Fat Prophets Hot Stock: Silver Chef (SIV.ASX)

Saturday 8th April 2017

Undercooked

What’s new?

A quick glance at Silver Chef’s share price over the last decade or so is revealing for two key reasons. First and foremost are the capital gains that have been made along the way, with Silver Chef’s share price having increased from around $1 to $12 at its peak in late 2016. The second key point to note about Silver Chef’s share price performance over this timeframe are the periodic sell-offs, with the three notable ones being in FY11, FY14, and FY17.

While these share price corrections are part and parcel of operating in a competitive market place, they are arguably more common amongst emerging growth companies with reasonably complex or high risk business models. Although Silver Chef has developed a positive track record in terms of both risk management and growth, as history attests, there will inevitably be periods when things don’t go entirely to plan.

Take for instance the catalyst for the sell-off in Silver Chef’s share price in FY14, which was the result of a poorly executed expansion of the company’s operational footprint in Australia and offshore. While the market reacted negatively to the earnings impact that the operational issues caused, with the benefit of hindsight we now know that Silver Chef’s strategic intent was on-point, with these initiatives having paved the way for another period of strong growth post the initial teething issues.

Fast forward to the recent sell-off in Silver Chef’s share price, and we note that while the discovery of a major fraud within the company’s GoGetta business represents a major concern, particularly for a leasing business, management’s remedial actions have gone a long way to dispelling our initial fears. Not unlike the catalyst for the sell-off in FY14, the recent fraud event is arguably indicative of the significant growth that GoGetta has been generating in what are reasonably new sub-markets.

What makes the stock interesting from a contrarian viewpoint is the fact that despite the marked increase in Silver Chef’s share price over the last decade or so, the stock’s valuation metrics have remained within a reasonable range for a growth stock. This means that, notwithstanding the odd earnings headwind or operational hurdle, Silver Chef’s earnings have generally kept pace with the stock price, with the earnings multiple has for the most part ranged between 8.0 and 16.0 times.

Fast forward to Silver Chef’s 1H17 results, and the impact that the increase in bad debts/fraud has had on the company’s underlying earnings is evident. While an event of this magnitude does raise a number of concerns about the quality of the business being written in the GoGetta segment, we are also cognisant of management’s ability thus far to learn from its mistakes – the company’s founder and major shareholder remains on the Board, albeit in a non-executive capacity.

At any rate, management commentary at the 1H17 results and subsequent capital raising suggest to us Silver Chef’s underlying earnings are expected to resume their upward trajectory sequentially in 2H17. This in our view is likely to reflect the (i) strong growth in Silver Chef’s increasingly diverse base of rental assets, and (ii) normalisation of Silver Chef’s bad debts in 2H17 as the historical problem contracts in GoGetta’s light commercial channel are worked through.

Looking at Silver Chef’s business model more holistically, we identify three key drivers of profitability. These are (i) asset origination, which we believe is underpinned by the company’s compelling customer offering and diversification into new markets and ability to leverage a fixed cost base, (ii) credit quality, which despite a high return on invested capital can derail earnings in any given period due to the use of financial leverage, and (iii) funding costs and availability.

While Silver Chef’s strong growth in asset originations to date has at times tested the resilience of the company’s operating efficiencies and credit quality, it is perhaps not surprising to note that it has also stretched the company’s funding capacity. It is the latter that, in combination with the recent fraud event, has prompted Silver Chef to tap the market for more equity by way of a 1 for 12 fully underwritten accelerated non-renounceable entitlement issue at $7 per share.

There are in our view three key points to note about Silver Chef’s latest capital raise. The first is that the retail component of the entitlement offer commences on 28 March and closes on 12 April. The second is that the offer price represents a 9.2 percent discount to the TERP of $7.71. The third is that the target $21 million of new funds from the capital raise will be used to “support the company’s ongoing growth in its asset base and maintain an appropriate mix of funding sources”.

What is particularly interesting about Silver Chef’s latest capital raise is that they are likely to become less frequent going forward – note that Silver Chef has been reasonably reliant on equity funding, having raised $7.5 million from institutional investors in September 2016. The key reason for the expectation of a lower reliance on equity funding going forward is Silver Chef’s intention to develop a securitisation strategy.

This strategy has been used to great effect by peer company FlexiGroup. While the limiting factor to date has been the size of Silver Chef’s asset base, this is now becoming less of an issue given the recent growth. In essence, the establishment of a securitisation warehouse will (i) enhance the Silver Chef’s financial leverage without a commensurate increase in risk given it will be non-recourse, and (ii) potentially lower funding costs and increase dividends.

Outlook

There are two reasons to think Silver Chef’s share price is now offering more compelling value. First is management’s earnings guidance (i.e. underlying earnings between $23 million and $25 million) for FY17, which remained intact following the 1H17 results. The key drivers of the earnings recovery in 2H17 include ongoing momentum in asset originations, a higher rental rate and lower bad debts in GoGetta, and a modest reduction in corporate costs.

The second is the capital raising, which although dilutive near-term, does provide an increased funding base from which to continue to grow the company’s asset originations and ultimately earnings, with the latter being subject to a reduction in bad debts to circa 4-5 percent of revenue, from 5.2 percent in 1H17. Given Silver Chef’s track record to date and the increased diversification by both region and products, we expect the company’s profit margin to make a full recovery.

Price

While Silver Chef’s earnings multiple for FY17 of 11.4 times looks about right given the spike in bad debts in 1H17 and subsequent capital raise, we think that the company’s track record and inherent growth potential make the stock an attractive proposition, particularly from a contrarian point of view. Taking into account the TERP for Silver Chef’s latest capital raise and corresponding price action across the broader market over the intervening period, the current price looks attractive.

Worth buying?

There are two reasons to think Silver Chef’s share price is now offering more compelling value. First is management’s earnings guidance (i.e. underlying earnings between $23 million and $25 million) for FY17, which remained intact following the 1H17 results. The second is the capital raising that, although earnings dilutive near-term, does provide an increased funding base from which to continue to grow the company’s asset originations and ultimately earnings.

James Lennon is a senior analyst at investment research and funds management house Fat Prophets.

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