Morses Club: A misunderstood subprime lender about to thrive in a post-pandemic world

 Disclaimer: We are shareholders of Morses Club Plc

If Card Factory didn’t repel you last time, we bet this one will. But if you are like us, you know that it is precisely what opportunity smells and looks like. Take a deep breath and let us introduce you to Morses Club, you won’t be disappointed.

Elevator pitch:

Morses Club is the UK’s second largest provider of home-collected credit (“HCC”) with a market capitalization of £98m. It issues loans from £200 to £1,500 for a duration of 35 to 52 weeks at 75% to 95% interest rates to customers that typically have no fixed jobs, earn less than £15k per year (mostly from government assistance) and therefore have no access to mainstream lending. Key motives for taking out a loan include Christmas, holidays and unexpected household expenditures when an appliance/car/good breaks down. Having spent a significant amount of time working on the industry, we believe that HCC is profoundly misunderstood by investors and incorrectly assimilated to payday lenders and loan sharks. The cold truth is that, while unfortunate, HCC is a necessity for many households and most of them, as the regulator says in its High Cost Credit Review, “would be significantly worse-off if this line of credit was unavailable”. In addition, while headline interest rates look high, they must be compared to the impairment rate (c.23%) as well as the commission paid to agents (c.21%). All in all, well-run HCC providers earn c.20% return on capital, which, while good is hardly a sign of price gouging. This mismatch between investor expectations and reality therefore provides an extraordinary opportunity to buy a company that i) is cheap on pre-COVID metrics (6x P/E for the core HCC business, excluding the digital division), ii) will be a beneficiary of the post-pandemic rise in unemployment and iii) will see its #1 competitor Provident (44% market share) shut-down, creating a credible path for Net Income to more than double within 2-3 years. Morses is trading at less than 3.0x our “pro forma” 2023 earnings, which paves the way for a 3-bagger in the next 2 to 3 years (historical range since IPO was 9x - 12x). Keep in mind that these numbers do not include the optionality from the digital division (breakeven targeted in 2021) where Morses has a clear path to cross sell its existing HCC customer base and the potential to expand its addressable market by a wide margin. Lastly, insider ownership stands at 39.2%, providing for a good alignment of incentives (36.0% come from Morses’ reference shareholder – the Hay Wain Group – who has one seat on the board and 3.2% from the Executive Team). Also, Morses’ COO purchased £150k of shares four weeks ago, a clear sign of the things to come in our view. Obviously, such a valuation disconnect would not happen if there wasn’t material concerns around the industry/company. We take a look at both of the market’s biggest perceived risks (regulation and rising refund claims) and show why we think they’re overblown. Even if we are wrong and these risks materialize (highly unlikely in our view), we think that a permanent loss of capital would be very limited. 

 

1-    HCC Market & Company Description

As you may not be familiar with the market, let’s take a step back and go through an overview of the HCC industry and its customers.

What is it and how does it work?

The way HCC works is rather simple. A new customer will start by completing an online application on Morses’ website. If it passes the first screening, its local Morses Club’s agent will be in touch to finalise the details directly at its home (hence the name of the industry). This agent model is key to HCC providers as agents typically live in the community they serve, which helps create accountability and improves a lender’s knowledge of its customer base.  The prospective customer will then have to fill with the agent a lengthy questionnaire detailing its financial condition and weekly income/expenses. Morses will typically cross check the information given to its agent on a central credit database, but also crunch its own internal data in order to check for discrepancies (for instance comparing the weekly electricity bill / rent of a prospect to all its existing customers in the same area). If a loan is approved (approval rate is only 30% at Morses), the agent will deliver the loan to the customer either in cash or directly into its bank account. A loan’s duration can typically range anywhere from 14 to 52 weeks at interest rates of between 40% and 100%. Repayment is made weekly (both principal and interest is repaid) either to the agent in person at home or digitally. Contrary to other form of unsecured high-cost credit, there’s no hidden fee for rearrangements or if payments are missed. Customers value this weekly repayment system as it helps them navigate their finances more easily and mitigate the risk of bad surprises at the end of a loan.

Market Overview

Home collected credit is part of the broader non-standard finance market which is home to 10-12m consumers (20-25% of UK adults) who have difficulty getting credit from traditional financial institutions due to their damaged or sometimes non-existent credit history.

