Nicholas Financial has been written up a number of times on value investors club.  Currently the stock trades for roughly tangible book value, which is actually above where it has occasionally traded in the past (see write-ups from during the subprime crisis).

 

What makes the stock most interesting today is that it has become severely under-levered because the comapany earns a lot of cash but doesn't grow quickly.  The company announced last night that they are finally going to do something about this under-leverage.  Specifically, we believe they will tender for 5 million shares at a premium or pay a large one-time dividend of ~$5.50 per share.

 

 

This company will still be under-levered as compared to peers if it takes this route, will be able to borrow this amount of money with capacity on their current credit facility and is not at peak earnings.  We would also remind everyone that this company is an excellent under-writer of loans and has never had a money-losing year in 25 years in the business.

 

SUMMARY:

Nicholas Financial is a great business with a long track record of profitable operations and book value growth.  The company consistently earns attractive returns on capital while operating with less leverage than peers and has grown its business every year since going public in the 1980s.  Capturing less than one tenth of one percent of a $250 billion industry, Nicholas has the opportunity to expand its business significantly in the future.

This company has occasionally traded at a very cheap valuation because its business is subprime lending.  This is a sector that is not only toxic in the minds of many investors, but is also highly competitive in the current “easy money” environment.  What makes Nicholas Financial an attractive investment is that it has a completely different business model than any of its competitors.  This is what has allowed the company to be consistently profitable over the last 27 years (generating positive Net Income every single year of its life as a public company) in an industry known for irresponsible lending and ruinous cyclicality.

The current opportunity to invest in this company exists because in June Nicholas’ board of directors chose to walk away from a deal in which the company was to be acquired for $16.00 per share.  In the last two months the share price has fallen as merger arbitrageurs have sold and there have been few natural buyers for a micro-cap company in the subprime auto space.  Importantly, while there has been some recent press about investigations into subprime securitizations, Nicholas does not and never has securitized its loans.  Instead, this company focuses on profitable underwriting and keeps the loans on its books.

After adjusting for the excess costs Nicholas has recently borne in relation to the proposed sale and subsequent cancellation, this company is trading for a P/E multiple of 7.8x and a multiple of tangible book value of just 1.1X.  This is clearly cheap for a high quality business that has never had a money losing year.  In addition, Nicholas is much less levered than peers and earnings are currently depressed due to a highly competitive industry environment.  We believe this business is worth at least $20 per share in either a dividend recapitalization or a (likely) sale. 

Past experience would lead investors to believe that shares of this company will be available at a cheaper price once the subprime lending cycle eventually turns south, creating both opportunity for the company and a more attractive entry price.  Because valuations in the sector have increased while Nicholas’ financial leverage has decreased, this is unlikely to be the case this time.  We believe the likelihood of either a sale or a recapitalization of the company (and possibly both) over the next twelve months more than compensate investors for the relative illiquidity of these shares.  

KEY POINTS TO THESIS:

• Temporary Dislocation:  Shares of Nicholas Financial now trade 20% below the $16 per share price at which it could have sold itself.  Over the last year the company has underperformed the share price performance of its closest peer, Credit Acceptance Corp, by 35%. 

• Durable Niche Business:   Nicholas has demonstrated its ability to write loans at subprime-level interest rates of more than 29%, while experiencing full-cycle charge offs of roughly 6.5% over multiple cycles.  It took a long time to build this business branch by branch and we do not believe there is any direct competition for the type of lending this company does.

• Masked Earnings Power:   Earnings power is not only depressed in the current environment, but it is also masked by one-time professional fees that have recently been spent as a result of the attempted and then aborted sale of the company.   Without such fees, Nicholas trades at a trailing twelve month P/E ratio of 7.8X.

• Low Leverage:   Nicholas is utilizing only 73% of its capacity to borrow on the current lending facility (assuming it is increased by 20% in meetings with creditors in September).  In addition to this low utilization, Nicholas has a much lower leverage ratio than peers, who are at least twice as levered.  We believe Nicholas could and should borrow more money at a cheaper rate than is available through its current lending facility.

• Likely Acquisition Target:   Nicholas would make an attractive acquisition candidate for some of its larger competitors, but would probably be an even better fit in a larger financial company focused on capital allocation and long-term returns, a few of which are sitting on a large amount of cash in the current environment.  Because the company gains little from being public and the founder (who owns 13.2% of the outstanding shares) recently retired, we believe a sale is likely within the next twelve months. 

 

KEY RISKS TO THESIS:

• Unsuccessful Sale Process:   The company’s investment bankers made inquiries in the wake of the previous aborted sale and were unable to attract interest at the same level of $16 per share.  We believe this failure was likely the result of poor timing and the perception that the company was “wounded” rather than a genuine lack of interest.  Due to Nicholas’ unique business model, neither a competitor nor private equity - the two groups we believe the investment bankers reached out to - is the ideal acquirer of this business. 

