Medallion Financial Corporation (NASDAQ: TAXI)

June 5, 2012 - Long

Price: $10.52

52 Week: $8.50-12.59

Diluted Market Cap: $229mm

Dividend Yield: 8.0%

Price / Book: 110%

Price / TBV: 112%

Price / 2012E: 10.6x (consensus)

Price / 2013E: 9.5x (consensus)

3 Month ADV: 118k

Short Interest % of Float: 2.1%

Days to Cover: 4.6

Interest rates are at historic lows and we currently live in a “yield starved” environment.  Medallion Financial Corporation (NASDAQ: TAXI) is a stock that offers investors the opportunity to clip an 8% dividend in perpetuity that will grow over time.  In addition, the stock has several catalysts (increased medallion loan demand, conversion of bank to receive LLC tax treatment, etc.) that can provide additional price appreciation.

Overview: Based in New York City, Medallion Financial is the only publicly traded specialty finance company in the US that focuses on originating and servicing loans that finance the purchase of taxicab medallions.  In addition to originating taxicab medallion loans, the Company also originates commercial and consumer loans. 

Medallion Financial operates as a business development company (“BDC”) at the holding company level but conducts a significant portion of its business through Medallion Bank, an industrial loan company (“ILC”) regulated by the FDIC and Utah Department of Financial Institutions.  Medallion Financial is the only publicly traded BDC today that operates an FDIC-insured depository institution, which gives it the ability to retain capital and grow.

The original business, called “Medallion Funding Corporation,” was founded in 1979 by the Murstein family.  The family took their business public in 1996, and the Company is led by father and son team Alvin (Chairman, CEO) and Andrew Murstein (President) today.  The Murstein family owns ~14% of the Company.  Several notable figures sit on the Company’s Board of Directors, including former New York Governor Mario Cuomo, former Senator and Governor of Connecticut Lowell P. Weicker, Jr., and Hall of Fame Baseball Player Hank Aaron.

Warning: Trading volume in TAXI shares is thin and there are only a small number of owners in this Company.  As of 6/5/12, TAXI shares had a three month ADV of 118k.  Prior to the recent $35mm offering (given to mostly retail), which was for ~16% of the Company, Medallion Financial had only ~245 shareholders. 

INDUSTRY OVERVIEW

• A taxicab medallion represents a license to operate a taxicab and accept street hails.  Owners of medallions make money by driving a taxi themselves or leasing out their medallions to other drivers.

• The price of a taxicab medallion is artificially supported by government limiting fixed supply
  • As of December 2011, NYC had 13,237 taxicab medallions, of which 5,573 are individual medallions and 7,664 are fleet/corporate medallions.
    • Corporate medallions are more valuable because they can be aggregated by businesses, leased to drivers, and operated for more than one shift. 
    • The supply of medallions is controlled by the NYC Taxi & Limousine Commission, which reported in May 2012 that the average medallion cost $704,000 for individual owners and $1,000,000 for corporate owners.
      • Based on these price levels, the market value of all medallions in NYC would be $11.6bn ($7.7bn corporate, $3.9bn individual)
    • The fixed supply of taxi medallions in the NYC metropolitan area and most other major markets has historically provided price support for the medallions. 
      • Over the last 7 years, NYC taxicab medallions have outperformed most other asset classes, as corporation/individual medallions rose from $289,000/$241,000 in January 2004 to $1,000,000/$704,000 in May 2012.  During this period, the supply of medallions remained virtually flat, increasing from 12,779 (5,112 individual / 7,667 corporate) to 13,237.
      • To date, the taxi medallion’s value has only declined twice in the past three decades, once during the oil embargo in the 1970s and then immediately after the 9/11 terror attacks.
    • Similar laws limiting the number of medallions exist in most major cities, including Chicago, Boston, Newark, etc.
      • At Q1-12, 79% of the Company’s medallion lending, on a managed basis, was concentrated in the NY metropolitan area, with the rest spread throughout Chicago, Newark, Boston, and Cambridge. 

• Although taxicab medallions have appreciated in value over time, they are difficult justify as an income investment to new investors and non-industry participants. 
  • The argument for a medallion investment revolves around the regulated supply and recession-proof taxi-fare industry dynamics, but at a $1mm purchase price, a medallion generates ~$2,500-3,200 in profit per month for medallion owners (or $30-40k per year), amounting to a 3-4% yield
  • The majority of buyers are taxi insiders from Long Island who are using past investments and ownership as equity to finance additional medallion purchases. 
  • Many other types of bubble characteristics exist, including the lack of information transparency, wide bid and ask spreads, high commission and transaction costs, and a thin and illiquid market.

