Recommendation: Strong Buy

Recommendation and Summary

HPSC, Inc. is recommended as a Strong Buy. This specialty financing company deserves consideration by both value oriented and capital growth minded investors. HPSC is well financed, and has an excellent record of growth in revenues and earnings. We believe that the current market valuation of HPSC, Inc. does not reflect its excellent financial history, the value of its assets, nor the potential growth in the coming years from continued increases in loan portfolios and the current level and trend of interest rates. The Strong Buy rating is based on the following:

• The stock of HPSC, Inc. is selling at a 20% discount from book value.
  
• HPSC earnings per share increased at an average annual growth rate of approximately 45% in the periods of FY1995 to FY2000 (adjusted). Earnings for the nine months ended September 30, 2001, increased 20.3% (adjusted for a one time charge of $819,000 related to a settlement of a legal action in Texas).
  
• HPSC is now dealing with over 1,000 vendors.
  
• HPSC's gross owned and managed lease contracts and notes receivable continues to grow, increasing 12% to $782.4 million for the period ended September 30, 2001, over the year-end figure of $696.3 million, and 25% to $697 million at year end 2000 from $557 million at the end of 1999.
  
• HPSC is well financed, having completed a major $527 million, equipment receivables backed securitization in late December 2000. This transaction helped to increase the net interest margin going forward.
  
• The cost of borrowing is lower, not only because of the securitization, but also because of the trend in interest rates. The Federal Reserve Board has reduced rates by 4.75 basis points this year to its present level and we believe that investors should look favorably upon financing companies in the general market.
  
• Based on our estimated earnings per share for 2001 of $0.78, and our initial projection of $0.97 for the year ended December 30, 2002, HPSC, Inc. is selling at an attractive price/earnings ratio of 10.1x for the year ended 2001 and a price earnings ratio of 8.1x for the year 2002. Furthermore, when comparing HPSC fundamentals to those of its two peer companies, HPSC, Inc. offers investors exceptional prospects for capital gains over the next twelve to eighteen months.
  
  

The Company

HPSC, Inc., headquartered in Boston, Massachusetts, is a unique specialty/niche finance company whose core business is providing financing to licensed healthcare practitioners in the United States. The second and smaller portion of its business, conducted through its subsidiary, American Commercial Finance Corporation ("ACFC"), provides the asset-based financing to commercial and industrial companies that generally could not readily obtain traditional bank financing.

Healthcare Financing Market

HPSC's financing agreements with licensed healthcare professionals include equipment financing as well as non-equipment financing, such as practice finance, leasehold improvements, office furniture, working capital and supplies. The size of the leased medical equipment market is over $5.0 billion and is expected to grow at a rate of 10% through the year 2003. This healthcare market served by HPSC consists of more than ten different medical professionals including; internists, radiologists, OB/GYN doctors, ophthalmologists, dermatologists, dentists, chiropractors, cosmetic surgeons, veterinarians, orthopedists, and community health practitioners. This market is a "small ticket" market, in which the size of the transaction is usually $250,000 or less. HPSC's average financial transaction for its 20,000 healthcare accounts was approximately $40,000 in the past fiscal year. In connection with its equipment financing, HPSC enters into non-cancelable finance agreements and/or lease contracts, which provide for a full payout at a fixed interest rate over a term of one to seven years. HPSC markets its financing services to healthcare providers in a number of ways, including direct marketing through trade shows, conventions and advertising, through its sales staff with 22 offices in 13 states and through cooperative arrangements with equipment vendors. It serves more than 1,000 medical equipment vendors.

