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PREVIOUS ARTICLE Stock of the Week NEXT ARTICLE 18 Share Tips - 22 March 2010

By Leo Sek – Clime Asset Management 

Silver Chef Limited (ASX:SIV) has been providing commercial restaurant and catering equipment finance since 1986.

SIV provides financing through its Rent Try Buy product. This is a 12 month rental contract, through 400 hospitality equipment dealers nationwide. There is a minimum total asset value of $2,000 on each contract and the average loan size is $10,000.

A refundable security bond of an amount equal to 13 weeks rent is required upon signing the rental agreement. A document fee of $195 also applies. The security bond is refunded when the customer exercises the purchase option or if the equipment is returned at the end of the contract.

The customer may purchase the equipment at any time during the first 12 months and receive a 75% rebate of rent paid. We believe the rental rebate serves to encourage customers to take up the purchase option so that SIV can receive cash earlier and reinvest to maintain a high level of profitability or return on equity.

At the end of the 12 months, customers have the option to:

–    return the equipment if it is no longer required
–    continue to rent and the rental payments deducted from the purchase price
–    upgrade the equipment.

An example lease is presented below:
Should rent assets be valued at $10,000, by choosing the Rent-Try-Buy Solution, you could look forward to:

**Nett rent after-tax savings plus purchase price

Source: Silver Chef Limited website: http://www.silverchef.com.au/rent-try-buy/how-does-it-work-

Based on the above example, a customer pays $6,000 in rent over the first year and $6,500 to purchase the equipment at the end of one year. Therefore, SIV receives $12,500 gross for assets valued at $10,000, providing $2,500 gross profit. From this, SIV would have to deduct interest and administration expenses to arrive at its net profit.

Equipment comes with a manufacturer’s warranty, after the warranty expires, the customer pays for any repairs and maintenance.

In July 2008, SIV launched a new division, GoGetta, to provide commercial equipment leasing for uses such as trucks, trailers, health, bakery, compressors and industrial equipment. GoGetta operates under the same Rent Try Buy model.

GoGetta operates through 85 vendors and 47 finance brokers. The average deal size is $45,000.

Key Issues

Currently, SIV has a funding line from BankWest. The $38.5 million facility matures in July 2011, with $30 million of the facility fixed at 6.46% p.a. Management is trying to diversify and lower its funding risk by negotiating to create a second bank syndication.  

If the recent Flexigroup Limited (ASX:FXL) capital raising is anything to go by, there is a risk that banks may require SIV to contribute more equity into the business. Management appears to be cognizant of this, announcing a dividend reinvestment plan and flagging a capital raising to follow its October 2009 raising. The downside is that this increased capital may result in lower returns on equity. SIV is a leveraged business and by increasing the capital employed, ratio will result in a lower return on equity.

SIV’s credit risk assessment of its clients appears sound. Bad debt levels have averaged less than 2% of rental income over the past 5 years. Further, SIV now draws upon 24 years of financing experience.

SIV is a volume driven business, largely dependent on the fortunes of the hospitality industry. Rising interest rates and Australian dollar are headwinds for this business if inbound travel declines. However, improving Australian consumer sentiment with low unemployment and rising house values is supportive of the clients of SIV.

Noteworthy is that SIV performed strongly during the global financial crisis, growing its finance book from circa $64 million in FY08 to $84 million in FY09 despite the downturn in credit markets. Possibly businesses moved away from banks to the smaller financiers like SIV.

The business displays interesting revenue streams as the average contract life is 29 months and 74% of FY10 income was written in FY09.  Approximately 80% of customers continue to rent beyond the initial 12 month term, producing a 30% return on capital employed.  The remaining 20% of clients are split between returning and purchasing the equipment at the end of 12 months.

The purchase option generates a 30% return on capital employed while returns of equipment generate a lower 12% return.

SIV owns the equipment and so bears the risk of obsolescence or replacement. Despite this risk, 95% of assets are currently generating income. The risk is mitigated in the GoGetta business through a vendor remarketing agreement that obligates vendors to remarket equipment if returned within an agreed timeframe.

SIV is not a very liquid stock as the founder, Allan English, owns around 40% of issued capital and daily turnover averages less than 20,000 shares.

Founder Allan English will retire on 1 July 2010 after 24 years of service, replaced by Charles Gregory, who has been Chief Operating Officer since July 2008. Succession planning has been underway for two years. Mr English intends to allocate 100 days a year, for an unspecified period of time, to support Mr Gregory. Mr English has no intention to reduce his holding in SIV.

Valuation

Performance Chart – Silver Chef Limited (ASX:SIV)
Source: www.stockval.com.au

We see a history of sustained profit and return on equity (ROE) growth in the above performance chart, a characteristic of a good investment. A policy of paying out 60% – 70% of profit after tax as fully franked dividends provides investors with a robust income stream and allows SIV to retain money to fund organic growth.

The quality of reported profit is high with operating cash flow exceeding profit after tax from the period FY06 to first half FY10.

A downside to this business is its high gearing, with net debt to equity of 165%. This is to be expected as SIV is a financing company with little equity capital requirements.

For this reason, as well as SIV’s funding risk, low liquidity and changes in management, we have adopted a relatively high required return of 16.1%.

The market currently requires 27% profitability (APF) to justify the current price. We prefer to be more conservative given the rising interest rate environment and the potential for further equity to be raised, which may dilute ROE. Therefore, we have adopted 25%.

We believe the stock is trading around fair value and would look for a conservative margin of safety or discount to our valuation before acquiring this stock.

Clime Asset Management and StockVal are part of Clime Investment Management (ASX:CIW).

 

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