SIF Portfolio: Are recent falls a buying opportunity at H&T Group?

Shares in pawnbroker and gold dealer H&T Group have risen by 75% over the last three years. They’ve tidily outperformed the wider AIM market, which has risen by just 2.5% over the same period.

I first wrote about H&T for this column in July 2015, when the shares were trading at about 200p. I commented that the shares looked good value, but remarked on H&T’s falling margins.

My conclusion was that H&T had “decent upside potential” and could continue to outperform the market. I’m happy to say I’ve been right so far. The shares have risen by 25% since my article was published last July, while the dividend has risen by a chunky 75% to 8.4p.

H&T hit a 52-week high of 300p in August, after the company revealed a 42% increase in pre-tax profit for the first half of the year. But this has been followed by a broker downgrade and a sharp sell off.

H&T stock is now trading 16% lower at about 250p. This gives investors a chance to buy in at levels last seen before July’s surge begun. The question is whether this is a buying opportunity, or a warning of worse to come.

I’m particularly interested in H&T as this stock recently qualified for my Stock in Focus screen, making it a contender to join the SIF Portfolio. As I don’t currently have any financial stocks in the portfolio, the temptation to diversify is strong.

In the remainder of this article, I’ll take a closer look at the figures and decide whether to add H&T to the SIF Portfolio this week.

Is the price right?

H&T’s ValueRank has fallen from 87 to 73 since I looked at the stock in July 2015. Back then, the shares traded on a trailing P/E of 11.4 and a trailing P/FCF of just 5.6! Here’s how things have changed:

Over the last fourteen months, H&T’s profitability has improved, along with its dividend. The stock’s earnings yield (op. profit/EV) has risen from 7.5% to 8.5%, while the dividend yield has risen from 2.4% to 3.3%.

In my view, this offsets the increase in valuation. The price/book and price/sales ratio both look undemanding at 1.0. Asset backing is strong, with net tangible assets of 209p per share.

You may have noticed that H&T’s price/free cash flow ratio has risen dramatically over the last year. The reason for this is that the firm is investing in growth. During the first half of this year, H&T increased stock levels, pledges and loans. This absorbed all of the group’s operating cash flow and pushed net debt up from £2.1m to £6.9m.

I’m not too concerned by this, given the rising earnings yield. If this cash can be put to work profitably, then it should help fund future growth and dividends.

Improving quality

One of my concerns last year was that H&T’s return on capital and operating margin were falling. This was a potential problem because it would make self-funded growth difficult.

I’m pleased to see that H&T’s profitability now appears to be improving. The firm’s ROCE has risen from a low of 5.8% in 2014 to 7.3% over the last eighteen months. The group’s operating margin has risen from 7.1% to 9.4%.

What’s interesting is that these figures are still very low compared to their historical highs. Back in 2010, ROCE reached 30.7%, while H&T’s operating margin was 22.7%. I suspect that the gold boom and historically lax regulation of payday loans helped fuel these returns, so I don’t expect to see them again. But I’d guess that further gains may be possible -- perhaps towards a ROCE in the mid-teens?

Taking a broader view, one of the factors that may help H&T’s growth is its scale and relatively large footprint. A strong balance sheet and good management helped the group ride out the gold crash. This caused a certain amount of attrition among some of H&T’s high street peers. In its interim results, the firm said that fewer competitor stores were helping to stabilise the pawnbroking market.

However, pawn profits appear fairly stagnant. The pawn service charge fell from £14.3m to £14.1m during the first half.

H&T is pinning its hopes on growth in retail and personal loans. The group’s established store chain means that it can retail jewellery that smaller pawnbrokers might have to scrap. This gives higher profit margins. I’d imagine it’s also a useful way of building a pipeline of potential customers for H&T’s financial services.

The biggest of these is the group’s personal loan business. Gross profit from lending rose by 25% to £1.5m during the first half, while the net loan book rose by 85% to £6.3m. Around 95% of lending is currently done in store, but H&T is investing in new systems to enable it to sell loans online.

Running in parallel with the loan business are fast-growing foreign exchange, buyback and Western Union services. These all showed strong growth and “brought a significant number of new customers to H&T” during the first half.

Financial momentum

H&T’s MomentumRank of 71 is 14 points lower than it was 30 days ago. The recent broker downgrade and resultant sell off are probably to blame, but I think the overall picture is still reasonably positive.

Despite this month’s earnings downgrade, the outlook for 2016 and 2017 is still one of double-digit percentage earnings and dividend growth:

These figures give a 2016 forecast P/E of 14.1 and a prospective yield of 3.5% for 2016. That seems reasonable to me, given the rate of growth seen in H1.

At this point I’m going to stick my neck out.

I’m not really a technical investor, but I have learned through painful experience that ignoring an established trend can prove costly. Looking at the chart for H&T, my view is that the shares remain in an uptrend. The current pullback may thus be a buying opportunity:

Barring a profit warning, I expect the shares to find support at around 235p. A rally may follow. The RSI (relative strength index) is close to being oversold (below 30). After similar dips over the last year, the shares have made fresh gains.

The next few months should prove whether my reading of the chart is correct. Hopefully I’ll be right, as I’m going to add H&T Group to the SIF portfolio this week.

As always, please DYOR and let me know what you think in the comments below.