• Competitive Environment:   Like many lending sectors, there is currently a lot of “hot money” chasing sub-prime loans.  Nicholas has demonstrated a consistent ability to underwrite loans profitably and responsibly through the worst parts of the cycle in the past and they are currently doing so in this environment.  While conditions in the industry could get even more competitive, we believe the low current multiple adequately compensates investors at these levels.

• Suboptimal Capital Allocation:   Nicholas has consistently operated with a much lower-debt to equity ratio than its peers, which has resulted in lower returns over time.  We applaud the company’s conservative philosophy with regard to the balance sheet, but currently the company has far too much equity and far too little debt.  We believe the board of directors and management need to find sources of less restrictive financing and return excess capital to shareholders.

• Pace of Growth Limited:   Because Nicholas’ model is dependent on good underwriting, the company’s growth is limited by the ability to find capable branch managers with extensive industry contacts.  It takes roughly three years to supervise and “season” a new branch to ensure loans are being underwritten responsibly and profitably before a branch becomes profitable.  The company has plans to open 5-6 new branches this year, adding to a base of 66 locations.

 

BUSINESS STRENGTH:

SUBPRIME AUTO LENDING

In simple terms, Nicholas Financial lends money to subprime borrowers to purchase used cars.  The average loan is written to a borrower in his/her early 30s with a poor credit score, who is purchasing an eight-year-old vehicle on a used car lot for $10,000.  Typically the borrower will make a down-payment to the dealer of 15% of the purchase price and the other 85% will be financed over four years.  Nicholas does not technically loan this money, but instead immediately purchases this loan from the used car dealer for a discount to face value - usually the discount is 8-9%. 

There are a number of reasons that this is an attractive business model.  The dealer is forced to make a number of representations and warranties with regard to title and other potential problems with originating the loan.  Because only a portion of the purchase price is financed and Nicholas is able to purchase that loan at a discount, the company is actually lending less than the auction value of the used car. 

Of course a used car is a rapidly depreciating asset and subprime borrowers do not always make payments on their loans, so the purchaser of such a loan is actually at great risk.  Most subprime lenders spread this risk over many loans and run a low-cost operation so that the ~25% interest rates they are charging on loans will more than offset the cost of operating the business and the inevitable losses they will take on some loans.  As lenders put more money to work, creating a larger pool of loans across which they can spread costs and borrow more cheaply, riskier and riskier loans are made eventually leading to large losses and an industry shake-out, such as occurred in the last two recessions.

 

NICHOLAS FINANCIAL’S UNIQUE MODEL

Nicholas uses less leverage than peers, usually pays a higher rate on its debt despite this, and has higher origination and servicing costs (as a percentage of outstanding loans).  One only needs to look at the large number of community banks in this country to see what happens to a lender with these characteristics.  So how has Nicholas been successful over many years and many cycles despite these apparent weaknesses?

Nicholas Financial has a unique business model that is more easily understood as compared to a specialty insurance company or a careful investor in junk bonds than as a lending institution.  Unlike its peers, Nicholas is focused on underwriting good risks rather than spreading bad risks across a large pool of loans.  While competitors use a statistical model to make assumptions about how many 25 year old borrowers with a FICO score of 550 will default on a loan, Nicholas actually gets to know its potential borrowers.  Specifically, the company is looking to lend to “good people with bad credit” – often responsible borrowers who have bad credit because of a life event like a divorce, job loss, or medical problem.

This company is the only one of its peers we are aware of to actually interview each prospective borrower over the phone, a process which leads to rejecting 85% of these candidates.  In contrast, competitors simply plug basic information like the age and FICO score of the borrower into a computer, which makes lending decisions based on an actuarial formula.  Nicholas uses a proprietary and hands-on underwriting process to distinguish good subprime borrowers from bad subprime borrowers – or “credit criminals”.  After underwriting a loan to a borrower who appears to be a good credit, representative of the company will work to keep the loan current, calling the borrower if they fall behind by as much as one day early in the loan period. 

Founder Peter Vosotas and current CEO Ralph Finkenbrink have built this company to focus solely on good underwriting.  Each branch is regularly audited by a group from the main office and branch managers are paid bonuses based solely on the performance of the loans they have purchased.  The company has consistently stated that they will pull back lending rather than underwrite bad loans at the top of the cycle and the financial results have shown that they walk the walk on this commitment. 

