Orchard Funding Group: a premium finance lender at 69% of net current asset value
Orchard Funding Group Plc ORCH.L is an AIM-listed (LSE) micro-cap short term-lender that listed in 2015 and has been profitable ever since, and I’ve chosen to write it up as it is currently a net-net. The share price has not recovered since the start of the coronavirus pandemic, even though the company is still profitable and loan volumes will likely rebound after the pandemic is over. The company makes short term loans, with an average duration of six months, through two 100% owned subsidiaries:
Insurance premium finance through Bexhill UK Ltd. In FY ending Jul-20, this represented ~80% of Orchard Funding Group’s total lending. Non-life insurance premiums are normally paid annually, but if someone wishes to pay monthly this is typically financed.
2. Professional fee finance, e.g. accountancy fees, through Orchard Funding Ltd. represents the remainder of finance provided. This subsidiary also does other types of lending, mainly static caravan pitches for holidaymakers, and private school fee finance, both of which areas were significantly ramped up at the start of FY 19/20, after the introduction of new in-house bespoke software called LendXP facilitated their entry into these markets. Before Jul-19 they were 2% of Orchard Funding Group Plc’s total lending, but after this until Mar-20 when the Covid pandemic started, they were 18% of total lending. The picture below shows lending types undertaken by the Orchard Funding Ltd subsidiary.
Orchard Funding group is featured in our May-22 investing newsletter, along with a deep dive into the premium finance industry. To find out more and get access to our monthly newsletters, click below:
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Orchard Funding Group business model:
Funding sources: 25% of the loan value comes from company funds (from retained earnings, plus equity raised during their IPO), and the remaining 75% from bank borrowings.
Two tier customer structure, or B2B2C: Orchard Funding Group’s direct customers are insurance brokers, accountancy firms, private schools, and static caravan site operators, who in turn provide finance to their indirect customers, who are individual customers seeking to finance their insurance policy/accountancy fees/caravan pitch fees etc. In almost all cases (i.e. >97%), if the end user /indirect customer defaults, this is paid for by the direct customers of Orchard Funding Group – so ~97% of individual loans are non-recourse to Orchard Funding Group. Therefore, annual losses to Orchard Funding Group averaged just 0.26% of total lending over the last four years, or £0.177M/year. This is similar to other competitors in the premium finance industry, e.g. Premium Credit Ltd, reported losses of 0.17% (2018), and 0.22% (2019) on total lending. Losses are incurred either through fraud at the business customers, or insolvency, which is rare.
Software: Orchard Funding Group use bespoke software: LendXP, to allow their insurance broker/accountancy firm/etc. customers to automatically generate paperwork for end user customers, manage all the direct debits to collect money, track all client transactions, etc. This software is provided free of charge to the customers. They have also recently invested in an Open Banking company (30% stake), which is developing a solution to take advantage of the new UK legal framework called Open Banking, whereby banks must make all customer transaction data available to third parties at the customer’s consent, so they can build innovative financial services for the customer’s benefit. The Orchard Funding Group Open Banking solution, uses this transaction data from customer’s accounts to provide enhanced credit scoring data, reducing risks in lending, and will also be licenced to other companies, providing a very small additional revenue stream.
Loan durations: All loans are <12 months duration, weighted average is 6 months so there is little interest rate risk exposure for Orchard Funding Capital.
Competition to Orchard Funding Group
There are two big fish in the UK insurance premium finance world, compared to these Orchard Funding Group is small fry.
Premium Credit Ltd: a private company, do £3.52B in loans per year, or 50% of the market for premium finance
Close Brothers Premium Finance: part of Close Brothers Group Plc, a merchant bank, listed on FTSE 250 – they do £1.1B in loans per year, or 16% of the market
Compared to this, Orchard Funding group does ~£69M, or 1.0% of the market in 2020, up from £11.5M or 0.2% in 2015.
The total third party premium finance market is estimated at ~£8B/year, of total non-life insurance premiums written of ~£24B in the UK.
Orchard Funding’s stated strategy is to cater for small insurance brokers/accountancy firms, giving a better service than its larger competitors, and not charging them fees to use its software, as Premium Credit Ltd does. They claim to be more responsive to their customers than their larger competitors, In Orchard Funding Group’s AIM admission document, they make the point that prior to admission, they were not price competitive with Premium Credit Ltd for accountancy fee funding, due to the fact that they had to finance their borrowing at high interest rates, but they still managed to win 400 accountancy firms over to their business.
