By Leo Sek, Clime Asset Management FlexiGroup Limited (ASX:FXL) has three operating divisions. It provides: • Retail point of sale financing through Flexirent and Ezi Pay • Blink mobile broadband and • Cheques guarantee services through Certegy. The major part of the business is the provision of third party financing to customers of major retailers. This business is an arranger of finance and as such does not bear the major risk of default. Thus the bulk of the company’s revenue is generated from loan arrangement fees. FXL operates in Australia and New Zealand through established relationships with major retailers including Harvey Norman, Joyce Mayne, Noel Leeming, Bing Lee, The Good Guys, Michael Hill Jewellers and Modern Roofing. (a) Flexirent 90% of Flexirent financing relates to computers and electrical appliances. Flexirent services 15 to 20% of Harvey Norman’s IT sales. Its financing offer competes against cash, credit card and interest free loans. The Australian electrical and electronic goods market will approximate $19 billion in 2009 with the market growing by 1.8% in the 12 months to September 2009. Flexirent generates revenue at the following stages: • the beginning of the financing or loan contract • during the term of the contract through cross selling of other services; and • at the end of the contract through trading up to a newer version of the product The diagram below shows the transaction flow. Source: Flexigroup Ltd FXL funds the acquisition of assets through stand alone financing arrangements with five financial institutions. FXL bears the risk on bad debts up to an agreed loss reserve amount, which is approximately 8% of initial cost. The funder bears the excess. If the actual bad debt is less than the loss reserve, FXL is entitled to receive the difference in cash. At the end of the contract, FXL contacts customers to offer them the option of: • trading up to a new product by entering into a new contract; or • continue renting (known as inertia rent), make an offer to purchase, or return it to FXL for disposal. FXL focuses on customer retention rather than maximising inertia rent as making additional sales to an existing customer is cheaper than initiating a new customer. Inertia rent is lease payments made by the customer beyond the lease term. These payments have high profit margins as the ongoing expenses are relatively small. (b) Certegy Certegy provides interest-free finance in Australia through its Ezi Pay product. Approximately 3,200 merchants distribute Ezi Pay products through 5,100 locations. The Ezi Pay brand was acquired by FXL in October 2008 for $31.4 million. The acquisition did not include the existing loan book of $248 million. However, FXL expects to rebuild the loan book over the next two years. At 30 June 2009 the Certegy or Ezi Pay loan book had reached $126 million and is expected to double by June 2010. Flexigroup estimate the size of the Australian interest free finance market at $5 billion. The products that can be purchased using Ezi Pay include jewellery, furniture, gym equipment, pools, spas and sheds. Thus, the sales of Ezi Pay and Flexirent do not overlap in terms of products. The risk of default by Ezi Pay customers is lower than Flexirent, as customers are required to pay a 10% to 25% deposit with the retailer who ultimately bears the risk if the contract is incomplete or non compliant. The diagram below shows the transaction flow. Source: Flexigroup Limited Certegy charges the retailer a fee at loan arrangement and this forms the bulk of its income. A monthly administration fee is also charged. A loss reserve is created similar to the Flexirent. The percentage retained is lower as the Certegy loss rates are generally below Flexirent loss rates. As the products typically have a long life span they don’t require replacement or upgrading and there is no inertia rent income. Certegy is also one of two major cheque guarantee businesses in Australia and New Zealand, offered in 4,500 merchants through 16,000 outlets. This business accounts for 10% of Certegy earnings. (c) Blink mobile broadband Blink was launched by FXL in December 2008. There are two products offered through 350 retail outlets across Australia: 1. Blink Nomad - a month to month contract mobile broadband plan and 2. Blink Freedom - packaging mobile broadband with a laptop into one monthly payment like a mobile phone plan. Internet access is provided on the Optus network. Blink’s differentiating factor is the provision of a replacement product if the laptop requires repair. Blink offers insurance against theft, accidental loss and damage. Blink makes money by earning a margin over the cost of Optus broadband. KEY RISKS Regulation The major risk faced by FXL is if the Federal Government mandates disclosure of implicit interest rates on leases. Currently, FXL only discloses the total cost to the client, not the interest rate. The current review of the national consumer credit protection laws does not cover FXL products or services. Loss of funding FXL relies on credit being available. The risk of loss of funding has been mitigated by using five funders and not using a single funder for particular transactions or customer types. The average tenure of a funder is seven and a half years and funding was not interrupted by the recent poor credit markets. Business cycles FY 2009 has shown that FXL is not immune to an economic slow down. Transaction volumes fell from 84,000 units in FY 2008 to 80,000 units. Management actively tightened credit criteria in late 2007, causing lease volumes to contract but lease losses were maintained at historical normal levels. Management expects flat lease volumes in FY 2010. Reliance on Harvey Norman and IT equipment Harvey Norman accounted for 51% of revenue before the acquisition of Certegy, which gave Harvey Norman significant bargaining power over FXL. However, Harvey Norman faces high switching costs if it was to change lease providers as FXL owns the customer and can direct them to renew their lease at a different retailer. Under the terms of their agreement, Harvey Norman is not to supply services similar to Flexirent in its stores. After early 2011, if Harvey Norman reasonably believes that one of Flexirent’s competitors can offer more attractive leasing facilities, then Flexirent must match the terms within three months or Harvey Norman can make the competing facilities available in its stores. Post the Certegy acquisition, less than 25% of new volumes will be generated from Harvey Norman and 55% of volumes will be non computer and electrical appliances which will further reduce the dependence on Harvey Norman. Valuation FXL has achieved a consistently high return on equity in each of the last five years. In particular the recent returns of about 40% are an indication of a strong business franchise. The growth in shareholders equity from $35.9 million in June 2005 to $119.1 million in June 2009 has substantially been financed from retained cash profits. The company had historically a low payout ratio to build up capital reserves and approximately 45% of shareholders equity is cash. The franked dividends of $37.9 million paid in the last two years give investors comfort that the reported profit is real. Management has provided guidance for FY 2010 profit of $37 million to $39 million as leasing volumes are expected to remain flat. However, the continued growth in the loan book of Ezi Pay will be the major contributor to profit growth. If this level of profit is achieved then the StockVal assessment of value at $1.90 can be regarded as conservative as profit would represent a return on equity of in excess of 45% on average equity as against the StockVal estimate of 35%. Conclusion The business exhibits a number of strengths including the exclusive relationship with leading IT retailer Harvey Norman, mitigation of customer default risk through the loss reserve and diversification of funding. However, FXL is highly leveraged to the Australian retail cycle. While the economy appears to be recovering, this is likely to be gradual and meaningful growth may not appear until late 2010. This could constrain transaction volume growth in the short term. FXL looks to be good value even after selecting a conservative sustainable return on equity of 35%. Clime Asset Management uses StockVal. 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