Description

Situation Overview

Prior to last month, ECN Capital (“ECN” or “the Company”) was a collection of three niche specialty finance businesses. It sold its largest asset, Service Finance, which represented ~two-thirds of FY21 EBIT, for $1.5bn in after-tax proceeds (66% of the current market cap). The Company distributed the proceeds as a special dividend which was paid on December 22nd, leaving two business units remaining within ECN – Triad Financial and the Kessler Group. Triad Financial is a loan originator & servicer for manufactured housing (51% of PF EBIT) and Kessler Group is a credit card advisory & management business (49% of PF EBIT). While current EBIT is split roughly 50/50 between the two remaining assets, Triad Financial is the key tenet to the investment and focus of the write-up, given we expect its EBIT to CAGR at >20% through 2025 from market share gains in its core business and entrance into adjacent product verticals (more than doubling TAM).

At the current price, we are buying the stub at 14.5x ’22 EPS, and we estimate adj. net income will CAGR at 26% from 2021 through 2025, which along with slight multiple expansion produces a ~41% IRR through YE24.

Why does this opportunity exist?

We believe most of the existing shareholder base owned ECN for Service Finance, and given the relative earnings contribution, it was the historical focus of sell-side and investors. The sale of Service Finance will now focus attention on Triad Financial and Kessler Group, and we believe we are early in appreciating the business quality & growth prospects of Triad Financial. ECN Capital is still listed on the Toronto Stock Exchange, but its business units are entirely focused on the U.S, which we believe has added a layer of obscurity. Further, the large special dividend from a Canadian entity has withholding tax consequences which we believe many U.S. based investors were waiting to clear before stepping in. 

Company Overview

ECN Capital spun out from Element Financial in late 2016. At the time, ECN Capital was a balance-sheet heavy rail and aviation lessor. Steve Hudson, the CEO of Element Financial, became the CEO of ECN, proceeded to sell off the leasing assets and purchased three asset-lite specialty finance companies: Service Finance, Triad Financial, and Kessler Group all within two years. See Appendix 1 for further history.

Triad Financial Overview: Triad performs loan origination for the U.S. manufactured housing (“MH”) market through a network of over 3,000 dealers. It then sells these loans to financial partners comprised of banks, insurers, and the GSEs, with Triad taking no recourse. 70% of revenue comes from origination fees, 12% comes from ongoing servicing fees, and the remainder comes from interest earned on floorplan financing it underwrites for its dealers. Triad Financial has traditionally been a home-only loan originator (no land collateral), known in the industry as “chattel.” Over the past several years, the MH market has grown at roughly HSD a year. Within this market, Triad has steadily taken market share, as evidenced by originations CAGR’ing at ~14% from 2017 to 2020.

Kessler Group Overview: Kessler Group (“KG”) was founded in 1978 and can be thought of as a boutique financial advisory business focused on credit cards (like an Evercore for credit cards). It has over 40 years of providing advisory, structuring, and management services for credit card issuers with over 6,000 co-branded credit card partnerships created and $28bn of managed & advised portfolio assets. Unlike a traditional investment bank / advisory business, ~85% of total revenue is made up of multi-year & contractual revenue streams. It works with over 25 financial institutions including seven of the top 10 card issuers.

Investment Thesis

1)       Manufactured housing loan origination is an attractive niche.

2)       Triad should continue to grow and take share in its core loan products.

3)       Triad should see an inflection in loan origination growth over the next several years through new verticals.

4)       Optionality at Kessler Group.

Thesis Point 1: We believe manufactured housing loan origination is an attractive niche

Manufactured Housing Overview

Manufactured housing makes up MSD % of the U.S. overall housing stock and 10% of new single-family home starts, but 64% of all new homes sold under $200k (91% of homes sold under $150k). Around one-third of new homes are placed in communities. It’s instrumental to the lower-income cohort in the U.S.

Clayton Homes, the subsidiary of Berkshire Hathaway, has ~47% market share, followed by Skyline Champion (17%), Cavco Industries (13%), Legacy Housing (3%) and 28 other U.S. based manufactures making up ~20% of the market. Clayton Homes offers financing on its homes at its own retail sites through Vanderbilt Mortgage and at third party dealers through 21st Mortgage.

Units are primarily sold through independent dealers & company owned retail outlets (70%) and directly to communities (30%). There are ~4,000 independent dealers spread across the U.S.

Manufactured homes tend to have a reputation of being low in quality (“a trailer home”) but, in reality, quality and price points have a very large range; many units are just as good as a site built home (Appendix 2). The only major difference is that manufactured homes are produced indoors in a factory vs. on-site and outside. This controlled process allows manufactured homes to be built much cheaper. On a per sq. ft. basis, homes built in a factory are ~50% of the cost of a site-built home (excl. the cost of the land). Satisfaction is also very high: “90% of consumers who purchased new MH homes are extremely satisfied to very satisfied” – Manufactured Housing Industry.[1]

Manufactured housing is a unique industry in that we saw a significant decline in shipments even preceding the GFC. MH had its own boom-bust (similar to single-family in 2007) in the late 90’s, led by the bad actor, Green Tree Financial. A 2001 article in the NY Times does a good job here (Appendix 3).