HPSC's strategy of concentrating on financing prime credits within the healthcare professional market has served it well. Its history of net charge-offs has been $4.2 million, or 0.8% of owned and managed loans, in the twelve months ended 12/31/00; $2.7 million in 1999, or 0.6%; and $2.4 millio,n or 0.7%, in 1998. During the nine months ended September 30, 2001, the provision for losses was $6.8 million as compared to $5.4 million for the comparable nine-month period last year. Even so, these figures are relatively low when viewed against losses recorded by lenders in the general financing of small businesses. The decision to focus on the small-ticket health care market was based on the premise that HPSC is able to respond in a prompt and flexible manner to the needs of individual healthcare professionals. Further, history has proven that the medical provider's need for medical equipment, either new or replacement, is not usually affected by the state of the economy, but is based on the needs of the individual practice. Management believes that its quick response time, value-added sales support, and overall ease of conducting business that it offers the healthcare professional, make its service far superior to banks with their traditionally long approval time and rigid, committee-oriented standards of financing.

Terms and Conditions of Equipment Financing

HPSC finances the healthcare physician's acquisition of various types of equipment as well as leasehold improvements, working capital, and supplies. The contracts are either finance agreements (notes) or lease agreements, and are non-cancelable. The contracts are full payout contracts and provide for scheduled payments sufficient, in the aggregate, to cover HPSC's costs, and to provide HPSC with an appropriate profit margin. HPSC provides its leasing customers with an option to purchase the equipment at the end of the lease, generally for 10% of its original cost. Historically, the vast majority of all lessees have exercised this option.

All of the Company's equipment financing contracts require the customer to: (1) maintain, service, and operate the equipment in accordance with the manufacturer's and government-mandated procedures, and (2) make all scheduled contract payments regardless of the performance of the equipment. Substantially all of the Company's financing contracts provide for principal and interest payments due monthly for the term of the contract. In the event of default by a customer, the financing contract provides that HPSC has the rights afforded creditors under law, including the right to repossess the equipment and, in the case of legal proceeding arising from a default, to recover damages and attorneys' fees. The Company's equipment financing contracts provide for late fees and service charges to be applied on overdue payments.

Practice Finance

In 1993, HPSC began to expand into practice finance. Practice finance is a specialized segment of the medical finance industry, in which HPSC's primary competitors are banks. Since practice financing was a relatively new business, which had developed as the sale of healthcare professional practices had increased, HPSC has a competitive edge by being in on the ground floor. A practice finance transaction typically takes the form of a loan to a healthcare provider purchasing a practice, providing up to 100% of the cost of the practice being purchased. The loan is secured by the assets of the practice being purchased and may be secured by one or more personal guarantees and by the personal assets of the practitioner. The average original size of a practice finance transaction is approximately $225,000 in 2001, with a typical repayment term of 72 to 84 months.

Since 1994, HPSC has originated approximately 1,200 practice loans aggregating approximately $180 million in financing. The terms of such loans generally range from 72 to 84 months. In 2000, practice financing generated approximately 17 % of HPSC's total healthcare originations. Management believes that its practice finance business contributes to the diversification of HPSC's revenue sources and earns HPSC substantial goodwill among healthcare providers.

HPSC solicits business for its practice finance services primarily by advertising in trade magazines, attending healthcare conventions, and directly approaching potential purchasers of healthcare practices. Most of the healthcare practices financed by HPSC to date have been dental practices. HPSC has also financed the purchase of practices by chiropractors, ophthalmologists, general medical practitioners, and veterinarians. HPSC's customers are located throughout the United States, but primarily in heavily populated states such as California, Florida, Texas, Illinois, and New York.

Asset-Based Financing to Commercial and Industrial Companies

Through its subsidiary, American Commercial Finance Corporation ("ACFC"), HSPC provides asset-based lending to commercial and industrial businesses, principally in the eastern United States. ACFC makes asset-based loans of up to $5 million to commercial and industrial companies; the loans are primarily secured by accounts receivable, inventory and equipment. ACFC typically makes accounts receivable loans to borrowers in a variety of industries that cannot obtain traditional bank financing. ACFC takes a security interest in all of the borrower's assets and monitors collection of its receivables. Advances on a revolving loan generally do not exceed 80% of the borrower's eligible accounts receivable. ACFC also makes revolving and "term like" inventory loans, generally not exceeding 50% of the value of the customer's active inventory, valued at the lower of cost or market value. In addition, ACFC provides term financing for equipment, which is secured by the machinery and equipment of the borrower. The average ACFC loan is for a term of two to three years. No single borrower accounts for more than 10% of ACFC's aggregate portfolio, and no more than 10% of ACFC's portfolio is concentrated in any single industry.

