Borrowing Low And Lending High

Published in Company Comment on 9 April 2010

Is this cash-dredger sailing into troubled waters?

Provident Financial (LSE: PFG) has been in the news lately with the launch of its 7% 2020 Corporate Bond. The offer, which closes at noon on 12 April, comes in the wake of retail investors' new access to the bond market. The bond is being heavily promoted with, unusually, advisers being paid a 0.5% trail commission to push it.

However, Provident's ordinary shares also have an income story.

Sub-prime lender

Provident's core business is doorstep lending. It has a small army of self-employed commission-based agents who target people who find it difficult to access credit from conventional sources, such as banks.

The loans it makes tend to be small and short-term, typically a few hundred pounds for up to a year. But it makes a large number of them, with plenty of repeat business, and the typical APR is over 250%. It also offers a credit card, with a typical APR of 39.9%, through its Vanquis Bank arm.

Performance

Provident weathered 2008 -- that disastrous year for many companies in the financial sector -- very well. It saw a healthy rise in turnover and profit, and maintained its dividend at 63.5p.

However, in 2009, although its customer base grew by over 5%, pre-tax profit fell by 2% to £126m, as bad debts increased and customers became more cautious in their borrowing.

Provident warned that it expected the same customer behaviour to persist through 2010 and that it would be focusing on cost efficiency. Nevertheless, it maintained its dividend at 63.5p for the third year running.

Income attraction

The market was disappointed by Provident's below-expectations profit and its outlook statement.

The share price dropped, pushing up the dividend yield, which, as it was, had been attractive to income seekers for some time. Indeed, it's notable that Invesco and Schroders, who own over 30% of the company's shares between them, are both well-known for their equity income funds.

At Provident's current share price of 860p another maintained dividend in 2010 would give a yield of 7.4%.

So, the ordinary shares offer a starting yield a little higher than the new 2020 bond, and with the potential for income (and capital) growth over the decade. That comes with a risk to shareholders of a dividend cut or suspension, which is greater than the risk to bondholders of the company defaulting on its payments.

The dividend yield (and rating agencies rating the bonds only a notch above 'junk') suggest that Provident is widely seen as being at the less secure end of the spectrum for income-seekers.

Greed

Like insolvency companies, Provident has to negotiate the moral issue of making money out of the financially vulnerable.

At a time when the financial sector has been widely condemned for its 'greed', Provident may struggle to justify the very high rates of interest it charges its customers (although not in the same league as the four-figure percentages extorted by the friendly neighbourhood loan-shark).

While Provident sees its interest rates as being merely at a level for it to make a 'fair' profit, the Board of Directors hasn't always shown itself to be adept at judging the prevailing mood on 'reasonable returns'. A proposal to award substantial pay rises to the chief executive and finance director was voted down by shareholders at last year's AGM.

Headwinds

In addition to the operational challenges noted in the results, Provident faces potential external headwinds.

The Office of Fair Trading (OFT) has been investigating the high-cost consumer credit industry. It published an interim report last December and the final report is due this month. Interest rate caps may be on the agenda and other measures which increase compliance costs for companies such as Provident.

Collins Stewart analyst Robin Savage recently told the Telegraph that he believes Provident is likely to become a 'political football' in the run up to the election, and that a Labour victory or hung parliament could be disastrous for the company:

"It's quite obvious that if some of these measures [under consideration by the OFT] came in it would destroy their business." Even under lighter-touch Conservative proposals, "it is clear that there is little growth in the business."

Trick or treat?

A company's share price can often overshoot to the downside in the face of fears over regulation -- especially when they are couched in such stark terms as those expressed by the Collins Stewart camp.

Such fears can provide investors with what subsequently proves to have been a good buying opportunity, if the regulatory threat evaporates or is considerably watered-down, as it often is.

I took advantage of such a situation in the case of the water utilities late last summer, but I'm not so sure about Provident Financial. Essential utilities are one thing; a doorstep sub-prime lender is quite another. I'd view the risk of punitive regulation as higher in the latter case.

Another concern would be if the income-seeking institutions, which form such a large part of the company's shareholder base, decide there is a real threat to the dividend and decide to exit. As we've seen with Neil Woodford's recent ditching of BP (LSE: BP) and Royal Dutch Shell (LSE: RDSB), and previously banks, Invesco in particular are not averse to making radical all-out sector calls.

Take the bait or wait?

One unintended consequence of the high-profile promotion of Provident's 7% bond may be to highlight for critics the enormity of the gulf between the rate at which the company is borrowing money and the rate at which it is lending.

Provident's dividend yield and bond coupon are dangling hooks for income-hungry investors, but my bet is that there will be opportunities in the months ahead to get an even better deal -- if you are convinced that the regulatory threat is overdone.

More from G A Chester:

The author holds shares in BP and Shell.

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