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FSA is like a canoe salesman in the Sahara – we expect service fees to grow slowly, if at all, when the sun shines. But should a thunderstorm arrive … well, profits doubled during 2009’s financial crisis, without Australia even going into recession.
Market share

Though this year’s paltry revenue growth didn’t raise alarm bells, it did concern us that FSA’s share of total signed debt agreements fell from 48% to 45% (although FSA remains several times larger than its nearest competitor).
FSA’s Services division has large fixed costs, such as compliance, and benefits from economies of scale when processing debt agreements. This means it can spend more on marketing than its competitors which, in turn, supports the acquisition of new customers.
So far debt agreements have been a small niche. However, as the overall market grows, it could allow competitors to achieve critical scale, which would undermine the industry’s most significant barrier to entry. If competition increases, FSA’s Services division will have trouble maintaining its juicy 25% pre-tax profit margin.
Lending

Although Services still accounts for around half of the company’s net profit, which increased 25% to $13.5m this year, it was FSA’s Consumer and Business Lending divisions that contributed the growth.
Business Lending, which offers factoring finance secured against unpaid invoices to small businesses so they can manage their cash flow, grew its loan pool 20% to $24m.

	Column 1
1	Shoptalk
2	Net interest margin: the difference between the rate of interest customers pay to FSA for a loan and the rate of interest the company pays to its own lenders.

Unfortunately, revenue for the division was flat due to the net interest margin contracting (see Shoptalk) and the proportion of loans in arrears increasing from 4.8% to 5.9%. Factoring finance is more risky than other types of lending so we’ll be watching this number closely. Still, net profit tripled to $1.9m due to the recovery of debts previously written off as non-collectable.
FSA’s Consumer Lending division also performed well, with net profit increasing 35% to $4.8m thanks to the greater use of external brokers, which lowered staff and administration expenses. The result was also helped by a decrease in bad debts due to Australia’s booming property market.
The loan pool was unchanged at $221m making FSA the country’s largest provider of home loans where the borrower doesn’t meet standard lending criteria. These are known as subprime or non-conforming mortgages and are used to consolidate a client’s debts.
Seeing the word ‘subprime’ may have just sent a shiver down your spine; it surely does for many bankers – failing subprime loans were a major cause of the global financial crisis. However, FSA has done a good job of managing the risks, with the division still churning out cash even during the depths of the last crisis in 2009. What’s more, the debts are non-recourse to FSA, sitting in their own separate trust.
While just 3% of FSA’s equity is at risk, if a crisis hit, earnings from Lending could quickly evaporate. As Lending now accounts for roughly half of the company's net profit, today's low price-earnings multiple (see below) could actually look pretty expensive if loan defaults exceed expectations and the net interest margin contracts further.
Free cash

All three divisions provide long-term annuity-style income as interest and fees are paid as regular instalments. And, being a service business, the company has low capital expenditure requirements, running at just $500,000 per year.

	Year to 30 June	2014	2013	+/(–)(%)
1	Table 1: 2014 result
2	Services rev. ($m)	47.8	47.0	2
3	Lending rev. ($m)	17.7	17.4	2
4	Total rev. ($m)	65.5	64.4	2
5	Net profit ($m)	13.5	10.8	25
6	EPS (c)	10.8	8.5	27
7	DPS (c)	6.0	5.0	20
8	PER	11	14	n/a
9	Div yield (%)	5.3	4.4	n/a
10	Franking (%)	100	100	n/a
11	Final Dividend	3.5c fully franked,ex date 10 Sep

This means almost all the company’s net profit comes through as free cash flow, helping it generate a return on equity consistently above 20%. On the face of it these figures look excellent, especially since the company is currently priced at just 11 times earnings and has a dividend yield of 5.3%.
The trouble is that acquiring new customers needs upfront investment in marketing, sales staff and capital, for which FSA only earns a return after 3–5 years. So while the company is throwing off lots of cash now, while it’s not growing, to expand the business would require FSA to reinvest more of its earnings, thus reducing what can be distributed to shareholders.
Unless there’s another crisis, business and personal lending offer the best potential for growth but these products are also big cash hogs – requiring $1.5m and $3.0m of capital retention, respectively, for each $10m increase in the size of their loan pools.
FSA is best thought of as two independent businesses: one that’s counter-cyclical but exposed to significant regulatory risk (as it relies on a specific piece of legislation); another that’s essentially a mini-bank churning out cash but could potentially blow up if loan defaults get out of hand.
Australia hasn’t had a recession in more than 21 years so, with this as a backdrop, it’s impressive that FSA has increased revenue sixfold since 2003. We’re raising our price guide slightly, but we'd need a larger margin of safety before buying to compensate for the risks. The stock’s share price has risen 5% since FSA finds opportunity in insolvency on 13 May 14 (Hold – $1.09) and we recommend you HOLD.

Many thanks, much appreciated.