ACFC's loans are "fully followed," which means that ACFC receives daily settlement statements of its borrowers' accounts receivable. ACFC participates in the collection of its borrowers' accounts receivable and requires that payments be made directly to an ACFC lock-box account. Available credit under lines is usually calculated daily. ACFC's credit committee, which includes members of senior management of HPSC, must approve all ACFC loans in advance. Each of ACFC's officers has over 20 years of experience providing these types of financing.

From its inception through September 30, 2001, ACFC has provided 75 lines of credit totaling approximately $120 million, and currently has approximately $30 million of loans outstanding to 344 borrowers. The annual dollar volume of originations of new lines of credit by ACFC was $5.0 million in 1994, $12.1 million in 1995, $17.6 million in 1996, $24.8 million in 1997, $23.1 million in 1998, $18.2 million in 1999, $7.3 million in 2000 and $11.4 million through nine months ended September 30, 2001. For the nine months ended September 30, 2001, earned income on leases and notes for ACFC was $3.1 million vs. $3.9 million in 2000, and after provisions for losses and SG&A expenses, this group contributed $1,490,000 to net profit vs. $2,327,000 in the comparable period of 2000.

Risk, Risk Management, and Competition

We believe that HPSC faces several risks in its financing business: (1) maintaining and sourcing adequate capital to continue its growth; (2); managing credit risks; (3) managing within a changing economic environment; and (4) competition.

1) Maintaining and sourcing adequate capital to continue its growth: Historically HPSC has utilized a variety of funding sources. In late December 2000, it completed a major securitization and asset sale with Credit Suisse First Boston. The total amount financed by the Company through the securitization was $527 million. This transaction not only reduced the cost of borrowing approximately 60 basis points but it also provided approximately $95.2 million of new funding which shows on the year-end balance sheet as Restricted Cash-Prefunding. Through the nine months ended September 30, 2001, the Company utilized approximately $91.3 million to fund the Company's financing activity. The balance of approximately $3.4 million was used to pay principal on the notes. The December 2000 transaction was accomplished after several months of intense due diligence by the lending institution, Credit Suisse, First Boston, and completion of the transaction places HPSC, Inc. in a premium category for a company this size. S&P, Moody and Fitch rated the Senior Tranche AAA. The due diligence process and high ratings should make additional securitization transactions easier to accomplish should the Company choose to pursue further transactions.

2) Managing credit risks: The strategy of financing medical providers has proven to be successful for HPSC. Medical providers generally enjoy a higher credit rating than the general population. In addition, the Company utilizes comprehensive credit review procedures when making loans by checking the credit background of the potential client with one or more commercial credit reporting agencies, including TRW Inc., Equifax Inc., Trans Union Corporation and Dun & Bradstreet Corporation. The Company also considers the type of equipment being loaned against, and the vendor. HPSC also has a proven on-line credit evaluation procedure to screen applicants. In some cases, HPSC may require a personal guarantee by the medical provider. Proof of HPSC's ability to manage credit risk is validated by the fact of the relatively low net charge-offs of $4.2 million or 0.8% of portfolio in 2000, $2.7 million or 0.6% of portfolio in 1999, and $2.4 million or 0.7% of portfolio in 1998.