 

IMPRESSIVE AND CONSISTENT TRACK RECORD

Businesses of this type are often measured in terms of the “pre-tax spread” the company can generate.  This the amount of interest received on the portfolio, net of operating expenses, interest expense, and provisions for credit losses.  Nicholas Financial has generated an enviable “spread” throughout the subprime lending cycle as a result of good underwriting.  It is worth noting that this is the spread on the entire portfolio of loans (Nicholas does not securitize), regardless of how this portfolio is funded.  The interest expense calculation on the following chart is not the rate of interest charged, but rather the total dollars spent on interest divided by the total value of the portfolio at cost.  This is important to note, because this demonstrates that an appreciable increase in borrowings would not have a significantly detrimental effect on the spread.  The pre-tax spread can be thought of as similar to the ROA calculation for a bank.  Other lenders much use must higher levels of leverage than Nicholas to compensate for the smaller spread that results from higher losses due to poor underwriting of loans. 

(I'll find a way to insert the chart showing un-levered pre-tax spread of ~9% across the last 14 years)

There was an accounting change retroactive to Fiscal 2009 which related to the way Nicholas accounts for the discount to face value at which the company purchases loans from auto dealers.  Previously this discount was considered as a loan loss reserve taken at the outset of the loan.  From Fiscal 2009 onwards, this is amortized over the life of the loan, which increases the gross portfolio yield by roughly 4.5%.  There is a corresponding increase in reserves of loan loss provisions in each of these years (and going forward), so there is no net effect on the pre-tax spread.  This is the reason for what appears to be elevated current loss provisions in the above chart.

Over the last ten years, Nicholas has compounded tangible book value per share at 15% per annum when adjusted for special and regular dividends paid.  This was achieved not only using far less leverage than peers, but also using significantly less leverage than Nicholas itself has used in the past.  In fact, we believe Nicholas has the capacity to double its current amount of leverage, although without the ability to grow quickly – particularly in this environment – the only sensible use of such borrowings would be a special dividend. 

 

BALANCE SHEET FLEXIBILITY:

The business model of this company combined with the current competitive environment in the industry dictate that the asset side of the balance sheet – acquired loans – cannot grow quickly.  For this reason, Nicholas has become overcapitalized.  The company has drawn $131 million on the current LIBOR+300 line of credit facility and capacity on this facility of at least $225 million.  We would note that the company's lender, Bank of America, was prepared to provide a $250 million 3-year term facility to Prospect Capital on similar terms, with which they planned to acquire Nicholas.

We assume the company can and will return ~$70 million to shareholders in the near term.

 

VALUATION:

It is difficult to value Nicholas Financial precisely given the wide disparity in leverage between this company and its peers, none of which have quite the same business model.  The closest peer, Credit Acceptance Corp has debt/equity of 3 to 1.  The much larger consumer finance company Santander Consumer, which is also a competitor, is levered nearly three times that amount at 9 to 1.

We believe Nicholas could add $60 million in additional leverage and pay a special dividend in that amount without increasing its interest cost.  This would increase leverage to roughly 2/3 of the loan book, a level that Nicholas has comfortably borrowed at in the past.  With this increased borrowing, the company could pay a one-time dividend of $5.00 per share and we believe the remaining business should trade at ten times (currently depressed) earnings.  Ten times earnings of $1.55 per share (adjusting for additional interest cost) would equate to a share price of $15.50. 

Alternatively, peers trade at multiples of 2 - 4 times book value.  At 2X the current tangible book value of $11.67 per share, Nicholas would trade at $23.34 per share.  It is not difficult to come to a reasonable valuation for this business in excess of $20.00 per share and for this reason we believe the company is likely to be acquired in the next year.  We believe that in order for shareholders to receive a price closer to $20.00 rather than the $16.00 per share offer the company walked away from in June, the board of directors will need to take the necessary steps to return some of the excess capital on the balance sheet to shareholders in the meantime.

If the company instead tenders for 5 million shares at $14 per share, which we think is most likely, the remaining shares will trade for ~4X earnings.  We think these shares should trade for at least 8X earnings (and FCF) for a company of this quality, regardless of where we are in the cycle.  Any way we slice it, we see this stock worth north of $20 per share and we think the current corporate actions are a huge step in that direction.

 

CONCLUSION:

This is a very high-quality business, with a durable model that could not be replicated by a competitor in any reasonable timeframe.  While Nicholas is at the mercy of the lending cycle perpetuated by its larger peers, it is able to earn consistent returns over the cycle.  We like this model and the management team that runs the business.  We believe that the best place for this company is not in the public markets but rather on the balance sheet of a larger company with access to attractive financing and a long-term outlook. 

Management has suggested that the company is amenable both to making rational changes to the capital structure at this time and to a sale of the entire company at an attractive price.  While most investors prefer to buy companies when their industry is entering a cyclical upswing, we believe that shareholders will be well rewarded for taking advantage of the opportunity currently offered in Nicholas shares. 

 

Tender for 40% of shares at a premium

 

$5.50 per share special dividend (as alternative to buyback)

 

Possible sale of company in next 12 months