Description

Interstate National Dealer Services is a micro cap ($20 million market cap) that markets and administers service contracts and warranties for new and used cars and recreational vehicles and, to a lesser extent, watercraft, motorcycles and other vehicles. Sales are through three channels with independent dealers making up the majority of sales, and financial institutions and direct by the company making up the balance. The company also operates an affiliated insurance company, National Service Contract Insurance Company Risk Retention Group, that underwrites 70 percent of the insurance policies arranged by the company for its service contracts.

Caveat emptor: almost all the information below was gleaned from the financial statements as Chester Luby, the CEO, was less than forthcoming in the two conversations I had with him.

The business is competitive, with the major automotive manufacturers dominating, followed by some of the property and casualty insurers, with Aon and CNA being the largest providers in this segment. Unfortunately no other provider of these services is publicly traded to provide for a clean comparison.

Initially, the company’s business focused on extended warranties on new cars but in the last five years the bulk of sales are for warranties on used cars and recreational vehicles. The net rate for service contracts ranges from $75 to over $3,000 per contract with a typical average net rate per contract of $700 for a new or used car, $650 for a new recreational vehicle and $850 for a used recreational vehicle. The coverage offered on the contracts ranges from three months to seven years and/or 3,000 miles to 150,000 miles. Unfortunately, the company neither publishes any underwriting data nor would the CEO give me an idea as to whether they typically generate an underwriting profit or loss on their contracts.

What I can tell you is that, before interest income, the company generated an operating profit in every year from 1995 through 2000. In 2001 the company generated an operating loss of $426,000. The loss in 2001 was attributable to two things; first, a decrease of 3 percent in sales due to the company becoming more choosy about who they write business with and second, higher claims due to the larger number of contracts outstanding after rapid sales growth between 1995 and 2000. Until the 3 percent decline in sales in 2001 the company had achieved 35 percent compound growth in revenue between 1995 and 2000. This growth was achieved from a standing start in 1994. Also, between 1995 and 1999 the company achieved 27 percent growth in book value. Growth in book value has been somewhat understated in the last two years because of share repurchases but now stands at $4.60 per share or right around the current share price of $4.80.

Earnings grew at a 50 percent compound rate from 1995 through 1998 and have been downhill from 1999. Earnings, excluding an extraordinary item, were 50 cents for fiscal 2001; a 30 percent decline from the 71 cents made in 1998. Earnings grew rapidly in the earlier period as they grew warranty sales rapidly and claims from earlier sales were deferred until the later periods. Claims from warranties written between 1995 and 1999 are now being realized and this has put a fairly significant damper on earnings as sales have slowed. Claims (cost of services provided on the income statement) grew from 25 percent of sales in 1995 to 56 percent of sales in 2001.

I should also add that in 2001 the company incurred a $4.3 million extraordinary loss from the settlement of a lawsuit with a company they were writing business with. ISTN was not making any money on the business and wanted to raise contract rates. The company writing the business, Warranty Gold, claimed breach of contract and sued. While the resolution of the case appears as a settlement, the real cost was the transfer of the obligations and all the future benefits of this business to another insurer.

So what’s to like about this company? The primary reason to own ISTN is that they have been an aggressive re-purchaser of their own shares. In 2000 the board approved a re-purchase of 2,000,000 shares of the roughly five million fully diluted shares then outstanding. As of the end of fiscal 2001 (October 31st) the company had repurchased 731,700 shares at an average price of $5.26 per share leaving 4.3 million outstanding. In October of 2001the company agreed to extend the repurchase to an additional one million shares.

Also, the demand for warranties is fairly inelastic because it provides security to the buyer who may have concerns about the quality of the good they are buying. Warranties are also a critical source of revenue for the seller and they can significantly increase the profitability of a sale by adding in a warranty. Admittedly, sales in the short term may be adversely affected as people who may have bought a used car have opted for a new car with zero percent financing. But I believe, and Mr. Luby didn’t correct me, that they should be able to achieve three percent sales growth this fiscal year through a combination of price increases and new business. Since sales have flattened out the past three years I also believe costs of services (claims) will come in at about 55 percent of revenue, which is consistent with the last two years claims. This slight increase in revenue would lead to enough leverage to increase fiscal 2002 earnings to 58 cents a share. If they manage to re-purchase another 750,000 shares earnings will be 70 cents. Placing a 10 multiple on those earnings you have a $7 stock a year from now. The company also has no debt so there is nothing to hinder them from re-purchasing their shares with their available capital.

Backing you up on your purchase are three institutions who own approximately 30 percent of the outstanding stock and have been active with management in trying to realize a higher share price. This is only three percent less than the roughly 30 percent that is controlled by the CEO, Mr. Luby, and his family.

What’s not to like about ISTN? Beside the fact that Mr. Luby is unwilling to share any detail about his company is his fairly generous pay package. His compensation in 2001 was $400,000, including a bonus of $150,000. The annual bonus is calculated on the earnings of the company and is equal to the greater of $150,000 or 4 ½ percent of the company’s earnings before interest and taxes for the fiscal year. Mr. Luby also searched the market for capable senior executives and determined that his daughter, Cindy, was the best candidate for President and COO of ISTN. Ms. Luby’s compensation is not too gratuitous for the position but contains a like provision that her bonus is equal to the greater of $100,000 or 3 ½ percent of the company’s earnings before interest and taxes. From a compensation perspective it is nice to see that Mr. Luby hasn’t received any options in the last three years and Ms. Luby has only received 100,000 options in one of the last three years. While nepotism always scares me I have some confidence that nothing outrageous will happen with three large institutional investors investing alongside me at similar or higher prices. I would also note that Mr. Luby’s retirement would add about 10 cents a share to earnings.

The only other “wart” is that a LBO firm, Lincolnshire Management, tabled an offer of $9 for the company in February 2000. My sense is that the offer was dismissed by the board without appropriate review. Again, I think new institutional ownership would help in the event that such a thing was to happen again.

Altogether you have a reasonable business, trading at a reasonable price with very average management. I expect an almost 50 percent increase through a very marginal improvement in business and a significant share re-purchase.

Catalyst

A slight improvement in business and share re-purcahses should increase earnings by 40% in the short-term.