• On the contrary, it is difficult to see governments deregulating the supply of taxi licenses any time soon for many reasons: 
  • The issuance and sale of medallions is a source of funding for local governments
  • Fees, fines, and taxes can exist alongside medallion ownership and usage
  • Many constituents (drivers, lenders, government divisions, brokers, attorneys, etc.) will fight to preserve the system
  • The medallion/licensing system allows government to regulate the industry

• The upcoming fare increase for NYC taxicabs should continue to support medallion pricing
  • On May 31, the NYC Taxi & Limousine Commission held a hearing to discuss a lease cap and rate of fare increase
  • City hacks and fleet owners have proposed a rate hike of 15-20%.  Mayor Michael Bloomberg and TLC Commissioner David Yassky have publicly supported the move
    • Drivers claim that fuel prices and other costs have increased, including the amount drivers pay to lease medallions and cars from owners.
    • Fleet owners are pushing to lift the maximum cap drivers can be charged to lease cars, claiming that the increase is necessary due to the rising cost of liability and workers' comp insurance and the price of buying new vehicles.
      • It is important to note however, that TLC Commissioner Yassky is less optimistic of lifting the lease cap given the price appreciation of medallions over the years
    • A final TLC vote on the fare increase can come as early as July 2012

STRONG CREDIT QUALITY

• Historically, Medallion Financial’s credit quality has been strong.  To date, the Company has not taken a single loss on any of its taxicab medallion loans. 
  • The key to this success is based on the Company’s underwriting policy of originating medallion loans at LTVs of 60-75% as well as the steady appreciation of taxicab medallions over time. 
  • To quote Andrew Murstein, “Only a handful (of loans) default every year.”  Furthermore, loan loss severities have been nil because repossessed medallions are easily sold at a price to recoup losses. 
  • As of Q1-11, the average LTV of the Company’s medallion loans was ~40%.

• In order to properly evaluate true asset quality, it is vital to examine both on and off balance sheet assets
  • Since Medallion Financial operates as a registered investment company (“RIC”), it does not consolidate its bank subsidiary, Medallion Bank, onto its balance sheet, even though the bank is 100% owned. 
    • Instead, the bank is treated as an equity investment and held on the balance sheet at book value. 
    • On a GAAP basis, Medallion Financial’s investment portfolio totaled $441mm as of Q1-12.  However, if we consolidate Medallion Bank’s loan and securities portfolio, then the Company’s true portfolio size is $953mm on a managed basis.

• Hence, we should evaluate credit quality separately for the bank and specialty finance company
  • Asset quality metrics at the bank are strong
    • As of Q1-12, the bank had NPAs/Assets of 0.82%, Reserves/Gross Loans of 2.47%, and Reserves/NPAs of 280%. 
    • Since 2003, net charge-offs averaged 1.66% per quarter and NPAs/Assets averaged 48bps per quarter.  Net charge-offs to average loans peaked at 3.67% in Q4-09 and NPAs/Assets peaked at 1.31% in Q209.
    • Medallion Financial’s consumer lending business, which totaled $204mm (21%) of managed assets as of Q1-12, is held off balance sheet at the bank. 
      • These are primarily adjustable rate consumer loans secured by recreational vehicles, boats, motorcycles, and trailers located in all 50 states.
    • On balance sheet loan losses at the specialty finance company have been stable.
      • On an aggregate portfolio wide basis, realized losses as a percentage of average balances peaked at 1.22% in 2004.
      • Medallion taxicab lending losses have been nil.  Realized losses as a percentage of average balances outstanding from 2000-2011 for taxicab medallion loans peaked at 12 bps in 2002. 
      • Commercial lending losses have been decent compared to other specialty finance companies.  Realized losses as a percentage of average balances outstanding from 2000-2011 for taxicab medallion loans peaked at 5.9% in 2006. 
        • These are loans to commercial enterprises in a wide variety of industries, including manufacturing, wholesaling, administrative and support services, accommodation and food services, etc. 
        • Commercial loans are generally originated at LTVs of 60-75%.
        • 20%+ of these loans are made primarily in the NYC Metro area, with the balance scattered across the US. 