After the bust in the late ‘90s, lenders exited the market and there has been a dearth of financing from traditional banks ever since. Buffett capitalized on this industry shift with Berkshire’s purchase of Clayton Homes in 2003, and to this day remains the largest lender in the industry. While MH is otherwise a great solution for low-income housing – shipments have been held back by lack of available financing. The long-term average shipments per year for the MH industry is 200k (139k for the five years pre-GFC) and in 2020 only ~94k units were shipped (53% below long-term average). For comparison, total single-family housing starts were 1.38mm in 2020, or ~14% below the pre-GFC new starts of ~1.60mm. MH’s normalization has lagged housing more broadly (Appendix 4).

As such, we believe manufactured housing itself is likely below mid-cycle in terms of shipments, which bodes well for loan origination growth over time. MH financing is a fair amount different than traditional mortgage products in a way that actually makes it quite an attractive niche industry.

MH Financing Overview

There are two main types of loans in the MH industry:

1.  Personal property loans (referred to as chattel loans) for consumers where the home is the sole collateral for the loan.

2. Real property loans (referred to as land home) where both the land and home are collateral, akin to a traditional mortgage product.

Around 45% of MH loan originations are home-only (chattel). Rates for these loans are higher than traditional mortgages given the lack of a land guarantee. Rates for a >700 FICO score borrower are ~6%. Median interest rate for MH overall is 8.6% (chattel) and 4.9% for MH’s secured by land, which compares to ~4% for site built:[2]

This relative lack of financing has constrained the pool of potential manufactured housing buyers. It’s an interesting dynamic – while MH buyers indeed have lower net worth and annual incomes – they are actually less levered than site-built buyers:

[4]

Today, most applications are simply denied: chattel has a 50% denial rate compared to 7% for site built:

[2]

Now part of this, of course, is lower average credit quality of MH buyers vs. site built. However, across the credit spectrum, we see chattel approval rates much lower than site built. Super prime customers get approved only 60% of the time for chattel vs ~95% for site built!

[2]

Another data point here is the delinquency rate for Triad’s MH portfolio (held by banks) vs. single family. Triad’s DQ’s peaked at ~2.3% in the GFC vs ~10.5% for single family housing. Triad’s peak net charge offs were only 1.3% in the aftermath of the GFC and are sub 50bps today:

Source: ECN Investor Presentation

Part of the healthy credit performance is likely attributable to the way chattel loans are treated legally. As there is no land collateral – and they are not considered “real property” – a lender can typically run a repossession process akin to an auto loan vs. the foreclosure process on a regular home. Some states allow manufactured home repossession in as little as two months post default (which compares to the ~18 month timeframe for a foreclosure process).

So not only are rates better on MH homes (for the lender), the repossession process is generally more streamlined (and incurs limited net losses). Given this dynamic, it is likely reasonable to attribute a large portion of the lower approvals in MH to the general lack of financing & secondary market vs. a credit quality decision by the originator. It would otherwise appear that the industry is capital constrained and has their choice of the best loans to originate.  

Traditional banks for all intents and purposes do not make chattel loans (at least directly). They began deemphasizing the category after the late 90’s bust and with another 50% drop in the GFC, have all but exited the market. Further, there is no real secondary market for chattel loans, so overall market liquidity is limited. GSE’s do not have a chattel purchase program, and there is de minimis securitization (RMBS is limited for this market; we are aware of only three Fitch-rated securitizations post crisis).

This has in turn created an opportunity for independents, who are picking up the slack for the whole market:

[2]

Independent MH lenders

The lending industry for manufactured housing is unique in that it is very concentrated. The top five chattel lenders make up 73% of the market. We estimate an HHI score of 2,871 for the chattel lending industry, which is considered “highly concentrated.” Clayton Homes, the manufactured housing subsidiary of Berkshire Hathaway, controls 52% of the market, 17% of which under its Vanderbilt banner (for its owned retail outlets) and 35% through 21st Mortgage (works with third party dealers & manufacturers). Triad is next at ~12% of the market (2019 data), and then it quickly falls off to 5% (Credit Human) and 2.5% (Cascade Financial). For the full list, see Appendix 5.

So, the setup is such that the MH product is quite attractive and getting more attractive given broader housing affordability concerns, but MH financing is still quite constrained given limited players & lack of a chattel secondary market. As such, this is a pretty great setup for independent loan originators in manufactured housing. They are serving a clear market need with a product that is superior with respect to affordability. That’s probably the opposite of what one would think on first blush when they hear manufactured housing lending!

Thesis Point 2) We believe Triad should continue to grow and take share in its core loan products

Triad is the longest tenured housing finance company in the U.S, having formed in 1959. Triad focuses on prime & super prime customers in MH. It originates loans through a network of >3,000 dealers in the U.S. but holds no balance sheet risk, having >50 financial partners that purchase loans once originated. Given its historical focus on prime & super prime, it easily survived the prior ‘90s boom-bust and the GFC.

Triad is generally known as the highest end lender in the space when it comes to credit quality, and has historically been managed extremely conservatively. Since ECN’s purchase in late 2017, we believe Triad is now on a path to realizing more of its potential, without drastic changes.

Triad’s funding partner exposure is diversified and long-tenured:

Data from ECN investor presentation, showing graph from Credit Suisse investment research above

Triad’s borrower base has an average FICO score of nearly 750. The average interest rate is ~6.5% with mid-teens % down payment and a ~20-year duration. Additionally, while chattel makes up only 45% of the overall market, it is ~90% of Triad’s business.

