the group should deliver pre-tax profit in excess of £300m in 2019. This equates to approximately 160p in earnings per share in 2019, which at the time of writing represents a price / earnings ratio of around 3x. If we assume the resumption of dividends with a 50% pay-out ratio, an 80p dividend would equate to around 15% dividend yield.
These statistics illustrate the extent of the market’s over-reaction to today’s news, in my view. I’m not trying to dress this up as anything other than bad news – the company has given the market several reasons to be emotional. I do, however, believe it is critically important to maintain a disciplined, fundamentally-based perspective in my investment analysis. In all situations, it is vital that I do not let emotion influence my judgement.
With that in mind, I believe Provident Financial shares started the day undervalued, and have become even more so as a result of the market’s reaction to today’s news. I am hugely disappointed by what has happened to the consumer credit division but I continue to believe that it will, ultimately get back on track (this business has been around for more than a century, by the way, and I believe it will be around for many decades to come). When it does so, Provident Financial’s share price deserves to be appreciably higher than it is today.