The HCC market in particular is a very established market in the UK, having existed for over a hundred years. It caters mainly to the unemployed and underemployed (working part-time while looking for a job or on zero-hour contracts) who have low and fluctuating-income streams. HCC customers typically take out small, unsecured, short-term loans to finance events such as birthdays or Christmas, or unexpected expenditures. The average loan value in the HCC market in 2020 was c.£770. The market is mature and has been rather stable in recent years at c.£1.1bn, despite increased regulation and an employment rate (pre-COVID) at all-time highs.

 

 

Source: Morses AR

The industry has consolidated around 3 national players who represent c.80% of the market in 2020 as smaller firms have struggled to keep pace with the FCA demands on technology and auditability. In addition, these firms lacked the resources to invest in their digital offerings, which made them highly uncompetitive in the marketplace. Provident is currently #1 with a 44% market share, followed by Morses at 28% and Loans at Home at 10%.

(See the last section for our comments regarding investors’ concerns over sustainability and recent challenges with CMCs, which we think are overdone)

Customers Snapshot

The following snapshot is mostly derived from the PwC review, which was requested by the FCA (the HCC regulator) as part of its 2018 High Cost Credit Review. While this study is based on 156 re-borrowers (whose profile might differ from a typical customer), our discussions with industry participants lead us to consider it as a good proxy for the overall HCC customer base.

As shown by the demographical profile below, the typical HCC customer is more likely to be a female, over 55 with annual income of less than £12k (most of which coming from government benefits).

 

 

 

 

 

 

 

 

The purpose of its borrowing was either to purchase a specific item or fund a specific event (55% of the time) or to cover different kind of daily expenses (25% of the time).

 

There are two main reasons why customers choose HCC:

·       They have a limited access to alternative products and traditional high-street banks. Indeed, only 28% of HCC re-borrowers have a credit card and less than 20% have an agreed overdraft (see below) resulting in around ¾ of them considering no other options for a loan. Of the small number that had considered alternatives, the main options mentioned in the study were borrowing from friends or family, selling something or getting a bank loan. “Most were confident that mainstream credit wasn’t an option and they either didn’t have friends or family in a position to lend to them or were not comfortable asking”;

·      The other reason is “because it was known in their community, often people knew either an agent or someone borrowing from them, and most had been referred by a friend or family member”. Also cited was the “convenience of applying in home – or completing in home if starting the application over the phone – receiving the loan in cash on the spot and having flexibility on repayments when needed”.

Despite high interest rates, customers are very loyal and do not really consider the cost of the loan, which help explains the high amount of recurring business in the industry:

·      The cost of the loan is not their main concern: “There was little to no evidence in the qualitative interviews of customers shopping around” and “little thought was given to the overall cost of each loan or the longer term cost of repeat borrowing”;

·       They often use the same provider and for a long time: “Customers described how once they had started borrowing it soon became a habit as they found it convenient, valued using a known provider and could get the money quickly”. “60% of those in the quantitative research had been with the provider of their most recent loan for 3 years or more”.

Company description

Morses Club derives 90% of its GBP133m revenues from its Home Collection Credit (HCC) division, where it provides small (£200 to £1,500) short term loans (35 or 52 weeks) to 220,000 customers at interest rates of 75% or 95%. The impairment rate as a % of revenue is c.23% and commissions paid to its self-employed agents is c.10% of customer repayments (21% of revenues), which incentivize agents to loan only to customers they know will repay.

On top of that, the group established an online division in 2020 after acquiring Dot Dot Loans (digital short-term instalment loans) and U Holdings (e-money current account). The idea behind this move was to widen the company’s addressable market by targeting customers that needed different types of loans. It has a customer base of c.30k people across the UK to whom it offers loans of up to £5,000 on a maximum duration of 48 months. Impairment rates are close to 50% online and accordingly, the company charges higher rates at more than 100% (which both reflects the longer duration of the loan book).

Below is a financial snapshot of Morses’ HCC and digital divisions that will serve as the basis for the next section. The FY2018 appears twice as it is restated for IFRS9 changes.