Triad historically has been growing this core business in three key ways, which we expect to continue:

1. Enjoying growth from the overall market

2. Taking share of prime + super prime loan originations

3.  Increasing the amount of loans it fully services

1) Overall market growth

Triad charges a variable ~6.5% origination fee on chattel loans, so both volume & pricing drive origination revenue (see “additional sources of upside” section for further explanation of the accounting here).

Volume

The MH industry has been enjoying a cyclical recovery since 2009. Since 2014, the rolling five year CAGR of growth has been positive and between MSD/HSD. The market was largely flat between 2018 and 2020 after growing 15% in 2016 and 2017, but through October 2021 shipments have grown 13% y/y:

Source: Census data

There is no real sign of shipment growth slowing down. MH shipments have otherwise been held back by capacity constraints at factories. Through October 2021 (latest data from Census.gov), MH shipment y/y growth has lagged single family housing starts by ~4ppt. MH shipments have otherwise kept up with single family housing starts – keeping a 10-11% ratio until 2020 (9.5%) and 2021 (~9.3%), which we attribute to factory capacity constraints (2021 is ~15% below “normal” if one assumes an 11% ratio to single-family housing starts is normal):

Source: Census data

The manufacturers have made it clear that they are operating below full capacity and adding supply where possible. Skyline Champion on COVID-delays impacting factory utilization (low 60’s vs. ~80%+ normalized):

“During the quarter, our U.S. manufacturing facilities improved capacity utilization by 5%, reaching 63% during the quarter despite being hampered by intermittent COVID plant shutdowns, supplier disruptions and short-term hurricane-related outages.”– F2Q21 call, 10/28/20

“Our capacity utilization of 64% during the quarter was also affected by higher-than-anticipated COVID-related delays. We continue to focus on the health and safety of our employees and take the necessary actions to ensure a safe and healthy environment at all of our plants… So we would look to ramp up volumes and bring on capacity to supply more as quickly as possible to take care of our customers.” – FQ22 Call, 11/3/21

While utilization improves, manufactures have also been making investments to increase nameplate capacity:

“So we have several idle plants today that we're looking to reopen as the supply chain frees up supply availability or we have confidence in the supply availability of materials to effectively ramp those. So we will open up another capacity -- or another plant in Texas by the end of this fiscal year, and then we are going to look at North Carolina for some additional capacity as soon as supply chain continues to come to bear.” – Skyline Champion conference call on 9/9/21

“We announced expansion of our Fort Worth plant. This investment in improved process flow and work environment will increase the plant's capacity by about 20% and is just one example of similar investments in our existing plants.” – F1Q22 Cavco call, 8/6/21

Pricing

Commodity cost inflation and the general s/d imbalance of housing broadly has sent prices up high-teens in 2021 (after years of MSD). Overall housing supply is at a 20 year low, while pricing growth is at a 20 year high:

MH pricing is very similar. MH pricing per sq. ft. from 2014 to 2020 has CAGR’d at 5% – and in 2021 – pricing per sq. ft. has risen 23% YTD:

Source: Census data

Both volume and pricing have grown MSD for the past five years on average (pre-2021). We expect a combination of both to continue going forward, though at a slower pace off the higher base set in 2021. Our base case calls for ~MSD industry growth.

2) Taking share of prime + super prime loan originations

To reiterate, Triad’s business can be thought of simply as a network of 3,000+ dealers on one end and 50+ financial partners on the other (relationships built up over decades, albeit).

Dealers and customers like Triad

Our research suggests dealers enjoy working with Triad Financial as they are one of the few nationwide originators. Instead of Triad, dealers would be dealing with 21st Mortgage, Credit Human or Cascade Financial as their nationwide options and a large assortment of small regional players.

While 21st Mortgage is the largest with 35% market share, they generally do not offer the best rates – focusing on the lower credit spectrum customers (we have confirmed this through speaking with manufactured housing dealers. We are omitting specific quotes for purposes of this write-up but can elaborate in Q&A).

Additionally, in the past, 21st has implemented strategies which prioritized their manufacturing business over the lending business. For example, in 2009, 21st refused to fund independent dealers that were not selling Clayton Homes’ product.  

Among the other nationwide competitors, #3 Credit Human is a credit union and has limited ability to fund growth in new loans, with only a handful of other credit unions signed on as partners.  #4, Cascade Financial is the closest in form to Triad structurally, but Triad is ~6x the size.

Clearly, Triad is an attractive offering for customers and well-liked by dealers. We think Triad’s loan products are also performing phenomenally well for its financial partners, and in high demand.

We believe Triad’s products are in high demand from financial partners

Even with rates that are best-in-class, ROA on Triad’s loans are extremely high for its financial partners. We believe Triad’s partners are currently earning a 3.25% all-in ROA (after servicing, origination, tax, and funding costs) which compares to the ~1.4% ROA a typical bank earns on single-family mortgages. Supporting this logic, Triad has continued to add new funding partners (12 in 2020, and 12 YTD through 3Q21 vs. historical commentary of “50+” partners).

