Proven Investments Limited: Prospects for a Pioneer

André Brown, Analyst

Proven Investments Limited (PIL) is a St Lucian IBC, incorporated on November 25, 2009 as a holding company.

In February 2010, PIL successfully raised US$20 million through the private placement of 200 million ordinary shares, and commenced operations in March 2010.

In July 2010, PIL listed on the Jamaican Stock Exchange by way of introduction, that is, without issuing additional shares or raising additional funds.

The company subsequently expanded its capital base through a US$9.6m rights issue in August of that year, followed by a J$1 billion five-year preference share issue in December 2011.

As an IBC, Proven is not regulated by the Financial Services Commission (FSC). Its business model was the first of its kind in Jamaica and is based primarily on holding tradable securities for investment purposes.

PIL also actively seeks lucrative private equity investments which have led to the acquisition of a 100 per cent stake in Guardian Asset Management Jamaica Limited - later rebranded as Proven Wealth Limited (PWL); and Asset Management Company Limited (AMCL).

PWL, a securities dealer, is regulated by the FSC and engages in the management of client portfolios; while AMCL, the owners of the 'Easy Own' brand, is a hire-purchase financing company.

PIL also has an 85 per cent stake in Proven REIT Limited (PRL), a company established to facilitate real estate-related investments. Proven Kingsway Limited is a wholly owned subsidiary of PRL, and is the vehicle through which the sole property owned by PIL was purchased in February 2012.

INVESTMENT MANAGER

PIL has no employees. Instead, Proven Management Limited (PML), a Jamaican incorporated company, is the investment manager for PIL, which manages the company's assets and businesses.

PML holds the 10,000 units of Manager's Preference Shares, collectively representing 50 per cent of voting rights in PIL. Management compensation is structured to incentivise strong performance for shareholders, with performance-based dividends only being paid if a predefined LIBOR-based hurdle rate is exceeded.

PIL has a five-member board, chaired by Hugh Hart. These professionals collectively bring expertise which spans a range of industries. This means the board can provide strategic leadership over existing segments in which PIL operates and growth areas which it wishes to penetrate.

PIL's objective of diversifying its operations outside of Jamaica is well supported by its board composition, with directors bringing knowledge and experience from several Caribbean territories, including Cayman, St Lucia and Dominica.

In adherence with good corporate governance principles, PIL has an independent chairman, which should help to balance the interests of management and shareholders.

Investment manager PML has a four-member board chaired by Christopher Bicknell. Only one member holds dual roles as director of both PIL and PML, which may help to minimise potential conflicts of interest.

Led by CEO Christopher Williams, one of PML's assets is its strong management team which has a wealth of experience in the financial sector.

BUSINESS STRATEGY

PIL's business model is similar to that of Berkshire Hathaway, a US holding company which manages a diverse number of businesses across the world.

PIL targets viable high-quality fixed-income instruments and equity positions in companies which yield above-average return on investments. The ability to provide attractive returns is supported by its tax-efficient structure.

Given the scope and risks associated with its investments, PIL targets the high net worth (HNW) market.

Proven's investment strategy focuses primarily on three main revenue drivers: carry-trade, portfolio positioning, and private equity transactions.

Carry-trade: A core strategy of Proven is the investment of funds raised through the issuance of short- to medium-term debt instruments in a diversified portfolio of securities. Its balance sheet is funded through issuance of secured structured notes and equity-linked notes, as well as margin arrangements with international brokers.

This strategy, given the duration of liabilities, provides greater stability in PIL's fundraising relative to the repo-based model employed by most local securities dealers. Its portfolio of diversified, investment-grade securities (approximately 60 per cent of entire portfolio) stands as suitable collateral when sourcing funds from international lenders.

The carry-trade strategy works well in the context of low borrowing costs and undervalued assets. The uncertainty in the market and decline in US interest rates has pushed the prices of investment grade bonds to all-time highs, thus limiting the profitability of this strategy.

Subsidiary PWL also has local repurchase agreements, but has been actively reducing its exposure to this product.

Portfolio Positioning: PIL currently generates most of its revenues from actively analysing regional and global markets, in an attempt to identify attractive investment opportunities. This primarily includes fixed-income securities as exposure to equities was reduced in light of the recent volatility in equity markets. Similar to the carrytrade strategy, potential return from portfolio positioning may be affected by large exposure to investment-grade bonds and the current low yields on these assets.

Private Equity: PIL targets equity positions in companies which have strong business models with the potential for high levels of growth over the medium term. The success of this strategy will depend on the availability of market opportunities, management's ability to identify these opportunities and the availability of capital to execute as they arise.

INDUSTRY ANALYSIS

Proven operates in a niche market, raising capital from local and international investors for investment in various asset classes.