The same procedures for credit checks are utilized for the commercial lending prospects of ACFC. ACFC's underwriting procedures include an evaluation of the collectibility of the borrower's receivables that are pledged to ACFC, including an evaluation of the validity of such receivables and the creditworthiness of the payors of such receivables. ACFC may also require its customers to pay for credit insurance on its loans. ACFC typically makes accounts receivable loans to borrowers in a variety of industries that cannot obtain traditional bank financing. Consequently, ACFC takes a security interest in all of the borrower's assets and monitors collection of its receivable. Advances on a revolving loan generally do not exceed 80% of the borrower's eligible accounts receivable. ACFC also makes revolving and "term like" inventory loans generally not exceeding 50% of the value of the customer's active inventory, valued at the lower of cost or market value. In addition, ACFC provides term financing for equipment, which is secured by the machinery and equipment of the borrower. The average ACFC loan is for a term of two to three years.

3) Managing risk within a changing economic environment: HPSC's strategy of lending to medical providers has insulated the company to some extent from economic downturns. The individual medical providers equipment needs have proven to be a constant during periods of slow economic growth. The fact is that the doctor's decision to purchase new or to replace a piece of equipment is usually based on the practice's immediate need rather than the level of the economy. Since HSPC services a vast number of medical providers (over 20,000 at year ended 12/31/00), the risk during downturns is lessened. For ACFC, the lending activity actually increases during slow economic times and the Company's individual credit checks help to insure that the loans made during these times are still viable and profitable.

4) Competition: HPSC faces competition on several fronts, including companies similar to HPSC that specialize in financing for healthcare providers. In addition, HPSC faces competitors that include equipment manufacturers that finance the sale or lease of their products themselves, conventional leasing companies and other types of financial services companies such as commercial banks and savings and loan companies. HPSC's believes that its quick reaction time of twenty-four hours or less and its proven record in the medical equipment lending business combine to make its practices most competitive. In addition, the size of the medical leasing business (over $5 billion) provides room for continued growth and expansion.

Financial Highlights

In the latest third quarter of FY2001 results, net revenues increased 5.8% to $13.5 million as compared to $12.8 million for the third quarter of FY2000. Net income increased 16.3% during the third quarter of 2001 to $1,000,100 or fully diluted EPS of $0.23 as compared to $860,000 or fully diluted EPS of $0.20 for the comparable period last year. For the nine months of FY2001, net revenues were $40.8 million with net income of $2.3 million, diluted EPS of $0.54 as compared to net revenues of $37.2 million with net income of $2.3 million, or diluted EPS of $0.54. The results for the nine months of 2001 were impacted by a one-time charge of $819,000, and without this charge, the operating results for the nine months of 2001 would have been $2.81 million or diluted earnings per share of $0.65. HPSC's gross owned and managed lease contracts and notes receivable increased 12.1% to $782 million from $697 million at year end 2000, and 40.5 from $557 million at the end of 1999.

The year 2000 was a strong year with growth in revenues of over 28%; however, the Company only reported net income of $87,000 or diluted EPS of $0.02 for the year. In the fourth quarter of the year 2000, net revenues increased 37% over the fourth quarter of 1999 and 28% for the year 2000 as compared to 1999. These numbers do not tell the complete story for HPSC's year 2000. The net income was impacted by two events:

(1) The provision for losses was abnormally high in the latest fourth quarter and year ended 12/31/00, principally due to the bankruptcy of a vendor, resulting in disputes with HPSC. The potential exposure to litigation between the clients, HPSC, and the vendor prompted management to increase the loss provision by approximately $2.0 million;

(2) The gain on sales of leases and notes for the fourth quarter of the year 2000 was abnormally high at $6.3 million (up from $1.2 million in last years comparable quarter). This was a result of the costs associated with the $527 million term securitization transaction of $7.0 million (See explanation of the transaction). The $7.0 million was made up of non-cash charges of approximately $3.2 million associated with structural and rate differences upon the transfer of previously sold leases and notes from the Company's Bravo and Capital commercial paper conduit facilities into the term securitization facility. The second category of expense, which totaled approximately $3.9 million, was costs incurred to break existing interest rate swap contracts associated with the terminated borrowings from the Bravo and Capital facilities.

