Shoham – 40% ROE compounding machine

let’s start out strong with one of my favorite Israeli companies- Shoham business (SHOM.TA), but First, let’s talk about Israel’s credit market.

More than 90% of the credit in Israel, and practically all mortgages, are issued by banks. There has been a non-bank-lending sector in Israel for almost a century, but the banks have been aggressive lenders and with their cheap deposits, they kept an almost complete control of the credit market.

To compete with the banks you needed credit, and since the credit is controlled by the banks – non bank lenders would find it really difficult to compete with bank while paying banks high interest loans (~10%) to fund their own activities. Even so, there have always been segments and businesses in the market that banks just do not serve, some of which are very safe. In such cases these businesses would work with the small non-bank-lending sector.

Things started to change with the credit crisis in 2008. Banks in Israel were hit with losses and an increase in regulation at the same time. This made the banks act a lot more defensive. To give an example, it would be common to get a phone call every few weeks from your banker asking if you need a loan. nowadays this never happens, and even if you ask for a loan – almost any loan request has to go through the branch manager or even regional manager, and almost anything that isn’t 100% perfect would make the bank reject the loan outright.

This change of approach gave the budding non-bank-lending sector an opening to break out and stop depending on banks. The first company in the sector to go public was Nawi in 2012. A few months afterwards Nawi issued bonds which allowed it to not depend on banks, and in a few years their loan portfolio grew from 465 M ILS in 2011 to 2.2 B ILS in 2019.

Following Nawi, a few more private non lending companies went public and today there are ~10 public non-bank-lending companies, all very different from each other and with different customer bases. One could say the non bank lending companies hardly compete with each other – their main and almost only competition is the banks that still control >90% of the credit market.

Fast forward to present day Israel – banks are again hit with a crisis it would take a few years to deal with, and would have lasting implications in making the banks even more exclusionary in their lending. Already I hear from friends and business owners that always worked with the bank, that the bank “made a decision” to no longer willing to no longer work with their sector, even though their business is doing well.

Knowing and working (as a bankruptcy lawyer) with banks, I estimate it would take at least a decade for the banks’ paranoia do die down. At the moment mortgage and loan payments are being deferred, but at some point they would need to be paid. This will give a lot of hard work for years to come, creating a huge opportunity for the non-bank lenders.

But wait, weren’t the non-bank-lenders also hit in the crisis? well, not nearly as much, and to understand why let’s talk about cheque discounting.

Cheque discounting

When a contractor finished a job in Israel, be it a government entity or a large building company, he usually gets paid by a deferred cheque that can be cashed 1-3 months from that time.

When the same contractor has to pay his subcontractors, to manage his cash flow he would also have to pay them by deferred cheque. Since most projects in Israel work as a pyramid of subcontractors getting paid by deferred cheques, there is always a need to manage the timing of cash flows.

File:BlankCheque.png - Wikipedia
[How a cheque looks,]

So, let’s say Moshe (the “Payee”) got paid by deferred cheque by a reputable, AAA, Israeli company (the “Drawer”). The cheque is cashable in one month, but Moshe needs the money in his account to pay an employee to whom he gave a cheque that is cashable tomorrow.

Moshe can turn to the bank, but there are two problems:
The first is that it is almost certain that the bank won’t agree to cash the cheque. I have researched this quite deeply, with current and former bank employees, and the reason is mostly – that the banks see the cheque discounting as a loan to Moshe, instead of seeing it as what it is – a note from a reputable, AAA, Israeli company. So if Moshe has ANY problem with his account (say a cheque for rent bounced 6 months ago because of an error) there is no way they would work with him, no matter who the cheque drawer is.

The second problem is that even if things are practically perfect (and they rarely are), the bank clerk would almost always move the decision higher up the chain. Discounting checks is a headache for clerks, requires specific forms and can take weeks to authorize (or deny), which kind of misses the point (Moshe needs the money tomorrow!). I’ve heard from current bank employees that when a customer comes in with a cheque, they just refer him to a non-bank lender to save themselves the work.

So Moshe turns to a company like Shoham. Unlike the banks, Shoham is willing to do the hard work that goes with cheque discounting. They call up the Drawer to make sure the cheque is authentic and check the reliability of the drawer in their own systems, they ask for liens and guarantees from the payee (at least if he’s a new customer, otherwise he would already have a credit frame determined by the liens and guarantees he gave to Shoham). Usually a customer can get an answer within a matter minutes, not weeks.

Cheque discounting is both an extremely profitable, and extremely safe form of credit.

The common rate for cheque discounting is 2-3% a month, a price Moshe is happy to pay because the alternative is his own cheque bouncing in a few days, which would create a “spot” on his public credit record – this would be enough to make him lose work and ruin his business, but what makes the credit so safe?

When Shoham discounts a cheque, it can collect the deferred payment from either the Drawer, the Payee, and usually Shoham makes sure it has other guarantees. In Israel, if you don’t pay a loan the lender can take you to court which would probably take years, but with cheques- the moment a cheque bounces the information becomes public, and the lender can make enforcement actions almost immediately. Cheque bouncing is a death sentence for a small business, and business owners would do anything to avoid it.

Furthermore, Shoham’s credit portfolio has a half-life of only 1-2 months! this means that in a crisis, like the corona, Shoham can change it’s portfolio completely before companies start going under.