Additionally, Triad is “fully funded for 2021 and 2022.” Instead of raising fees, Triad has chosen to reduce risk / volatility and secure funding commitments:

“We don't have enough loans at either service or Triad to satisfy the demand. So we could have done -- we could have done two things -- one or 2 things, we could have increased origination and servicing fees we elected not to, we've gone for longer commitments. As you heard my reference earlier, we're now into 2023 funding discussions. So we make a long story short, we've taken that demand, which is unprecedented and increase in commitments in the two- to three-year period, and we're working through that.” – ECN 1Q21 call

“We’ve been able to turn all of these relationships into hell or high water which is that you as an institution, when you provide that commitment, are now required to buy up to that limit. They’ve [Triad partners] turned into perpetual funding relationships.” – ECN 1Q21 call

Triad has increased share over time

With happy customers, dealers, and financial partners, Triad has taken material share of the industry over time. From government-published HMDA data, we estimate that Triad has grown their chattel share from 8.7% in 2018 to 13.3% in 2020.

We believe Triad Financial should continue to take share from the long-tail of smaller regional players.  While Triad does not appear to have taken share from 21st Mortgage over the past few years, we think this is probable going forward. 21st does not focus on the high end of the credit spectrum and Triad continues to improve its product.

Triad has room to improve its product 

Triad Financial generates a huge amount of applications every year, only ~16% of which get fully funded into originations:

Part of this will never become originated (denials due to credit quality, though this may improve with the bronze program discussed later), but there is a five point gap between approvals and originations. ECN has attributed this gap to generally slow turnaround times – which they are making investments to improve.

“For every 100 applications that come in, 15 get funded. 15% get funded. 18-23% range is where it should be on look to book. Can’t change credit underwriting. What is causing those consumers to go elsewhere? We just started to invest in the front end. Without having to originate more loans, we can approve 2-3 % points more. 5-6ppt over time from improving things like turnaround times. We are working on some tech / approaches to improve things like turnaround times for loans.” – Steve Hudson (ECN CEO) at a recent management meeting 

Our VAR checks have confirmed that Triad generally has a slower turnaround time than 21st Mortgage. While the time-frame does not strike us as long (half a day), it seems like this is a large enough gap to allow 21st or another lender to take some of Triad’s potential demand (presumably customers are submitting multiple applications).

If Triad can close just half this gap through improving turnaround times, it would be a ~15% uplift to originations (half of the 4.8% gap b/w approval % and origination % over the 15.8% origination rate in 2020), and would come at high incrementals as the loan application work has already been done.

3) Increasing fully serviced loans

Lastly, Triad has steadily increased the % of loans which it services. In 2018, only 34% of loans were fully serviced (as Triad did not focus on attempting to service loans it originated for bank partners), but they have since altered programs to service more of new loans originated. Management expects ~60% of managed loans to be fully serviced in 2021, and we estimate that close to 3/4ths of incremental loans are fully serviced. This is leading to outsized servicing growth for Triad, where it earns a ~0.7% annual fee.

Without Triad changing much at this point (just enjoying compounding of loans originated w/ servicing rights attached), we expect fully serviced assets to CAGR at >30% from 2021 to 2025 (and service revenue to CAGR at 25% +, with some assumed fee compression):

Thesis Point 3) We believe Triad should see an inflection in loan origination growth over the next several years through new verticals

While Triad is long-tenured and trusted in the MH industry, it has kept its offering quite narrow – high FICO and chattel. We believe this is now changing, as recent new loan verticals should propel growth significantly.

Chattel → Chattel + Land Home

Land Home is a larger market than chattel in both volume and value. We estimate total originations for Land Home at 71k vs 57k for chattel (2020 HMDA data, home purchase only). Avg. loan amount is double for land-owned (~$151k vs. ~$68k for chattel). The overall origination TAM is therefore ~$3.9bn for chattel and ~$10.6bn for Land Home, or $14.4bn combined for home purchase intent only (excludes refi’s, which were just 0.7% of Triad’s business in ‘20). Triad should be able to service most of this TAM – it has ~3,000 dealers out of the ~4,000 total – with the largest chunk missing attributable to Clayton’s own dealership base (we believe their own retail base makes up ~11% of the market).

Triad’s share of chattel loans on a volume basis in 2020 was 13.6% (HMDA gov data) and just 0.9% for Land Home. If they can get Land Home market share in-line with chattel, they would be doing 9,000 land-owned originations and ~$1.4bn of originations. Origination fee is lower (3.5% vs. 6.5% for chattel), but this is still ~$49mm of revenue (at very high incremental margin). That’s the same size as Triad’s overall origination revenue in 2020, and would represent ~45% growth vs. our total 2021 Triad revenue estimate.  

Triad formally launched its Land Home product in August of 2020. It needed 1) new funding partners and 2) new servicing systems & team to launch into this vertical.

New funding partners

Triad needed new funding partners to facilitate the launch of Land Home because its existing financial partners (mostly banks & credit unions) much preferred the higher returns achieved from the chattel product. Land Home looks a lot more like a traditional mortgage (~100bps higher rate than a traditional site-built mortgage) and is just not as differentiated. Still, Triad already has a huge dealer network and is already receiving loan applications from thousands of potential customers. New funding partners that can take Land Home paper would allow an “unlock” of growth for Triad.

