This story was originally published on July 01, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere.

By Greg Peel

Microequities is an Australian financial adviser specialising in in-depth research of listed "micro caps" - those companies of low capitalisation too small to register on ASX indices or to attract research coverage from leading stockbrokers. In June Microequities hosted its Rising Stars conference, at which selected companies presented their stories. FNArena was invited to attend, and over a period of time will provide conference highlights. This is the first in the series.

It is important to note that Microequities analyses and selects companies to present at the conference as “rising stars”. Companies do not simply pay Microequities for the opportunity.

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Twenty-four years ago Alan English was sitting in a pizza restaurant in the US watching the bustling restaurant staff deal with an influx of orders for home deliveries. Alan was impressed with the speed in which the restaurant was able to move from order to dispatch, and particularly noted such speed was made possible by the use of a conveyor oven. The pizzas were prepared and placed in the oven at one end, and simply rolled off the other ready to be boxed and delivered.

What a good idea, thought Alan. I bet those ovens would go down really well in Australia.

And so it was Alan returned downunder, borrowed money, and ordered a load of conveyor ovens from the States believing he was on a sure winner. But to his surprise, Alan struggled to sell even one. The problem was the ovens were not cheap, and represented a sizable outlay for any typical Aussie pizza restaurant running on slim margins. No one disagreed conveyor ovens were a good idea, but no one could afford to stump up the cash on the spot. Alan ended up stuck with a load of ovens and a big debt.

With the creditors knocking on the door, Alan was getting desperate. It was then he had his brainwave. Returning to those underfunded restaurateurs, he asked if they might wish to rent the ovens instead. This would at least cover his interest payments. Then if they liked the ovens, and business improved through their use, the restaurants could choose to buy them at a later date.

He rented out the lot, and eventually sold them. So was born Silver Chef ((SIV)) and its Rent-Try-Buy business for the hospitality industry.

In 2009, Silver Chef made a profit of $3.5m from what we might call its microfinance business. In 2009, Aussie punters were still being frugal about eating out post-GFC. But this was up from a profit of just over $2.5m in gloomy 2008, which in turn was up from just over $1.5m in 2007. Silver Chef saw no negative impact from the GFC. As at early June, the company had registered profits of $3.22m for the first half of 2010. That's up 288% from the first half of 2009 (noting that the second half of 2009 was much more profitable than the first).

While the Rent-Try-Buy name might be registered, the concept is not a new one, as Alan English readily admits. Companies like Radio Rentals have been offering a similar service for decades at the consumer electronics level. But whereas consumers might rent first and later buy a television because they just want one, Silver Chef's hospitality customers are using Rent-Try-Buy to acquire vital equipment for their businesses. Obviously Silver Chef now offers a wide range of restaurant equipment other than just pizza ovens.

We all know the restaurant game is a dicey one, and that restaurants come and go in a heartbeat. Indeed, six to seven of every ten start-up restaurants fail in the first year. One might consider it a risky business to borrow money, buy pricey equipment, and rent it to the next Masterchef reject who fancies himself as the new Gordon Ramsay, all in the hope the restaurant will thrive, rental payments will be met and the equipment will ultimately be purchased. But Silver Chef does not operate with any naive illusions.

To enter into a rental agreement, clients must lodge a security bond with Silver Chef equivalent to 13 weeks rent. This ensures restaurants are not exploiting Silver Chef simply as a means of financing a misguided dream that can simply be walked away from if it doesn't work out. Contracts are for 12 months, and if the client elects to buy the equipment within the period they receive a 75% rebate of rent paid to date.

Moreover, Silver Chef conducts its own strict credit assessment of each rental applicant and applies an internal credit rating system. On this basis, the company turns away an average 50% of applicants. What this means is that of the restaurants who become Silver Chef clients, only one in twenty fail in the first year. A 5% default rate is a far cry from a 60-70% default rate.

Nor does Silver Chef expose itself substantially to any one client. Of 7,560 clients at present, the largest represents less than 1% of rental income. And rent is paid weekly. On the other side of the coin, Silver Chef does not overly expose itself to its own lenders. Of all assets acquired by the company for rental, currently 95% are earning income. And these are “must have” assets like ovens and fridges, not peripheral “want to haves”. If a restaurant is struggling, the last payment they will stop making is the rent on the equipment vital to its survival.

Despite its Rent-Try-Buy business being made possible by buying rental assets with debt in the first place, Silver Chef is only geared 40% against the $100m worth of assets it currently holds. Of rental and sale revenues generated, $40m per year is used to fund new assets. The company has a facility with BankWest which expires in July 2011, but negotiations with the bank for a new deal are currently underway.

In the first half of this year Silver Chef successfully placed $2.5m worth of new equity and raised another $4m in a 1:4 rights issue which was 50% oversubscribed. The company intends to continue expanding and is currently considering another capital raising ahead, and/or issuing debentures, the interest for which can be paid out of cashflow. But while debentures sound like an interesting alternative proposition for the potential investor in Silver Chef, since 2005 the company has paid dividends equating to an 8% yield, fully franked. Over that period, earnings have grown at a rate of 23.1% (compound). And the company already knows where 70-80% of its FY11 income will come from.

It must be considered that not all equipment purchased by Silver Chef and placed in the Rent-Try-Buy system is ultimately bought by the client. Clients may also which to upgrade to a new model. But Silver Chef also has a successful “remarketing” process for this “back end” of the business. The company cleans and services the returned equipment itself and either re-rents it, sells it through a dealer, sells it over the internet or auctions it over the internet.

The company hopes to have achieved its target for FY10 of selling out 80% of returned equipment within 60 days of return.

Despite its impressive growth in client base (6,500 to 7,560 clients in the first half of 2010), Silver Chef estimates it only has 3% of the Australian hospitality industry as clients. While these now include big chains such as Subway and Domino's rather than just one-off restaurants and cafes, clearly there is further room for growth. Given the success of both its front-end Rent-Try-Buy system and back-end remarketing system, the company has now begun to apply its model to a wide range of equipment required by industries beyond just hospitality. Silver Chef sees its “GoGetta” brand as providing significant potential for growth.

Silver Chef's market capitalisation has grown from $13.4m in 2005 to $46.8m 2010. Despite continuing to grow earnings throughout the GFC, the company's shares suffered like all others to the trough in early 2009 where they reached $1.00. At the time of writing they are at $2.27. Not bad for a company yielding 8%.

To listen to Silver Chef's presentation is like watching The New Inventors, slapping yourself on the forehead and saying “Of course! How obvious”. But the secret to managing a successful microfinance business is careful risk management. Judging by Silver Chef's growth, its diversified customer base, its low default rate and the defensive nature of its earnings stream as exhibited by growing earnings throughout the GFC, the company has its risk management clearly under control.

Silver Chef offers proven earnings growth potential with a solid, fully franked yield.

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