 

2-    Operational set-up and valuation

A hidden/delayed COVID beneficiary

Morses is set to fire on all cylinders in a post-pandemic world. While COVID-19 has impacted customer numbers in the short-term (they had nothing to spend their money on!), its long-term impact has materially increased the company’s earning power in three ways:

-     As the pandemic ends and the UK government cuts business support, rate reliefs etc., unemployment should rise and demand for Morses’ products, which are counter-cyclical, will go through the roof;

-     The community of small, family-owned HCC businesses has been badly hit by the pandemic and the number of companies registered with the Consumer Credit Association as HCC providers declined from 400 to 262 in 2020. As the last standing man, Morses is ideally positioned to capture a disproportionate amount of market share from these businesses;

-        Adoption of remote payment options has been significant, going from 39% of collections to 80% last year, with no impact on collection rates. This has led Morses to rethink its operational structure as this shift to digital means agents are not required to visit customers on a weekly basis but could rather visit them on a bi-weekly basis or even once a month. As a result, the company managed to shed 30% of its agents (c.600), lower their commission rate from 10% to 8.5% while increasing the absolute commission per agent (see below). This change will enable the group to save c.£4.4m, or 20% of HCC’s pre-pandemic profit before tax.

 

 

 

 

The #1 HCC lender is exiting the industry

Provident, HCC’s #1 player, announced three weeks ago that it would wind-down its HCC business after years of losses following a botched operational overhaul in 2017 (it tried to shift from an agent-led model to an employee model) and an unsustainable level of refund claims from past customers (Provident was a notoriously “aggressive” underwriter of loans in the HCC space, which came back to haunt them -  more on this later). Here is a recap of HCC customer numbers (excluding digital customers) and market share among the top 3 HCC players (which represent c.80% of the industry).

It is important to mention here that while Provident lost c.400k customers between 2016 and 2019, it did not flow to other players in the industry as i) most of them were low quality and would not fit into their lending criterias and ii) the industry shed many customers following some regulatory changes. The situation is quite different today and Provident indicated in its 2019 results that its customer base had started to stabilize and indicated higher customer quality.

We expect that Morses, as the new largest player will capture a disproportionate number of Provident customers in the aftermath of its exit. We apply a 50% haircut to Provident’s 386k customer number to reflect Morses tighter lending standards as well as Provident falling customer base in recent years (although as we mentioned it had started to stabilize pre-COVID). The following table shows how much additional Net Income Morses can generate depending on what % of Provident customers post-haircut it acquires. It is our opinion that Morses can reasonably capture 40% to 60% of Provident customers post-haircut and therefore add between £13m and £20m to its pre-COVID £18m Net Income.

 

Valuation

Below is a table that sums up most of the moving parts highlighted above in order to arrive at our estimate of the business’ earning power for FY23 (ending March 2023).

As you can easily see, while Morses is on the cusp of a significant inflection point in terms of customer and loan book growth, this is far from being reflected in the current share price. The company trades at 6x its pre-COVID earnings and c.3x our pro forma earnings estimate (c.30%+ free cash flow yield). As the catalysts we identified above become clearer to the market, we expect shares to quickly recover to pre-pandemic levels. If reality is anywhere near our base case expectations, we think that the share price can triple in the next two years.

 

Bear in mind that all of this excludes the digital division, which has been losing c.£7m per year since it was acquired. The business is now rightsized, and management expects breakeven for the end of this year which is highly realistic given the fixed nature of the cost base and the customer growth numbers seen so far. We think that this division provides significant upside optionality if management executes well. Indeed, Morses online offering targets a wider part of the 12m person UK non-standard credit market, which would significantly increase the company’s addressable market. It is ideally positioned and can jumpstart its growth by cross selling its HCC user base into digital products. Indeed, Morses’ internal research shows that over 50% of its existing customers want to use its e-money current account services and online banking services. However, until we see tangible proof of execution going the right way, we value the digital division at £0.

 

3-    Why is it cheap? Regulatory and other risks

By now you must be thinking this is too good to be true. And you are right, it is!

There are two main concerns in the market at the moment and they pertain to i) the sustainability of the industry and ii) the sharp increase in refund claims in the past year. We have done a lot of work on these and think they are way too overblown.