• Given its RIC structure, the accounting treatment for on balance sheet loan losses is slightly different than typical specialty finance companies or banks.
  • Typical lenders maintain a loan loss reserve on balance sheet to absorb net write-offs.  For Medallion Financial, this is called the “unrealized depreciation of investments.”
  • This loss reserve is maintained through loan loss provisions on the income statement, called “change in net unrealized depreciation.” 
  • Realized gains or losses on investments are recorded when the investments are sold or written-off

WELL POSITIONED TO GROW ASSET BASE

• Several opportunities exist for Medallion Financial to grow its loan book, including (1) increasing its presence in existing cities, (2) penetrating new cities such as San Francisco and Atlanta, and (3) refinancing existing medallions that have gone up in price. 
  • As of December 2011, Medallion Financial reported that it financed 880 medallion loans in NYC, the largest market in the US.  The Company estimates that it holds ~25% market share in NYC medallion financing.
  • Opportunities exist to gain market share in other cities.  As of December 2011, the Company financed:
    • 275 loans in Chicago (cap is 6,951 medallions)
    • 140 loans in Newark (cap is 600 medallions)
    • 66 loans in Boston (cap is 1,825 medallions)
    • 32 loans in Cambridge (cap is 257 medallions)

• Despite a recent judge ruling, Mayor Bloomberg and TLC Commissioner Yassky are still fighting for the “borough taxi” plan.  If successful, this would create major demand for medallion financing
  • On June 1, Justice Arthur Engoron, of the State Supreme Court in Manhattan issued a temporary restraining order halting Mayor Bloomberg’s "borough taxi" plan, which would convert ~18,000 livery cars into lime-colored taxis offering street-hail service in Northern Manhattan and the outer metro boroughs, where yellow cabs are scarce.
    • The judge made this ruling despite the fact that Mayor Bloomberg’s plan was signed into law by Governor Andrew Cuomo in December 2011
    • The addition of 18,000 livery cabs could adversely affect taxicab profitability (and medallion pricing), but its overall impact could be limited. 
      • According to recent GPS data collected by TLC, 95% of all yellow taxi street hail pickups are in Manhattan’s Central Business District and at LGA or JFK airports
      • Enforcement of livery cabs will be key for yellow cab taxi drivers
    • The ruling also halts the planned auction of the 2,000 new yellow-taxi medallions[1], since the legislative deal required that they couldn't be sold until the new borough taxis were in operation.
      • Medallion Financial would benefit greatly from the amount of loan demand created through the sale of 2,000 medallions.  The upcoming fare increase would partially offset the impact on medallion pricing from increasing supply.
    • The city has vowed to appeal.  Michael Cardozo, the city's corporation counsel, said NYC would explore an appeal of the decision.
      • Furthermore, the city budget depends on $1 billion in anticipated revenue from the sale of new medallions.

• A similar situation happened 8 years ago…
  • The nearest precedent for the pending proposed 2012-2014 sale of 2,000 medallions was the auction of 900 medallions in 2004-2006. That sale increased the number of medallions by 7.4%, or around half of the 15.1% rise from the pending sale of 2,000 treated here
  • Moreover, the last across-the-board increase in taxi fares was in 2004, when the fare rose by 26 percent. 
  • During that time, the TLC predicted that medallion values would decline by approximately 3% over that period. In actuality, corporate medallion prices climbed 66% over this period with individual medallions rising 40%.
  • During this time period, Medallion Financial increased its medallion loan portfolio from $288mm as of Q4-03 to $522mm in Q4-06, a 3 year CAGR of 22%.

• With its entrenched market leadership, Medallion Financial is well positioned to capitalize on the growth of the industry
  • Medallion Financial’s competitors consist primarily of credit unions (Melrose, Progressive, Montauk, Lomto), and to a lesser degree, finance companies and banks. 
    • Credit unions have various restrictions, including the ability to raise capital, individual borrower loan limits, and caps (12.5%), though it may increase, on lending to businesses
    • Nevertheless, large players such as Capital One, Doral Financial, and Signature Bank are entering the market

• Medallion Financial has capacity to fund its growth in the near term.
  • The Company completed a $35mm capital raise in May 2012.  The majority of participants were retail investors.
  • In addition, the bank has ~$108mm of deposit capacity and $30mm available in Fed Funds lines with several commercial banks

ADVANTAGEOUS FUNDING STRUCTURE THROUGH USE OF MEDALLION BANK

• Medallion Financial currently funds itself through a variety of revolving lines of credit ($171mm, 20%), notes payable to banks ($81mm, 9%), SBA debentures ($58mm, 7%), preferred securities ($33mm, 4%), and deposits at Medallion Bank ($510mm, 60%).