Through its subsidiary, PIL has extended its business lines outside the financial industry, already occupying space in the real-estate market with further plans to target healthcare, tourism and security industries.

PIL's major competitors, based on its business model, are Sterling Investments Limited and BCW Capital Limited, both recently incorporated entities.

Though Proven may have a larger share of the market given first-mover advantage, these entities have aggressively increased their market presence, which will erode Proven's market share.

Subsidiary PWL actively competes with local securities dealers in the HNW space. The strategic move by PWL to divert from its repo-based business model is shared by many of its peers, given the regulatory thrust and the drive to move revenue generation off balance sheet.

The impact of the NDX has further reduced investor confidence in GOJ and will see dealers diversifying their product offerings, ultimately threatening PIL's niche. These larger players, being more highly capitalised and having access to a wider branch network, are expected to make inroads into Proven's market.

Proven REIT has only one property in its portfolio. Locally, there has been improved demand for properties helped by falling interest rates which have made mortgages more affordable.

Within the United States, the properties market remains depressed, providing opportunities for Proven to acquire discounted properties outside the Caribbean region.

Nonetheless, PREIT's ability to acquire properties and close private equity deals will be dependent on liquidity in the capital markets.

AMCL has moderate market presence, with services being offered through seven retailers, whose operations span 22 stores, including Bashco and MegaMart.

Proven's CEO noted that hire-purchase sales at participating retailers have been low, creating a need to expand product reach.

Expansions in the MegaMart network should allow for greater market presence. However, operating in a market already dominated by retail giants Singer and Courts, which have large consumer databases and a wider market presence - 23 and 29 stores respectively - AMCL will face significant challenges growing market share.

FINANCIAL PERFORMANCE

PIL has performed creditably over the last two years. In 2011, its first full year of operation, earnings totalled US$6.6m and included a US$5m gain from the purchase of GAM Jamaica.

Return on equity of 19.28 per cent was on par with average of larger players. However, net profit dipped 50.1 per cent in 2012 to US$3.3m.

Similar to local securities dealers, net interest income - NII - accounts for a significant portion of PIL's net revenues. However, this is mainly from the investment of funds raised through private placements and a preference share offer - unlike other securities dealers that raise funding primarily through repurchase agreements - at a positive spread.

Despite the notable difference in strategies, PIL's NII declined by 1.2 per cent to US$3.1m in 2012, consistent with the market. Consequently, net interest margin - NIM - declined to 2.43 per cent (FY2011: 2.68 per cent).

There is some concern for PIL in a declining interest rate environment as the duration of its existing liabilities cannot quickly adjust the cost of existing funds.. The duration on existing liabilities are medium to long term which limits speedy repricing.

On a positive note, though, PIL has only seven per cent of its assets invested in GOJ securities and therefore will not be significantly impacted by the NDX. Further, the low interest rate environment may allow PIL to raise new capital at lower cost.

Trading gains increased 7.8 per cent to US$3.31m in 2012. Growth could be tepid in the coming year given that most of the portfolio is invested in investment-grade credits which are currently priced at historic highs.

With a cost to income ratio of 52 per cent, PIL's cost structure is largely in line with the 50 per cent international benchmark.

Operating expenses declined 18.3 per cent to US$18.3m given a decline in amounts paid in preference share dividend.

Administrative costs, which account for the majority of expenses, rose 8.8 per cent, just above point-to-point inflation of 8.02 per cent.

PIL's capital base stood at US$33.1m in 2012, down 3.3 per cent relative to the prior year as a result of fair value losses on available-for-sale securities.

Capital to assets ratio, however, held firm at 24 per cent, suggesting an unchanged funding structure. Its asset base declined marginally reflecting reduced cash levels.

Through its subsidiary, PWL, there has been a gradual reduction in repo liabilities.

PIL has negative operating cash flow - US$25.9m in 2012 - which is typical for a company in the early stage of its life cycle.

However, dividend obligations will increase cash requirements. A more prudent decision might have been to suspend dividend payments on ordinary shares until the company has adequately built up retained earnings and its cash reserves.

For April to December 2012, Proven's earnings increased 23.7 per cent to US$3.13m, driven by growth in trading gains (+18.7 per cent). Operating expenses grew by 24.7 per cent due to higher preference share dividend.

The inclusion of expenses related to AMCL also contributed to higher operating costs. However, CIR improved, moving from 50.7 per cent to 49.9 per cent.

NII coupled with dividend income yielded a 12.6 per cent year-over-year increase to US$3.48m. Trading gains rose 19 per cent to US$2.68m relative to the prior year.

All subsidiaries performed well for the nine-month period, with PWL reporting earnings of US$579,000 while AMCL and Proven REIT generated net revenues of US$366,000 and US$21,560, respectively.