Sustainability of HCC

Investors often mix up HCC with payday loans/ loan sharks or the wider high cost credit industry and therefore consider the former as an industry at risk of being wiped out by the regulator. Nothing could be further from the truth. In its study of the UK’s High Cost Credit industry made on behalf of the FCA (the high cost credit regulator), PwC studied the 6 most popular unsecured high-cost lending products and concluded that “home collected credit customers had the lowest indicators of harm of the 6 high cost credit products covered in the study”. You will find below the results of the PwC survey comparing HCC and Payday Loan customers.

DK View on regulation

In its 2018 High-cost Credit Review (which we highly recommend to any prospective investor), the FCA highlights a few interesting points about its perception of the HCC industry. Its concerns are mainly related to the risks of repeat borrowing, rather than the price of a single loan:

“A number of comparisons have been made during our study between home‑collected credit and HCSTC, with calls to extend the HCSTC price cap to home‑collected credit. Such considerations need to take into account the specific characteristics of the particular products and there are significant differences between HCSTC and home‑collected credit products. Home‑collected credit loans will typically have more, and more frequent, repayments than HCSTC, with few if any contingent charges and no balloon payments at the end of the loan to clear the debt. While the costs for some home‑collected credit consumers can accumulate, this is the result of how some firms refinance consumers’ loans, rather than the pricing of individual loans. Our proposals aim to address this source of harm directly and we would expect to see reductions in the cumulative cost paid by consumers. We are therefore not currently planning to develop proposals for a price cap for home‑collected credit but will revisit this issue when we assess the effectiveness of the changes we are now proposing”.

Relending is the FCA’s major point of contention, arguing that some customers may be using HCC as a “revolving line of credit” throughout the year, which quickly traps them into a circle of debt, given the interest rate charged. However, it also stressed that “repeat borrowing and multiple borrowing is clearly a prevalent feature of home‑collected credit use. We do not consider that this in itself is harmful. Providing creditworthiness assessments are carried out effectively, weekly repayments should be affordable and sustainable. Repeat borrowing can be a useful means of managing cyclical income shortfalls”. Multiple loans arise for the need of families to finance in a single year vacations, Christmas and the back-to-school period for the kids, as well as other unscheduled expenses throughout the year. 

Interestingly, the FCA found out that “generally, consumers are mainly positive about using home‑collected credit” and that “many said that they would be significantly worse‑off if this line of credit were unavailable to them”.

The FCA highlights a few alternatives to HCC, among which credit unions and local authorities but quickly points out several barriers such as low appetite to finance riskier customers from and caps on rates that credit unions can charge, which limit their participation in the subprime market. In addition, the sector has seen a very low rate of market entry since, as the Woolard Report points out, “without economies of scale, the higher costs of lending to sub-prime consumers, especially where relatively small sums are being lent, is not profitable enough to encourage entry from commercial firms without interest rates comparable to high cost credit.”

From our work on the industry, we do not think that the FCA will impose material changes on relending in the coming years. But let’s say we are wrong and the FCA regulates repeat borrowing: What would happen to our numbers? The following chart shows the distribution of HCC loans origination per borrower:

We assume anything above 3 loans per customer per year is considered excessive by the FCA (in line with our perception) and forbidden outright. As most reputable HCC firms do affordability assessments for every single additional loan they issue to customers, we would expect a regulation – if there ever is one – to be less rule-based and leave more room to HCC providers. Anyway, the following table shows that based on our calculations, such a regulation would reduce loans issued by c.21.5%. This include a mitigation factor from all customers above the 3 loans per year threshold shifting to only 3 loans per year.

We then apply this 21.5% haircut to our base case amount of loan issued. We increase the interest charged to consumer from 67% to 70% as we believe that Morses would use its “pricing power” in order to offset part of these regulatory changes. Overall, we estimate that while the regulation would reduce Net Income by c.40% compared to our base case, it would still be 20% above 2019 levels. Shares would then trade at 4.4x our Net Income estimate, which would simply be way too cheap once regulatory concerns are “de-risked”.

NB: the Net Income from Provident customers acquired has been adjusted to reflect a similar customer number adjustment.