• Medallion Financial is the only publicly traded BDC today that operates an FDIC-insured depository institution.   
  • This unique setup gives Medallion Financial the ability to raise cheap deposits (i.e., brokered CDs) and be less dependent on wholesale funding. 
  • The deposits are raised through the use of investment brokerage firms.  Rates paid on deposits are competitive with market rates and include a brokerage fee of 0.15-0.50%.
  • At 0.74% as of Q1-12, Medallion Bank provides the Company with the lowest cost of funds. 

• Medallion Bank can also help Medallion Financial retain capital.  Whereas BDCs must dividend 90% of its investment company taxable income, Medallion Bank can retain its earnings for future growth.

• The bank is well capitalized and enhances leverage for the franchise.
  • Medallion Bank can finance taxicab medallion loans up to three times Tier 1 capital, or $327mm as of Q1-12. 
  • At quarter end, the Tier 1 Capital and Tier 1 Leverage ratios totaled 18.2% and 17.6%, respectively.  As a condition for FDIC insurance, Medallion Bank is required to maintain a 15% Tier 1 Leverage ratio. 
  • Medallion Financial periodically contributes capital into the bank in order to continue growing and maintain capital adequacy levels.

• On a standalone basis, Medallion Bank is more profitable than the average bank in the US
  • The Company reported a 14.9% ROAE, 2.63% ROAA, 7.60% net interest margin, and 30% efficiency ratio in Q1-12
  • With the exception of Q1-04, the first quarter in which the bank was launched, Medallion Financial has been profitable in every quarter of its existence

• Potential catalyst in conversion of Medallion Bank to obtain LLC tax treatment
  • Medallion Financial is currently in discussions with the IRS to obtain LLC tax treatment for Medallion Bank, which would provide “pass-through” taxation for shareholders.  The State of Utah has already agreed to this arrangement. 
  • If successful, this treatment would reduce taxes and increase the earnings of Medallion Bank

• Use of SBLF funding
  • In July 2011, Medallion Bank issued $26.3mm of preferred stock to the US Treasury under the Small Business Lending Fund (“SBLF”) program, and simultaneously redeemed its $22.3mm of preferred stock outstanding under the Treasury’s Capital Purchase Program (“CPP”).
  • Medallion Bank currently pays a 1% dividend on the SBLF proceeds.  The dividend on the preferred shares will increase to 9% by January 2016.

LIABILITY SENSITIVE BALANCE SHEET

• As of Q1-12, the Company reported a cumulative one year interest rate gap of -$184 million, or -48% of its total interest rate sensitive assets on a reported basis.  On a managed portfolio basis, the interest rate gap was -31%.

• Management believes the effect of changes in interest rates will be mitigated by regular turnover of the portfolio.  Management anticipates that 40% of the taxicab medallion portfolio will mature or prepay as borrowers are more likely to refinance in a declining interest rate environment.
  • Adjusting for this 40% prepayment assumption results in a cumulative one year negative interest rate gap of -$81mm or -21%.  On a managed basis, the interest rate gap is -$99mm or -10%.

• In consideration of this issue, the Federal Reserve has stated that it will keep interest rates low in the near future.

VALUATION

• No appropriate trading comparables exist

• The stock, which currently trades at 110% of book, should command a premium to book value for several reasons:
  • Medallion loan losses have been virtually zero throughout the Company’s existence
  • The Company is the only publicly traded BDC that has a bank subsidiary, making it less reliant on traditional wholesale funding and giving it the ability to retain capital and grow. 

• At the current state, investors should be able to clip an 8% dividend yield in perpetuity that will gradually grow over time

• Certain catalysts could provide additional price appreciation
  • Converting Medallion Bank to receive LLC tax treatment enhances the earnings profile of the franchise significantly
    • Medallion Bank paid $2.6mm in income taxes in Q1-12, or $0.12 per share
    • For comparison, Medallion Financial declared $0.21 per share in dividends to shareholders in Q1-12
    • Growth opportunities to expand medallion lending exist
      • Like the 2004-2006 sale of 900 taxi medallions, Medallion Financial could be a huge beneficiary if NYC eventually gets permission to sell 2,000 medallions.  During the 2004-2006 time period, Medallion Financial increased dividends per share from 7 cents in Q4-2003 to 19 cents in Q4-2006

• Some additional items for thought
  • The bank is hugely profitable but carried at book value
  • The Mursteins are entrepreneurial and could explore investing in other businesses with Medallion Financial. 
  • Medallion Financial currently holds interests in companies such as Generation Outdoor, Appliance Recycling Centers of America (NASDAQ: ARCI), FNBNY, Inc., RPAC Racing, etc.