In addition, Shoham sees so many thousands of Cheques a month, that they are the first to identify a problem that comes up with a Drawer since one of the first signs of trouble is that a company that usually pays with cheque deferred by one month starts paying with cheques deferred by 1.5 months. This would be enough to make Shoham stay away, months or even years before cheques start bouncing.

I hope this is enough background, for now. Let’s get down to some numbers and why Shoham is so interesting.

The 40% compounding machine

The demand for Shohams services is multiples of what Shoham can offer (Shoham grants ~20% of the credit requests it gets in a day) and is restricted only by its quickly growing equity. The bank covenants limit Shoham credit portfolio to 5 times its equity (20% equity to assets).

So Shoham balance sheet should look something like this: Say have 100 equity. Shoham’s credit portfolio will be around 500 (because of the covenant) funded by 100 equity and 400 outside loans (bond, banks and other outside loans).

Shoham consistently achieves >20% return on its loan portfolio (~2% a month), so the gross finance income will be around 100. On the 400 of outside finance Shoham is paying less and less (down to ~4% from ~9% in 2016), so around 16-20 finance cost, so around 80 net finance income.

As I noted earlier, Cheque discounting is a very safe form of credit. Shoham’s bad debt is historically less than 1% a year on its loan portfolio, or around 5 in our example, and that’s including “general bad debt expense” – an expense that is expensed “just in case”, even without any real bad debt.

Shoham has one branch, and only 10 employees including the owner/operator Eli Nidam, which has been in the non-bank lending business for almost 30 years as a private company. Shoham is so efficient that it has been profitable only 2 quarters after it started working (Q1 2016), and has been profitable and growing every quarter since.

So I can’t translate Shoham’s entire reporting history, But I’ve organized, for your convenience, Shoham’s entire reporting history from Q1 2016 when it started working to the latest report – Q1 2020 (Q2 report should come out next week).

A few clarifications should be made regarding the results:

First, Shoham’s finance expenses include something called “Owner’s Guarantee”. To get a better interest from outside lenders, The owner/operator Eli Nidam personally guarantees, Free of charge, all of Shoham’s debts. Since in accounting everything must have a value, the owner’s guarantee is a shown as a “theoretical expense”- what the accountants think the guarantee is worth even though no money has been or will be paid by the company for it. It also doesn’t count as an expense for tax purposes, but it still obscures Shoham’s actual profit.

Second, in 2019 Shoham’s few employees got awarded an option plan with a 3 year vesting. For some reason Shoham chose to discount almost the entire plan (which has a value of around 4 million ILS) during the first year, and through the profit and loss.

When adjusting for these two expenses, Shoham’s results make much more sense and the tax actually paid becomes much closer to the nominal corporate tax rate in Israel -23%.

After all these expenses and adjustments, as you can see in the Excel, we’re consistently left with a profit of around 40% ROE, both on the existing and the reinvested equity. Since the demand is so much higher than the supply, I expect Shoham to approximately double every couple of years for the foreseeable future. Shoham is only a drop in the huge credit bucket controlled by banks, and the current crisis only increases Shoham’s potential market.

So with a current equity of around 80 Million ILS Shoham’s profit in the next 12 months should be about 40 Million ILS and keep growing for years to come at around 40% a year based on its incredible ROIC. Shoham is currently trading for 200 Million ILS.

Businesses that can predictably show a 40% return on equity are rare enough – and those that can reinvest that capital and still show a 40% ROE are the kind of businesses you meet a few times throughout your investing career.

Shoham‘s portfolio and the corona crisis

As I mentioned before, Shoham, as well as other non-bank lenders, have shown remarkable resilience to the current crisis. When the corona virus started to become an issue in early march, Shoham already started cleaning its portfolio from the more problematic lenders. Shoham never worked with tourism businesses or restaurants, but they became even more careful than usual.

Shoham’s Portfolio time to maturity (in days)- 31.12.2019
<30 days35%
31 to 60 days24%
61 to 90 days21%
91 to 120 days8%
Over 120 days (long term RE backed loans)12%
Shoham’s Portfolio by Industry exposure- 31.12.2019
Real Estate38%
Infrastructure36%
Services7%
Commerce12%
Others7%

Since around 80% of the portfolio gets redeemed within 90 days, by mid june the portfolio was practically new. Unlike the banks that are still deferring loans payments, Shoham is already enjoying from and extreme increase in demand and a rise in rates from 2% a month to around 3% a month.

In Q1, which came out in towards the end of May, Shoham showed remarkable resilience and very few credit losses, even though the management Increased the general expense (“to be safe”) by around 1 Million and included, in its bad debt expense, even debt that “went bad” between March and May, and it still showed a healthy profit of 4.7 Million! (around 1.3 M of which is from bond buyback).

Looking forward, The current crisis is exactly what the non-bank lending industry needed to make banks go on the defensive and allow the non-banks to take some serious market share from them in the coming years.

The only challenge left for Shoham to surge forward is to refinance its bonds or replace them with bank or other debt. Their maturity mostly through the end of 2020, and Shoham is waiting for the somewhat weak bond market (no FED buybacks here..) to get stronger.

Meanwhile Shoham can replace the bond payments with other sources (it has enough credit, though the interest is higher at around 6-8%). I estimate we will see a bond issue by the end of 2020, which will allow Shoham to reach a loan portfolio of around 500 Million ILS in the next few months, with earnings of around 50-60 Millions a year, that will keep accumulating into its equity with a 40% ROIC. For around 200 Million ILS – Shoham is my largest holding.

I hold, directly and through the fund I manage, shares in Shoham.

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