Premium Credit Ltd also lend to the specialist areas of leisure (e.g. golf club memberships), static caravan fees, school fees, etc, that Orchard Funding Group expanded into in FY 19/20. Orchard managed to increase lending in this area from £0.07M in FY 18/19 to £6.7M in FY 19/20, giving credence to the idea that their thesis that there is a gap in the market there for smaller customers, is correct. They utilised their new software platform Lend XP to do this.
Efficiency and pricing power of Orchard Funding Group vs competitors
It is helpful to consider the whole income statement of Orchard Funding Group Premium Credit Ltd, who are the market leader with 50% share in insurance premium finance, and also do other types of lending such as accountancy fee finance, private school fees, leisure (gold club membership etc.). In total, Premium Credit Ltd make 48x more loan advances per year than Orchard Funding Group.
Premium-credit-Ltd-accounts-2019-DecDownload
Premium Credit Ltd has a total revenue in gross interest and fees, as a percentage of loans advanced, of 3.9% in 2018 and 3.6% in 2019, vs Orchard Funding Group which has comparable revenues of 7.1%- 8.1% over the five years to 2020. This suggests that although Orchard Funding Group is very small in comparison to Premium Credit Ltd, it has much better pricing power with its customers. Orchard Finance Group directors believe they have a competitive advantage, with the smaller customers that are not the focus of larger competitors such as Premium Credit Ltd.
Looking down the income statement to the net interest income, (after deduction of securitisation costs and interest paid on borrowings, but before deduction of overhead admin expenses), for Orchard Funding Group, net interest income as a percentage of loans advanced ranges from 5.4%-6.0% over the five years to 2020, whereas for Premium Credit Ltd, this is 2.8% for 2018, and 2.7% for 2019.
After deduction of administrative expenses, the net profit for Orchard Funding Group, is 1.5% – 2.6% of loans advanced over the last five years, compared with 1.0% for both 2018 and 2019 for Premium Credit Ltd. Therefore it can be seen that the advantage is gross profitability for Orchard Funding Group of about 2x revenue, translates all the way down the income statement to the operating profits.
Durability, and risks of Orchard Funding Group
What could go wrong at this company to cause it not to be durable? The single biggest thing is withdrawal of the lending facility provided by Barclays Bank. Although it has been in place since 2002, it is annually renewed at the bank’s discretion, and without it the company would have to shrink its operations very significantly, and may not be able to be profitable. Guaranteed access to reliable, low cost funding in order to maintain its business, and grow it, has been a perennial issue for Orchard, and is clearly a concern for the directors, as it is key for the durability of the business, but also a constraint on growth. Prior to admission, Orchard had two sources of funding: i) retained earnings, ii) bank overdrafts with Barclays bank, for premium funding, and Bracken Holdings Ltd, for accountancy fee funding. The Barclays facility has been in place since 2002, but is annually renewable by Barclays. It is used to finance 75% of loans made by Bexhill UK Ltd, so this is critical for the business. It was not withdrawn during the 2007-2008 financial crisis, however, so seems fairly reliable, and in 2020 cost LIBOR+2.9%+fees.
The Bracken Finance Ltd facility used until 2015, cost the greater of 10% or LIBOR +9.5% (2015), which meant that Orchard Funding Ltd., which financed accountancy fees could not compete on cost with competitors. After admission to AIM, £8.7M was raised for the company and the Bracken Holdings Ltd facility was completely repaid, and a new facility with Connister bank was agreed, at a rate of 5.1% in 2020. Overall in 2020 the net cost of finance to Orchard Funding Group including interest and fees was 4.86%.
In order to address the liquidity issue and have more stable funding arrangements, Orchard explored purchasing a small bank in 2019 so they could take deposits, but did not follow through after doing due diligence on the target’s loan book. They then twice started and subsequently withdrew an application for a bank licence, due to the Covid crisis constraining loan demand and creating uncertainty. The cost of obtaining a licence is quoted by the directors as circa £1M, which is 60% of the average annual profit in the last five years, so a significant expense. It is unclear how much of this is a one-time expense. The average cost of external funds is £0.58M in interest and fees, over the last five years. The second banking licence application was withdrawn in Oct-20, and is now on hold until the pandemic is over.
The main risk to the business model is the loss of the ability to finance the loans through bank borrowings with Barclays bank – the company relies on this to generate it’s profits, and without this facility would not be able to operate in it’s current form. Interest rate risk is not considered very significant, since the company loans are all short term with an average duration of six months.
