Distribution Finance Capital Holdings plc (LON:DFCH) is the topic of conversation when Progressive Equity Research’s Head of Research Ian Poulter caught up with DirectorsTalk for an exclusive interview.
Q1: DF Capital, could you just give us a brief synopsis of the company?
A1: The full name of the company is Distribution Finance Capital Holdings, it was founded in 2016, it’s incorporated in England and currently main country of operation is the UK.
Its subsidiary DF Capital Bank is the main business and it’s a specialist lender to SME’s – that is small and medium size enterprises – and it’s also a personal savings bank. The bank has provided loans totally over £1 billion to dealers and manufacturers since it started lending activities in 2017.
I think perhaps the most crucial development recently was that it received permission to become a deposit taker, otherwise known as getting a banking license, at the end of September 2020 which has allowed it to successfully replace more costly wholesale funding with retail deposits.
It’s also recently had a capital raise which effectively doubled its lending capacity from a regulatory capital perspective and we expect it to grow its loan book at a pace with that £40 million capital raised, supporting a loan book of around £550 million pounds.
It’s initially concentrating on its inventory finance loan product to secure run rate profitability during the fourth quarter of this year but it also holds the promise of supporting, what is generally seen as a poorly served market with the addition of new longer term products in adjacent segments in the future.
I think it’s worth noting that with access to deposit funding, DFCH has raised £145 million of deposits in the 12 weeks to the end of December 2020 which allowed it to repay all its other forms of more expensive borrowings and obviously bring down its cost of funds substantially.
Finally, on this brief run through, the group has got a very experienced management team in place. The Chairman, John Baines, has 30 years of experience in the banking industry, the CEO, Carl D’Ammassa has 20 years of experience in commercial and SME finance and the FD, Gavin Morris possessing over 20 years of financial services experience across banking, corporate lending, and leasing.
Q2: What sort of SME customers does the company lend to?
A2: It offers inventory finance and supply chain products which provide working capital solutions so it effectively purchases assets from manufacturers and these are then delivered to those selling the products. For instance, a caravan dealer or something like that for onward sale to the final consumer so its loans are repaid when the dealer sells its asset to that final consumer and the lending product is actually known as Pay-as-Sold for that reason.
Its current target customers are those in sectors that deal with things like motorhomes and caravans or lodges and holiday homes but also marine motorsports, transport, agricultural and industrial assets. The main purpose of inventory finance products is to support growth in those customers businesses by allowing them to match their cash cycle to the lending term, which effectively releases working capital for them. A typical average loan duration is around 150 days but the actual duration varies with the individual agreements.
So, the company offers what I think is termed unit specific finance on predominantly new inventory and that allows dealerships to stock financed assets and display them to customers. As I say, the loan amounts repaid in full on the asset sale, or it’s repaid in full at the end of the contractual term if the asset doesn’t get sold at that particular time. Once it is repaid, the facility remains available for further drawdown by the customer against other assets during the life of the facility.
Generally, the facility average over £100,000 but they will currently consider providing facilities between £30,000 and £9 million, although we understand that this limits a function of limits set by the PRA for all banks as a percentage of their regulatory capital. So, the recent capital raise should theoretically allow them to offer larger facility sizes up to something like £18 million to those sectors.
Q3: How big is the SME market segment that it’s targeting now and where do you think the company may look to establish new products in the future?
A3: Firstly, just as an aside, it’s probably worth mentioning that in November 2020, Andy Haldane, who’s the Chief Economist of the Bank of England, reiterated the point that UK SME’s face a large annual funding gap, which has previously been put at some £20 billion. The overall level of lending to UK SME’s was around £213 billion at the end of December 2020, again, according to the Bank of England stats.
So, specifically to DFCH, within that, the estimate is the inventory finance lending across the sectors in which they operate is around £20 billion in terms of the overall size.
On other products, in our note, we highlight two possible areas within which we think that it’s likely that the company could look to establish new products in the future and the first of those is asset finance and leasing, which is judged to be around a £38 billion market. The second is the market for short term working capital funding and that’s around £40 billion so we see those as significant opportunities for the group in the medium term.
Q4: More immediately though, what levels of growth do you expect to see in the loan book over the next few years?
A4: The company has had significant growth prospects and inventory finance lending from its current position and its loan book was £125 million in mid-January 2021. The group has previously outlined potential pipeline of £850 million which it could easily support towards getting its current capacity up to £550 million in terms of actual lending.
Our estimates assume that it reaches that £550 million level in early 2023, with further growth thereafter to around £725 million by the end of 2023. Of course, our current growth estimates are based on its existing loan product, what we don’t know is when they might introduce those new products that we were just talking about.
We’ve included a broad scenario analysis in our note on the company, which looks at adding a new product during 2022. That would obviously add further loan assets to the book and in our example, would also add around 12% to our 2023 adjusted diluted EPS estimate. Essentially, it would produce a base for accelerated growth if management chooses to go that route and have the new products, in our view.
Q5: Finally, what do you think are the main attributes of DF Capital in the current market conditions?
A5: Well, as we mentioned in the note, and as I’ve just said earlier, the company has got a highly experienced management team which is pretty focused on delivering swift growth from that existing inventory finance product, as I say, to hit run rate profitability later this year, in fourth quarter.
Importantly though, it received full authorisation for its deposit taking, it didn’t go down what’s termed the mobilisation route to obtain its license which would have seen it authorised but with restrictions so it’s got no restrictions on its license.
Also, on that deposit base, that, and the digital processes I think are set to add further impetus by supporting the addition of new products and these days, the efficiency brought by digitalisation is pretty crucial to operating efficiency. The company uses online digital processes to reduce the cost of underwriting, onboarding, administering, and auditing its lending customers and those systems in turn support management and staff with specific sector knowledge of lending and savings products.
I think another key point is that credit quality has remained well controlled, the group also now has experience, of course, of testing its approach to risk management and its systems during what was a very difficult year last year. Importantly, and probably unlike many peers, it was able to start 2021 with no COVID-related legacy in its loan book.
As an aside, also they do not currently lend to the motor trade or car dealerships and following its experience of lending during the pandemic last year, it has carried out a review of its entire dealer network and we’d expect the number of dealers to reduce given its focus on credit quality.
Again, as I mentioned before, it should be able to grow its loan book within its current capital capacity but also has the potential to grow more quickly with the new products, with a backing of additional capital and deposit funding.
I think it’s also important to acknowledge how quickly the group has been able to establish a deposit funding base. Having received permission to take deposits at the end of September last year, it’s raised deposits totalling £145 billion in the 12 weeks or so to the end of 2020 following the launch of its deposit taking operations.
We estimate that that’s reduced the funding cost of the business from around 6% to less than 1.5% and the group has repaid all of its wholesale funding and other loans. Management really expects to fund all its near term growth from deposits.
So, all around, it looks well positioned for growth to us, it has an excellent opportunity to grow its loan book swiftly, combining that low cost funding with a robust business model in what was I said earlier is a poorly served SME lending market.