Both Fannie Mae and Freddie Mac (“GSEs”) have received more pressure to fulfill their “duty to serve” mandate, which specifically addresses Fannie and Freddie to serve underserved markets including: manufactured housing, affordable housing, and rural housing) by improving liquidity. This “duty to serve” mandate was originally established as part of the Housing and Economic Recovery Act of 2008, but was not clarified until late 2016. So the first plans (which are now required to be put forth by the GSE’s every three years) were not published until 2018. In these plans, both Fannie and Freddie put clear targets to their purchase goals for manufactured home loans collateralized by land and home – a perfect fit for Triad, which is now approved to work with both entities.

New servicing systems + team

As part of working with the GSEs, which Triad did not do historically, they needed a new servicing system. Triad began the implementation of Black Knight in late 2019, and simultaneously, Triad built out is Land Home team.

“Well it was started 2.5 years ago, and it was build block by block by block whether it's installing Black Knight, recruiting 50 best-in-class people to run the business… Two great business leaders who have joined Mike, the investment in Black Knight technology, the licensing and underwriting from Freddie and Fannie. It's almost a three year on a success story and I think -- I believe in my heart that the Land Home business in the very near term could be as big as the core business.” – Steve Hudson on shareholder meeting call 2/21

The government has continued to support the expansion of this program. The White House gave guidance in September 2021 for the GSE’s to increase financing for Land Home manufactured housing loans.

“FHFA will authorize Freddie Mac to purchase mortgages for single-wide manufactured homes, thereby extending its 2020 authorization to Fannie Mae. The Enterprises also will continue outreach on financing options for manufactured homes. Such properties have been significantly improved in terms of quality and amenities and, because they are pre-manufactured, they can quickly enter the supply chain.”[3]

Since launching in August 2020, Land Home loan approvals have quickly grown over the past year to ~$150mm per quarter. ECN has commented that around 60% of approvals become fully originated, so Land Home is already doing ~$90mm of quarterly originations per this logic (~1/3rd of total originations). This has not yet fully flowed into origination revenue on ECN’s income statement, though, as a loan is not fully “originated” until the home is delivered & “constructed.” Typically lead times from factories are around three months but given the heightened demand for manufactured homes (and certain issues retaining manufacturing labor), lead times are approaching 12 months today.

As of 3Q21, ECN is sitting on a backlog of $185mm fully completed loans awaiting home construction. On a run-rate basis, we believe Land Home is already a $360mm origination business, or 52% of total originations in FY20!   Given the ramp & lag in realizing revenue, we believe Triad will only report ~$112mm of Land Home originations in 2021. The incremental ~$248mm of originations will flow through over next year and equates to roughly ~$9mm of origination revenue for Triad (8% of 2021 revenue and should be at an extremely high incremental margin given limited additional costs). These loans can be originated out of the same dealer network, supported by personnel already hired to manage the program.

FHA

Triad should also see further growth in its Land Home product from participation in Federal Housing Administration (“FHA”) insured loans. FHA insured loans make up one-third of the overall Land Home market, which ECN did not have approval for until October of 2021. An FHA insured loan is simply another government sponsored program designed to boost affordable housing. These loans are usually sold to the GSE’s. This should be thought of as an extension of the Land Home product (and we only differentiate it because management does and to peel out drivers of growth).

We believe FHA represents a 58% uplift to the TAM ECN was working with in Land Home through 3Q21:

Using this logic, we believe the launch of the FHA program will be at least a ~$200mm uplift for ECN in 2022. ECN described the opportunity here in an investor deck as follows: “should add $300mm in originations over time (ramp will take time).”

We believe Triad will do ~$1.08bn of originations in 2021 and Company guidance for 2022 is $1.25-$1.50bn of originations, or $295mm growth at the mid-point. Assuming no incremental growth in the Land Home product (only the $248mm of incremental originations flowing through on a lagged basis due to delivery / revenue recognition timing) and $100mm from the FHA program, Triad should realize close to $350mm of origination growth next year from its Land Home products. That alone is above the mid-point of guided growth, assuming no growth in the core business at all (which we expect).We think guidance is clearly sandbagged, resultantly, and look for this to be raised materially at the investor day.

 We have Land Home originations growing from ~$112mm in 2021 to $738mm in 2025 and FHA contributing $350mm, or roughly a 6% market share combined (vs. Triad’s current chattel share of ~13%).

Prime → Prime and Near-Prime

The second major area for Triad to expand its loan program is to move down the credit spectrum – slightly.

94% of Triad’s business has been to customers with FICO’s 675+. 670-739 is considered good and 750-799 is considered “very good.” This strikes us as perhaps “too conservative” and likely a result of preferences from historical funding partners.

Triad claims that “for many years, dealers and manufacturers have requested Triad expand its credit box.” They are calling the new lower FICO program their “bronze” and stating it was “created as a growth opportunity to capitalize on rejected application volume.” The bronze program officially launched in 2020.

Similar to the story in Land Home, Triad has added new funding partners (we believe ~four institutional investors so far) who are willing to underwrite this near-prime paper. If they can continue to add funding partners, they should be able to materially expand their share at high incrementals.

The main competitor here is 21st Mortgage. It seems like Triad’s initial bronze program underprices 21st fairly significantly on the origination fee. Our channel work has suggested Triad has been successful in gaining initial traction here.

