The world’s great investors all know that if you’re looking for great potential investments, then the one place to start is in the stocks that are owned by investors that you both know and respect, and that have a demonstrated track record of success. In fact, it’s a method espoused by greats such as Warren Buffett and Charlie Munger.
"I used to wait for the Graham Newman newsletter to come out each week so I could see what they were buying and it would be a good place to start to look for investments. If Graham Newman was looking at something it was definitely worth my while to look into it." ~ Warren Buffett
"Start looking at what other people that you know and respect are buying. This is far from a silly filtering device." ~ Charlie Munger
That doesn’t imply that you blindly follow those investors into stocks, but it will provide a short list of potential candidates for further investigation. That’s how I found CML Group.
CML Group (ASX:CGR) is a company with just over a $100m market capitalization whose main business is lending to SME’s. It trades on c11-12X consensus FY19 earnings multiple and has guided to 15-20% underlying EBITDA growth this year.
So what’s attractive about CML Group?
CML’s main business is ‘factoring services’. This is a form of small business financing where CML purchases a company’s invoices at a discount to their value. CML releases funds almost immediately and collects the outstanding monies in around 42 days. CML earns the difference between the invoice proceeds and the money provided.
As an example of this, take a food supplier to Woolworths who has sold them goods, has invoices and is awaiting payment. The supplier can sell that invoice to CML Group who will release payment almost immediately. CML charges interest and administration fees. The supplier frees up critical working capital to expand, doesn’t have to mortgage property and needn’t chase up customers for payment. This financing allows the business to grow and ordinarily doesn’t impact the business’ other financing arrangements.
Factoring, when managed well, is one of the safest forms of lending there is. In the example above, CML Group’s security lies with Woolworths. CML mitigates the repayment risk by only lending a percentage of the invoice, choosing the invoices it will lend against and insuring every invoice against loss [at 90% level]. CML’s loss ratio has been just 0.1% in each of the last 3 years.
Barriers to entry include scale, a shallow pool of experienced personnel, and client relationships.
Furthermore, CML’s acquisitions over the last few years have enabled them to scale the business to access cheaper sources of funding unavailable to smaller competitors. A recent bank financing facility is expected to save CML Group over $2.5m a year in funding costs - not bad for a $110m market cap company!. These savings are likely to be retained by CML rather than passed onto customers. That’s pricing power.
Macroeconomic developments tend to hold far less importance to CML Group than industry trends such as the policies of banks and the industry structure. Tougher capital requirements imposed by APRA have made factoring less attractive to banks and seen most exit the market.
The recent banking Royal Commission is likely to tighten lending criteria and further limit the financing options available to SME’s, making factoring an attractive solution for businesses.
The factoring market has consolidated into two key players with the combined market share of the top two players now being c70% [CML Group c20%, Scottish Pacific Group c50%].
Given business profitability is determined primarily by the competitive environment on the supply side, a more consolidated industry should lead to higher returns.
Runway for Growth
The runway for industry growth is attractive given factoring is under-represented in the Australian market. Its market penetration is estimated at just 25-50% of more developed international markets.
CML Group is also moving into invoice discounting, a complementary product line with a market size some ten times larger than factoring. The group has also started an equipment leasing business which should provide further growth and cross-selling opportunities.
Skin in the Game
The CEO and Chairman have significant stakes in the company which ensures alignment between shareholders.
CML Group trades at an undemanding multiple of c11-12X consensus FY19 EPS. This compares to the c18.7X FY18 NPATA that the private equity firm, Affinity Equity Partners, has offered for Scottish Pacific Group.
The recent bid by Affinity for Scottish Pacific highlights the corporate appeal of such businesses. Private equity has already taken many of the Australian non-bank financials private, including Pepper Group , La Trobe Financial and Bluestone . Now that Affinity Equity has targeted Scottish Pacific, it’s not too hard to imagine other groups running the ruler over other non-bank financials.
In summary, CML provides an opportunity to buy into a good business in a consolidated industry, with strong barriers to entry and corporate appeal.
The business has a tailwind from tightening bank financing, an underpenetrated end-market, and complementary new business opportunities.
Management has a track record of successful acquisitions, disciplined growth, and with plenty of skin in the game. Provided management remains vigilant in their risk management, CML Group has the potential to continue to compound investors’ wealth into the future.
And lending to SME’s can be a highly profitable business. German listed Grenke is a case in point: It’s a leasing/factoring specialist that’s been a 15 bagger over the last ten years. On 28X FY19 earnings, it clearly demonstrates what can be done.
Views expressed in this article are those of the author, and are not necessarily the views of Moelis Australia
Thanks for the article. Just on the same theme I came to buy into CGR back in 2016 when a director from another small cap I own MNY moved across to CGR. I was impressed with MNY's team at the time and thought CGR must be worth investigating. The rest as they say is history. Thanks again.