To show more accurately the operating results for the year 2000, we have adjusted the net income for HPSC in the year 2000 (see our adjustments in Table 1 Adjusted Net Income) to shows net income increasing over 20% during that period and net revenues increased approximately 23% for the year 2000 as compared to 1999.


Table 1 - Adjusted Net Income Year 2000 (click to view table)

A detailed description of the $527 million financing with Credit Suisse First Boston Corporation is as follows in Table 2:


Table 2 - Seven Tranches of Credit Suisse First Boston Corporation Note (click to view table)

Table 3 - Balance Sheet - September 30, 2001 (click to view table)

Table 4 -Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2001 and 2000 (click to view table)

Projections:

As a result of the December 2000 securitization transaction, the HPSC balance sheet is strong and it has additional capital at attractive rates for continued growth for the coming year and into 2003. In the year 2000, HPSC's financing contract originations increased 10% to $248.8 million from $226.5 million last year. At December 31, 2000, its customer applications that had been approved but not yet funded totaled approximately $119.0 million of, a 15% increase over year-end 1999. Based on this and the recent financing, we are projecting an increase of 4.0% in 2001 originations to approximately $258.0 million. We are projecting earned income to remain level at $49.3 million, while gains from sales of leases and notes projected to increase to $13.7 million; its provision for losses is projected at $8.8 million, resulting in net revenues of approximately $54.1 million. SG&A is projected to increase approximately 11% to $22.6 million, an amount equal to 46% of the projected earned income. The resulting income before taxes is $5.6 million. Based on an assumed overall tax rate of 41%, the net income for 2001 is projected at $3.4 million, with Basic EPS of $0.84 (basic shares outstanding of 4,000,000) and Diluted EPS of $0.78 (Diluted shares of 4,315,000).

Table 5 - Operating Statement Actual 1998 to 2000 Adjusted 2000 and Estimated 2001 and 2002 Results (click to view table)

Valuation:

We have compared HPSC to two peer companies; DVI, Inc. (NYSE:DVI) and Financial Federal Corp. (NYSE:FIF). DVI, Inc. is an independent specialty finance company that provides large ticket leasing and asset-backed financing to health-care providers. Financial Federal, Corp. is a nationwide independent financial services company that provides collateralized lending, financing and leasing services nationwide to primarily middle-market commercial enterprises representing diverse industries such as general construction, road and infrastructure construction and repair, manufacturing, trucking and waste disposal.

Table 6 - HDR vs. Peer Companies Comparison (click to view table)

Compared to Financial Federal and DVI, HPSC sells at a relatively low valuation, including its price earnings ratio. Based on trailing twelve months EPS, the P/E for HPSC is 9.7x, 10.1x based on our estimated 2001 EPS of $0.78, and 8.1x based on our 2002 EPS estimate of $0.97. For Financial Federal, based on trailing twelve months EPS of $1.82, the P/E is 16.3x, 14.9x based on Wall Street FY7/31/02 EPS estimates of $2.00, and 13.0x based on 7/31/03 EPS of $2.28. DVI sells at a 14.3x price earnings ratio based on trailing twelve months earnings of $1.19, 10.4x P/E ratio based on 7/02 Wall Street estimated earnings per share, and 13.0x based on 7/31/03 EPS of $2.28.

On a price to book value (BV) ratio, HPSC sells at 82.7% of book while FIF sells at 238.0% of book value and DVI sells at 108.3% of book value. HPSC's EPS growth rate from 1995 to 1999 was 47% while FIF's EPS growth rate from 1995 to 1999 was 23% and DVI's growth rate was 18%.

Most recently, HPSC's EPS growth rate from FY1999 to FY2000 was 22% while FIF's growth rate from FY1999 to FY2000 was 18% and DVI's growth rate was 17% during the same period.