This is huge untapped potential for Triad. If there is demand from their financial partners, they can leverage infrastructure already in place and simply start approving way more applications at high incremental margins. To reiterate, the Company is likely already getting a significant fraction of loans it could choose to approve if it expanded its credit box (it rejects ~60% of applications).

21st Mortgage has ~35% of the market and focuses on lower FICO customers. Triad should be able to eat at this share (and the overall market). We project the lower FICO program (bronze + silver) to do ~$450mm of originations in 2025 in our base case, which equates to ~5,000 originations (loans are lower $ size on average), or roughly 9% of the total market. We are doing more work here and attempting to find better data on market size by FICO score (gov data does not have FICO scores, just debt to income levels).

Thesis Point 4) Optionality on Kessler Group

The focus of our research has been on Triad Financial given its growth trajectory. With that said, we believe the Kessler Group may turn out to modestly increase its earning power over time as well.

Existing business

Kessler’s existing business is its role as a leading provider of advisory services for credit card issuers. Its three main business lines are:  

1.  Partnership services: managing & advising cobranded credit card programs (78% of LTM revenue; multi-year contracts / recurring).

1.  KG acts as a middle man between the issuing bank and co-brand partner, advising on the best way to structure & manage cobranded credit cards. Contracts are generally 3-10 years with “high probability renewals.” Appendix 6 for customer concentration and length of relationship.

2. Marketing services: product design, marketing strategy (direct mail & digital campaigns), and ongoing program monitoring for issuers (13% of LTM revenue; partially recurring in nature)

3. Transaction services: advising on the purchase & sale of credit card portfolios (9% of LTM revenue; one-off / lumpy). “Undisputed leader in transaction services for the cobrand segment.” Appendix 7 for examples.

Within partnership services, Kessler mostly gets paid based on the size of balances it advises & manages. If they add a new portfolio, the revenue impact may look something like the following – 15bps of partnership revenue on outstanding balances per year (growing ~MSD, in-line w/ balances) with one-time transaction fees recognized at the start and end of the contract (representing advisory services in a bank to bank portfolio transfer):

Generally speaking we expect KG’s partnership services business to grow in-line with total consumer credit card balances. Credit card balances are inherently exposed to consumer health / the economy. For the five years leading into the 2020 pandemic, balances grew ~4% on average and then declined 11% in 2020 (the GFC saw a 21% drawdown from December 2008 to April 2011). KG managed to still grow its partnership services revenue by ~20% in 2020 (implying new customer growth), and we expect partnership services to grow closer to MSD going forward (in-line w/ balances). EBITDA margins for the business overall are quite attractive at 62%.

New business line

Kessler acquired a credit card investment management platform in 4Q19, which has the potential to materially grow KG’s income base. The idea is, in addition to advising and managing bank-to-bank credit card portfolio transfers, to have a hand in bank-to-institutional-investor transactions. In this business, KG sources credit card portfolios, conducts due diligence, valuation, and acts as a program administrator for external capital. One of their largest partners is Blackstone, which has set aside $10bn for credit card asset investments. KG is essentially acting as an external investment advisor (not providing any of the capital itself).

Since 3Q20, they have accumulated ~$950mm of credit card balances. Management has disclosed that they earn higher fees on the CCIM business than traditional partnership services (around 75-100bps vs. 15-25bps) with a performance incentive above a hurdle rate of return. We believe the new CCIM business is earning ~$5-10mm of rev on an annualized basis (~10% of total KG revenue at the mid-point). Management estimates an opportunity to add $1-3bn annually to the platform, which at the midpoint would add ~$17mm of management fee revenue per year (would represent 20% of 2021e revenue). This is not as long-duration of a fee income stream as a traditional asset manager (some of these portfolios are run-off balances), and we need to do more work on evaluating KG’s right to “win” here, but execution could materially transform this business unit (from a MSD net income grower to low-teens grower).

Valuation

Triad Financial

We believe the core driver of Triad is origination growth. We expect origination volume ($mm of loans originated) to grow from $1.08bn in 2021 to $3.08bn by 2025 in the base case, or $2.0bn of growth. Of this, we have new loan programs contributing $1.55bn and core growth of $450mm.

• New loan programs ($1.55bn)

• New loan programs are the difference between this being an excellent investment and just an OK one. The biggest driver of growth is the Land Home product, which in our base case drives ~$1.1bn of origination growth through 2025 and equates to a ~6% market share (less than half their current chattel share).

• We expect the “Bronze” lower FICO score program to drive another $400mm of originations, which we think of as being achieved by adding an incremental $100mm originations per year. Another way of thinking of the Bronze program is that it’s adding ~7.5 points of market share over time (see below for market share including Bronze originations and the core prime originations only):

• 

• The remaining $50mm of origination growth is in the Company’s new rental program, where they lend to communities to support their purchase of rental units. There has been limited commentary here and it has not been the focus of our work.

• Core growth ($450mm)

• This represents a 10% CAGR from 2021 to 2025, which we think of as ~MSD from market growth (combination of volume & pricing) and ~MSD of continued share gain.

•  Margins

• We assume incremental EBITDA margins of 70%. Triad achieved an 85% incremental EBITDA margin in 2019, which has come down to the mid-50s in 2021. We believe the Company has been making excess investments to support the growth of new loan verticals and going forward incrementals should be higher.