A small area of risk is loan demand: in the 19/20 FY a significant growth area for the company has been static caravan pitches, and also private school fee financing, but both of these areas have been curtailed by the pandemic. However H1 results released covering the period to 31st January 2021 show that the company is still profitable mainly from its core business of insurance premium finance. It is assumed that these business come back after the pandemic, but if this is not the case, then the company may struggle to regain profitability. However, the rapid growth in these areas pre-pandemic indicates that there was an untapped demand for them, so it is expected that in the short-medium term these areas will fully recover, as people will still be using private schools, and static caravans etc. once they are permitted to again – these are durable wants/needs.
Growth of Orchard Funding Group
As discussed above, one of the constraints on growth is the access to low cost reliable funds. Management are forecasting £80M annual loans advanced in 2022/23. The lowest advances:loans ratio in the last five years was 2.22, so £80M/2.22 = £36.0M loans outstanding. Of this, 75% would come from bank finance, or 36*0.75 = £27.0M, and £36.0M-£27.0M = £9.0M from the company’s own resources. Currently, Orchard Funding has a £17M facility with Barclays, and a £2M facility with Conister bank, so they would need to find an additional £27M-£17M-£2M = £8M to be able to finance this volume of business. Currently, they have £15.5M in company assets, so if they were able to use 80% of this, or 0.8*15.5 = £12.4M, this would give an additional £12.4M-£9.0M = £3.4M, so they would still be short £8M – £3.4M = £4.6M. This assumes that there is no contribution from retained earnings in this period. Even during the Covid pandemic to 31st Jan 2021, the company has remained profitable so far, so this is a very conservative estimate.
Their Barclays facility has been in use since 2002, and has been increased from £10.0M in 2015 to £17.0M in 2020, so it is reasonable to expect that it may be increased in line with business growth to meet the funding shortfall. However, it is clear that Orchard Funding Group’s growth is constrained by it’s ability to borrow, which is why management will likely return to the banking licence application to allow it to take deposits and use them as a source of funding.
If the business does achieve the forecasted £80M in the 2022/23 FY, at the pre-pandemic net margin of 36%, and a revenue to loans five year average of 7.4%, this will mean that gross revenue will be £80M*0.074 = £5.92M, and net profit will be £2.13M, for a P/E multiple of 5.0x on the current market cap. Current loans are £65.5M so the forecast is for CAGR of 10.5% over the next two years.
The UK is planning to lift all covid pandemic restrictions on 21st June, and as of 31st March, 50% of the UK population have coronvirus antibodies, from either previous infection or vaccination: 31M people, or just under 50% of the population, have been vaccinated with a single dose, and 4M people with two doses. Provided no new vaccine-resistant strains emerge, the timetable to emerge from restrictions looks good.
Appraisal
The business may be valued in at least two ways:
Net current asset value
As of 31-Jan-2021, Orchard Funding Group has current assets of: £28.1M receivables (loans to customers) +£4.1M cash = £32.2M.
Current liabilities are £6.5M trade/payables, £10.1M borrowings, for total £16.6M, and non-current liabilities are £0.1M.
Net current assets – total liabilities are therefore £32.2M – £16.6M – £0.1M = £15.5M.
There are 21.35M shares outstanding at a current price of 50p, so the market cap is 21.35M*0.5 = £10.7M, so the company is valued at 10.7/15.5 = 69% of net current asset value.
Net current asset value per share = 15.5M/21.35M = 73 p/share vs current share price of 50 p/share, or a margin of safety of (73-50)/73 = 32%.
Historically over the last five years, the company has traded at year end premiums to book value of 1.4x – 2.2x, vs the current 0.7x, so if this reverts to the lower end of the range, the share price would double.
2. Price:earnings ratio
Earnings after taxes (where the tax rate averaged 19% over the last five years), average £1.64M, (with a median of £1.64M, a standard deviation of £0.22M and a variance of £0.05M).
Taking the average, assuming that a normal multiple would be 10x after taxes, the company would be valued at 1.67*10 = £16.7M, vs the current market cap of £10.7M, for a (16.7-10.7)/16.7 = 36% margin of safety. This assumes that earnings which are currently lower due to the pandemic curtailing demand for loans, return to levels seen in the last five years on average.
Disclosure
The author is long Orchard Funding Group, and does not hold any positions in any of the other equities mentioned in this idea.
Disclaimer: While every effort has been made to ensure the accuracy of the figures quoted here, no guarantee is given as to their accuracy – please do your own research.
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