Stock in Focus: H&T Group

Pawnbrokers protect their profit margins by only offering customers a fraction of what their items are worth and by lending cash at eye-watering rates of interest.

Does this pragmatic approach to operating at the distressed end of the credit market make them a good investment?

Investors might expect so, but pawnbrokers have been through the mill over the last few years, thanks to the gold price slump and to tighter restrictions on payday lending and short-term loans.

AIM-listed pawnbroker H&T has emerged from this downturn with a strong balance sheet, falling net debt and a positive outlook.

The firm is also the second-highest ranked UK stock in Stockopedia, with a StockRank of 99 and Value, Quality and Momentum ranks of 87, 91 and 97 respectively.

The question for investors is whether the strong fundamentals implied by these ranks can be maintained, or whether H&T will fall prey to a new set of problems in a few years time.

A complex mix of parts

H&T’s history can be traced back to a business founded in London in 1897, and the firm floated on the AIM market in 2006.

The group had 190 trading units at the end of June. Of these, around 150 are H&T branded pawnbrokers, while the remainder are second-hand jewellery stores, trading under the Est 1897 brand.

For investors who are not overly familiar with how modern pawnbrokers make money, it’s worth explaining that in H&T’s case, there are four main strands of activity.

The largest single source of profits is traditional pawnbroking, which contributed £28.4m to H&T’s gross profits of £45.7m in 2014.

H&T also operates a ‘we buy gold’ service, as do most of its peers. Gross profit from this unit halved from £4.8m to £2.4m last year, due to the weaker gold market and a shift in focus towards retail.

H&T’s retail sales, which are mainly of second-hand jewellery and watches, rose by 24% to £30.9m in 2014 and contributed £10.7m to gross profit.

The final area of the business is unsecured lending. Formerly a payday loan operation, this division was repositioned as a personal loan service last year in-line with changing regulations. H&T offers loans of £50-£1,000 for up to two years. The group sees this as “a key medium term opportunity”, although gross profit from lending fell from £2.9m to £1.8m in 2014.

In total, H&T reported revenue of £87.7m and a net profit of £4.3m in 2014. It’s a far cry from the gold market peak of 2011, when net profit reached £18.1m.

Investors need to ask if the firm’s new focus provides for a return to this level of profitability. Is H&T a genuine Super Stock?

Cash-backed value

H&T’s ValueRank of 87 suggests that the stock is currently amongst the 13% least expensive stocks in the market on a blended basis.

The group trades on a trailing P/E of 11.4 and a mouthwatering price-to-free cash flow ratio of 5.6.

That’s a remarkably moderate valuation versus cashflow and explains why H&T qualified for the Free Cash Flow Cows Screen earlier this year. This screen has delivered an annualised return of 16.5% per year since its inception.

Traditional value investors will also take comfort from H&T’s price-to-book ratio of 0.82. When goodwill and intangibles are stripped out, the shares currently trade at their tangible book value.  This asset backing may help provide downside protection.

(Although the value of the firm’s inventories of gold and jewellery could fall if market conditions change, I think it’s fair to assume we’ve now seen the worst of the gold bear market.)

H&T paid a dividend of 4.8p last year, giving a reasonable yield of 2.4%. This is expected to rise steadily, but it’s worth remembering that the payout was cut from 11.9p in 2013, when the gold crash left the firm with big losses on its gold inventories.

Defensive quality?

Measures of investment quality have to capture both financial strength and intangibles such as a defensive moat.  H&T has a QualityRank of 91, suggesting it scores highly on both of these fronts.

The firm’s strong balance sheet and cash-generative profitability is reflected in a Piotroski F-Score of 7, out of a possible 9. The only real weak point are that profits, measured as return on assets, fell last year.

This highlights a wider trend. Although H&T’s long-term average return on capital employed is a healthy 18.1%, what this metric doesn’t show is that ROCE has fallen steadily since 2010, when it peaked at 30.7%. In 2014, ROCE was just 5.8%, which is almost certainly below the firm’s cost of capital.

These figures suggest that H&T’s advantages of scale aren’t as effective as they once were.

In fairness, the firm’s turnaround plans may address this decline. I expect ROCE and operating margins to rise gradually over the next few years, but I don’t expect a return to the levels seen during the gold bull market.

Strong momentum

The key ingredient in the H&T pie is undoubtedly momentum. The company’s MomentumRank of 97 highlights solid outperformance against earnings forecasts and good technical momentum.

H&T qualifies for both the Josef Lakonishok Momentum Screen and the Bold Earnings Revisions Screen, which have outperformed the FTSE 100 by 35% and 45% respectively over the last two years.

Looking at the two aspects of momentum in turn, it’s clear that H&T’s earnings have been improving faster than analysts’ forecasts. Earnings per share were 9.4% ahead of consensus forecasts at the time of its most recent results. Analysts’ forecasts for 2016 have also inched higher over the last month.

Despite a 25% price gain already this year, price momentum also continues to look strong. The firm’s shares are just 5% below their 52-week high, while the 50-day moving average is 111% of the 200-day figure.

Relative strength is encouraging at 55, although momentum seems uncertain, at just 1.25.

Outlook

Trading on a forecast P/E of 12.0 and a forecast yield of 3.2%, H&T shares look reasonably valued with decent upside potential, in my own personal view.

Free cash flow generation is deeply impressive. I believe that if H&T can deliver incremental growth and a modest increase in profit margins, the dividend could rise substantially without the payout becoming too risky.

Ethically, this stock might not be everyone’s choice, especially given its personal loan business.  Fundamentally, however, given its exposure to sound fundamental and valuation drivers, H&T continues to look like it could become a solid small-cap outperformer. As always, this is just a personal opinion and it’s essential to DYOR.