The flood of refund claims

Because of the FCA’s lack of clarity regarding what constitutes “problematic” repeat borrowing, there has been in 2020 a significant step up in claims for refund by Claims Management Companies (“CMCs”)  on behalf of past HCC customers. For instance, Morses went on from paying £0.4m in FY20 to £4m in FY21. Usually the claim process carries two steps: i) claims are brought to the attention of the company, which then rejects it or negotiates a settlement; ii) if both parties are unable to resolve the issue, then the claim is referred to the financial ombudsman service (“FOS”). Successful claims generally require the reimbursement of interests paid by the customer and an 8% interest penalty. CMCs then take a cut of the amount paid to the customer by lenders (typically a percentage).

Importantly, the way CMCs gather all these claims in a cost-effective way is through online ads directed to past HCC customers (“Ever took out a doorstep loan? You could get a refund! Fill in our form to see if you are eligible”). This is very similar to what happened to airlines in Europe a couple of years ago with EU 261. The tables below gives an overview of all the complaints that have been reported to the FCA by the companies. It is important to keep in mind that this data includes all kind of complaints received (like somebody not having been able to access its online account etc.). Nonetheless, we think that the data is directionally correct. 

 

As an aside, it is interesting to note that Morses’ upheld rate is the lowest among major players (while Provident has the highest), which indicates better underwriting standards – at least compared to peers. This is further confirmed by the upheld claim per customer rate of Morses being the lowest among HCC participants. Also, bear in mind that current refund claims stem from past customers, which means that i) the 2020 upheld per customer ratio is artificially boosted by the COVID-linked temporary loss of customers and ii) Provident’s ratio is overestimated to some degree because it lost more than half of its customers in recent years.

As you can easily see, 95%+ of claims have centered around two companies: The first is Provident, because of the sheer size it had in the past (its HCC division had in 2015 c.800k customers, 4x the size of Morses) and also because it had notoriously been “aggressive” in its underwriting process. The second is Amigo, a provider of guarantor loans (a subsegment of the high cost credit market, similar to HCC). These loans are offered to borrowers with weak credit histories if they have friends or family willing to bear the risk of default. This would typically reduce the interest rate paid from 70/90% in HCC to c.40/50%. The sector was ripe for abuse (a “guarantor” signature is easily forged) and Amigo’s  poor compliance/KYC systems led it to carry a significant amount of irresponsible lending over the years.

Why does it matter? Well, these two companies both happen to have entered schemes of arrangement this year (21^st January for Amigo and 15^th March for Provident). The general purpose of such a scheme is to put an absolute cap on certain creditors’ claims (in this case the CMCs’) – generally at a discount to their face value – in order to avoid bankruptcy. So far only Amigo’s scheme terms have been made public: they intend to contribute £15 to £35 million to the scheme and 15% of profits over the next four years. This will effectively cap the claims at c.10% of face value. Despite the magnitude of the haircut, 95.09% of creditors voted in favour of the scheme (the alternative being receiving £0 as the Amigo goes bust!). While the court didn’t sanction these terms (the judgment is a fascinating read), we expect a revised deal to c.20%/30% of claims to be approved. Provident’s scheme should be very similar to Amigo’s, although the details have not been published yet.

The bottom line is, even if the deal ends up being a 50% recovery for creditors, the incentives for CMCs to bring in new clients have effectively disappeared. Indeed, from now on, whether CMCs bring in 0 new clients or 1m new clients, the absolute amount set aside by Provident and Amigo in their respective schemes of arrangement will be unchanged. It would make no sense for CMCs to spend money on online ads to make 0 incremental revenue (since their fees are a % of repayments). Because Amigo and Provident represented such a large amount of the profit pool (90%+ if the FCA statistics are a good proxy), we would expect the biggest CMCs to retreat from the market as i) the unit economics of an ad will considerably worsen (since 90% of customers acquired in the past will not be revenue generator anymore) and ii) it becomes a marginal revenue driver.  Of course, smaller firms may still make a living going after Morses and Loans at Home, but the retreat from bigger firms will nonetheless materially decrease the amounts paid by these companies longer term.

What if we are wrong? The following table shows the impact adding the previous section and a pessimistic scenario for claims (tripling to £12m). NB: we assume the company increases its interest rate charged to clients to 75% to partially offset the claim impact.

While this scenario would completely erase the upside, the fact that shares would still be worth a small 20% premium to the current share price at 10x PE is indicative of the significant asymmetrical risk/reward.