Summary:

HPSC is a specialty finance company that has found and developed a profitable niche market for its activities. The Company's management has done an excellent job of securing adequate financing at attractive rates and has a proven record of credit risk management. While the Company has recorded varying amounts of "Gain on Sale of Notes and Leases" as revenues in the recent years, management has indicated "·..that for the good of the Company its goal is to decrease this in the coming years." At the current price levels, on both a specific stock basis and on a peer comparison basis, the common stock of HPSC, Inc. offers investors an excellent opportunity for capital appreciation. Based on our estimated fully diluted earnings per share of $0.78 for the year 2001, the common stock of HPSC is selling at a 10.3x P/E ratio. Based on our 2002 estimated earnings per share of $0.97, the P/E ratio is8.1x. The price to book value ratio is 82.7% with net revenues to market cap ratio of 61%.

We are establishing a price target over the next twelve to eighteen months of $14 to $16 a share, with a mid-price of $15.00. This is based on:

• Price earnings ratio - Assuming HPSC makes the Estimated EPS of $0.78 for FY2001 and $0.97 for FY2002, we believe that near term HPSC could sell at a 15x price earnings ratio or a per share price of $11.70. Based on our estimate for FY2002, a 15x price earnings ratio would result in a per share price of $14.70.
  
• Price to book value - Based on the historical growth in originations and assets a level of 150% of book value would yield a per share price of $15.50.
  
• We believe that the historical growth rates in EPS over 45% for HPSC justify a higher price earnings than its current 8.1x ratio.
  
• Our assessment of management's ability in raising capital and controlling credit risks also indicates to us that HPSC is an undervalued situation.
  
  

Therefore we are assigning the stock of HPSC, Inc. our highest rating -STRONG BUY



Analyst:
Richard W. West, CFA

Richard W. West, CFA, has a range of experience extending over 40 years in securities analysis and investment management. Following three years as a broker with Stein Bros. & Boyce, he moved into investment management and research in the early 1970's with Delaware Management and, from 1974 to 1983, with Brittingham, Inc., where his responsibilities included management of the U.S. portfolio of the Nobel Foundation, one of the premier growth portfolios of its time. Mr. West formed an investment management and research firm in the mid-1980's specializing in small-cap growth stock analysis and investment publishing, following which he served as research director with Gaines Berland, an investment firm specializing primarily in growth stocks and special situations. He has been independently engaged since 1998 in corporate finance and private research activities. Mr. West is a graduate of the Wharton School, University of Pennsylvania (1960), served four years (1954-58) as a Navy pilot, and remains active as a pilot and Master Swimmer. He also maintains an office in New York City.


Contact:
HPSC, Inc. 60 State Street, 35th Floor, Boston, MA 02109. Mr. John Everets, CEO. Tel: (800) 225-2488. Web site: www.hpsc.com

J.M.Dutton & Associates, LLC. John M. Dutton, President and Supervisory Analyst, 801 S. Figueroa, Suite 1120, Los Angeles, CA 90017 Phone (213) 929-2616, Fax (213) 896 0457 Email: [email protected] Web site: www.JMDutton.com

Information, opinions or recommendations contained in this research report or research note are submitted solely for advisory and information purposes. The information used and statements of fact made have been obtained from sources considered reliable but we neither guarantee nor represent the completeness or accuracy. Such information and the opinions expressed are subject to change without notice. This research report or note is not intended as an offering or a solicitation of an offer to buy or sell the securities mentioned or discussed. Neither the Firm, its principals, nor the assigned analysts own or trade shares of any company covered. The Firm does not accept any equity compensation. Anyone may enroll a company for research coverage, which currently costs US $25,000 prepaid for one-year. Dutton & Associates received $19,700 from the Company for coverage for the year. Reports are performed on behalf of the public, and are not a service to any company. The analysts are responsible only to the public, and are paid in advance to eliminate pecuniary interests and insure independence. Please read full disclosure and other reports and notes on the Company at www.JMDutton.com..

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