•  Multiple

• We think by YE24, Triad will garner a 22x forward EPS multiple. We think is appropriate given Triad will likely be exiting 2025 still growing earnings M-HSD %.

Kessler Group

We assume modest revenue growth over-time (2.8% CAGR from 2019 to 2025) and modest leverage (op income growing at a 5.3% CAGR from 2019 to 2025). We are using a 14x fwd p/e multiple for this business. While ~85% of revenue is recurring in nature, this business has some amount of customer concentration risk and volatility over time, which the market will likely attribute a lower multiple to despite expectations for ~5% earnings growth over time. Capitalizing this at a 7% earnings yield feels decently conservative.

Legacy Assets

ECN still retains $97mm of legacy assets on the book held for sale, comprised of $55mm of aviation assets, $36mm of railcar assets, and $6mm of commercial & vendor assets. In its 4Q20 MD&A document, the Company has stated it: “remains focused on the efficient disposition of its legacy aviation, commercial and vendor finance and railcar assets. In the fourth quarter of 2020, the Company recorded an incremental after-tax provision of approximately $22.7 million related to its aviation assets. Total legacy assets classified as held-for-sale are down to $106.8 million from $143.0 million at December 31, 2019.” We believe they should be able to sell down these assets in the near term around book value, and give credit for doing so in all cases except the tail-risk case. Across the cases, this represents 3.8% of our PT, so this is not a focus.

Corp liability

Management has guided corp opex to run at ~$12mm on a go-forward basis (post Service Finance divestiture). We capitalize this, along with ECN-level D&A and interest expense, at a blended multiple of KG + Triad. In a true upside case, corp liability may be reduced if both KG and Triad are sold and all remaining capital is returned, but there will likely be adverse tax consequences in that scenario (so we leave this out of the analysis w/o a finer penciling out of the math from management).

Overall Valuation

We are valuing the entire entity at 19.6x forward 2025 EPS, which equates to ~$10.6 per share of operating company value at YE24. Adding in interim dividends and cash from divesting the legacy assets, we arrive at a price target of $11.8 at YE24, which represents 182% upside and a 41% IRR from today’s price. We believe the risk/reward is extremely attractive here as entry multiple of ~14.5x values the stub like a no-growth company (but we expect Adj. Net Income to CAGR at 26% through 2025).

Risks

•  Unexpected wave of credit losses / recession

•  Mitigant: the obvious mitigant is that net charge offs were low even in the GFC (1.3%).

•  The bigger issue here is likely to be on the volume side. If there is a major recession, MH shipments can decline double-digits. Though a temporary phenomenon (would be below mid-cycle), Triad’s revenue would be directly affected. Shipments declined 39% in 2009 but only 2% in 2020. Somewhere in the middle is likely fair to assume for a once in a decade extreme recession.

•  New capital is attracted to MH lending

•  Mitigant: Triad has been doing this for decades, has an established network with thousands of dealers, and this is a somewhat niche area. We will constantly evaluate this risk as it strikes us as the largest long-term potential threat. Additionally, there is a two decade trend of banks exiting the market (so new entrants would likely come in the form of independents, who would unlikely possess a funding advantage vs. Triad).

• Chattel loans gain significant GSE support

•  Similar to the above risk, part of the reason chattel rates are so attractive is the lack of players in the market. Banks do not want to deal with this product. If the government sponsored a significant and broad securitization program for chattel loans through the GSEs, this will likely change most banks’ attitudes towards originating chattel loans (if they are just selling it on to the GSEs). The mitigant here is the GSEs have actually attempted to do this in the past, on a small scale basis, and Freddie Mac shuttered their program (Fannie Mae’s program is still in limbo).

• 

• Secondly, it’s unclear the extent to which there is downside at Triad – it still has the origination network in place (and there will still be value here), but rates presumably come down if a liquid secondary market exists (pressuring Triad’s origination fees).

Additional sources of upside / accounting explained

While we do not contemplate this in our valuation, we believe Triad has room to increase its origination fees given its loan performance. Triad’s interest rate is ~7.0% for a typical chattel loan. Of this, Triad earns an origination fee equal to ~1.5% over the course of the loan’s life. So for a $65k loan with a 240 month term, Triad’s cumulative fee is ~$13,600. Of this, Triad recognizes 35% up-front, or roughly $4,800. The remaining $8,800 goes into a reserve account. So from the bank’s perspective, it is earning a 5.5% yield that is protected by an $8,800 reserve for a total $65k loan (13.5%). We think this is quite high / conservative accounting.

Triad’s credit performance has been phenomenal. Triad’s delinquency rate has hovered around 2% even through the GFC, way outperforming traditional bank single-family homes. Its net charge offs peaked at slightly above 1% in 2010 and have come down since to ~50bps from 2014 through 2018. Triad’s recent NCO’s have been even better, average close to 25bps in the past year:

Source: ECN Investor Presentation

We do not have full data from Triad, but from what we have the worse cohort was 2008 (which makes sense). At month 120, cumulative loss of this vintage was around 4.8%. Even if we doubled that to account for the full 240 month avg. loan life, it would suggest the worst recent cohort (GFC cohort) would have done 9.6% of cumulative net losses. That is well below the amount reserved for by Triad (13.5%, discussed above), and also is overstated as loan losses are front-end loaded (can see this below – the net loss curves flatten out over time):

Source: ECN Investor Presentation

Supporting this logic, on the 10/2017 Triad M&A call management disclosed that reserves have never been exhausted.” On ECN’s 1Q20 call, management stated they have “always operated well below those loss rate assumptions – even in the middle of a financial crisis [GFC].” They added that between 10-15% of origination revenue in a given year is from the release of excess reserves.