AMCL grew its loan portfolio by 42 per cent, albeit from a small base. Proven REIT is also positioning to take advantage of new lucrative real-estate opportunities.

PIL's asset base grew nine per cent to US$149.8m, reflecting a 19.8 per cent increase in available-for-sale assets, which was mainly funded through the issuance of notes during the review period. Consequently, total liabilities grew 7.4 per cent to US$114.2m.

The improvement in asset prices has led to an improvement in revaluation reserves, and ultimately, an increase in shareholders' equity, which climbed 4.9 per cent to US$35.4m (BVPS: US$0.12).

TECHNICAL ANALYSIS

Proven is the only stock included on the JSE's USD index. The stock was listed at US$0.112.

Despite some volatility, Proven has shown a tendency to revert to its list price. Over the last year, the price has been flat but has outperformed the shares of most securities dealers which declined.

The impact of the asset tax and other fiscal measures would have been far less on PIL's business relative to other dealers and this is likely reflected in its relative price performance.

The top-20 shareholders own just 27 per cent of the total shares outstanding, suggesting there is no concentrated ownership and a large free float. Despite this, trading volumes are fairly low, averaging 46,000 daily during the last year.

The stock has traded on 85 out of a possible 251 days, which further indicates low liquidity.

Higher dividend taxes — proposed to increase from five per cent to 15 per cent effective April 1 — augur well for increased interest in the stock given that Proven is incorporated in a tax-free jurisdiction. As such, the relative attractiveness of the stock should increase as returns from dividends are tax free.

EARNINGS PROJECTIONS

Interest income is expected to grow at a slower pace to US$7.63m in FY2012/13. Continued reduction in the interest expense of PWL should help in growing NII to US$3.16m.

Proven's FY2013/14 performance is expected to be relative flat as the company is faced with greater pressures from lower asset yields and challenges in the target economies.

Using year-to-date performance as a gauge, inflows from other revenue sources are expected to grow a further 28.8 per cent, driven by foreign exchange gains and dividend income. The outlook for these revenue sources during the FY2013/14 is less optimistic with trading gains and forex gains expected to fall.

Despite an increase in marketing related expense related to current and future private equity deals, operating expenses are expected to fall marginally in FY2013/14 as lower performance bonuses are paid to the management team.

The aggregate impact of these factors should result in net profit increasing to US$3.8m by the end of FY2012/13 (EPS: US$1.29), but is expected to decline to US$3.6m (EPS: US$ 1.21) in FY2013/14.

VALUATION METHODS

Income Approach: Proven has an aggressive dividend policy through which a minimum of 50 per cent of profits will be paid out annually. Using the Dividend Discount Model, dividends were discounted at 15 per cent required return derived from the Capital Asset Pricing Model with risk free rate of six per cent, beta of one per cent and market risk premium of nine per cent. This yielded an intrinsic value of US$0.11.

Book Value Approach: PIL, similar to other local securities dealers, trades at a discount to its book value due to a low ROE relative to its cost of equity. Over the last six quarters, PIL has reported an average price to book value of 0.9 times. Applying this multiple to its projected book value per share of US$0.127 gives an estimated forward price of US$0.11.

Recommendation: At its current market price of US$0.10, the stock is slightly undervalued as both models yield an estimated fair value of US$0.11, representing a 10 per cent premium to the current price.

The stock provides an attractive dividend yield which is estimated at 5.5 per cent in the next year. Using the five-year average historical depreciation as a guide, foreign-exchange gains could be close to six per cent. With a projected total return of 21.5 per cent which far exceeds the required return of 15 per cent, a 'Buy' recommendation is being placed on Proven. See insert 'PIL Investor Profile', for the profile of investors for which this stock is best suited.

OUTLOOK ON PIL

Proven has created a niche in a relatively untapped segment of the financial sector and is likely to benefit from first mover advantage even as other firms adopt a similar business model.

One of its major strengths is the management team which brings a wide array of knowledge and experience.

That said, the company will need to intensify its marketing efforts in order to remain in the forefront of investor's minds. This will be critical in executing its strategy as strong brand image is important and more so in times of uncertainty.

The current environment should provide an opportunity for the company to build out its private equity strategy as the weak economic environment is likely to present more opportunities for undervalued assets.

However, gains from this strategy are not always immediate and depend on management's ability to successfully identify attractive deals.

There are some concerns relating to the execution of its carry-trade and portfolio positioning strategies in light of heavy exposure of investment-grade securities. Given that these assets are at all-time highs, the yields are low and as such, income from these strategies should remain subdued.

Consequently, there may be greater focus on private-equity strategy to boost growth.

Diversification will become more crucial. The company should seek to make acquisitions across various industries, geographic locations and asset classes. Assets such as equities and real estate also provide lucrative investment opportunities given current market trends.

business@gleanerjm.com