So to this end, these loans seem very attractive for bank partners. In 2019, ECN put out a slide deck suggesting its bank partners earn a ~3.0% ROA (close to 3x the ROA of the average bank):

Source: ECN Investor Presentation

On their 1Q20 call, management called out an ROA of 3.25%, suggesting their bank partners have seen a 25bps improvement in ROA since 2019. On a call with management last month, the CEO hinted at the ability to increase their origination fees: “with a 3.25% ROA for our bank partners, it is clear that we are providing too much juice. Can cut some of back provided rates stay where they are at… can get larger commitments and better price [over time].”

If Triad took back just the amount ROA has increased since 2019 (25bps), it would increase its take by ~17%.

Note: We are doing more work on this analysis as it is unclear from published data exactly how prepayments flow into hitting the reserve account (so it is difficult for us as outsiders to figure out exactly how much cushion there is, other than to observe the increments – i.e. ROA improved or credit performance improved so there is incremental cushion).

Appendix 1 – ECN Capital history

ECN Capital was spun off from Element Fleet as the “BadCo” on October 3, 2016, cleaning up the higher multiple fleet leading business of rail, aviation, and commercial & vendor assets. As of 3Q16, ECN Capital had $5.6bn of assets ($2.3bn Rail, $2.3bn C&V, and $1bn of aviation) against $1.7bn of total equity.

Over the course of the past five years, ECN has steadily sold down these assets and purchased three capital-lite specialty finance businesses. The Company ended 2017 with $1.7bn of legacy assets, using proceeds from the sale to purchase Service Finance (September, 7, 2017 date for $334m including an earn-out), Triad Financial (December 29, 2017 for $100mm), and Kessler Group (May, 10, 2018, total capital invested of $311mm). Over the next several years, ECN continued to sell off legacy assets, which totaled $.3bn in 2018 and $.1bn as of 3Q21 using proceeds to execute several large share repurchases over time, with shares outstanding declining from 387mm at the time of spin to 251mm currently.

On August 11th, 2021, ECN announced the sale of Service Finance for $2bn, and will distribute the after-tax proceeds as a special dividend on December 22nd, 2021.

Appendix 2 – Examples of Manufactured Home Units

ECN’s slide on the matter:

Example of a $140k home in Florida:

Nicer kitchen than my NYC apartment!

Appendix 3 – NYT article on Green Tree Financial

“Green Tree Financial, a Minnesota lender, financed more than 40 percent of all manufactured homes sold in the United States during the industry's peak.”

“In their rush to lend, Green Tree and its rivals made loans to borrowers who had little chance of paying them back. Tens of thousands of those people have already defaulted and have been evicted.”

“Like many other banks and finance companies, Green Tree used a process called securitization to resell its home loans to outside investors. Green Tree grouped thousands of these small loans into a pool worth hundreds of millions of dollars. It then divided that pool into a series of bonds and sold them, promising to pay interest on the bonds from the interest it collected on the loans.”

“Bonds are divided into ''tranches,'' and one tranche must be repaid before payment on the next can begin. The bottom tranches are risky and pay higher interest, while the tranches that are repaid first are very safe.”

https://www.nytimes.com/2001/11/25/business/a-boom-built-upon-sand-gone-bust.html

Appendix 4 – Long Term MH Shipments

[4]

Appendix 5 – MH Loan Originator by Share

[2]

Appendix 6 – KG customer concentration and length of relationship

Source: ECN Investor Presentation

Appendix 6 – Examples of KG transactions

Source: ECN Investor Presentation

References:

1:https://www.manufacturedhousing.org/wp-content/uploads/2020/07/2020-MHI-Quick-Facts-updated-05-2020.pdf

2:CFPB report on Manufactured Housing from May 2021: https://files.consumerfinance.gov/f/documents/cfpb_manufactured-housing-finance-new-insights-hmda_report_2021-05.pdf

3:https://www.whitehouse.gov/cea/written-materials/2021/09/01/alleviating-supply-constraints-in-the-housing-market/

4: https://s22.q4cdn.com/367818993/files/doc_presentations/2021/05/SKY-Investor-Deck-May-2021.pdf

 Disclosure:

“The author of this post is an analyst at a private fund manager registered with the Securities and Exchange Commission as an investment adviser. At the time of its publication, funds and accounts managed by the author’s employer were long ECN Capital. Both before and after the publication of this post, without making any public or other disclosure or giving notice to any party, except as may be required by applicable law, such funds and accounts may, at any time, buy and sell securities of ECN Capital (and other companies mentioned in this post), including by changing to a short in ECN Capital. The information set forth in this post does not constitute a recommendation to buy or sell any security, or legal, tax, investment or other advice. This post] represents the opinion of the author as of the date of this post. This post contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This post is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this [investment memo/post] and undertakes no duty to update its contents.”

Catalyst

• EPS beat 4Q21, 2022, 2023, 2024
• Investor day in Feb 
• land home traction
• time