Nicholas Financial is a well-run niche subprime auto lender trading at 70% of book value and
approximately 10x severely depressed earnings. Nicholas has historically earned returns on equity in the
mid-teens.
Most subprime auto lenders have portfolios in the billions, and run underwriting and collections from a
central location. This portfolio size gives them the benefit of scale, and the centralized operational
model gives them low operating costs. However they tend to have high loss rates because this scale
model is more suited for a scattershot approach to lending than a selective approach.
Nicholas, in contrast, runs a portfolio that is just $400M in size. The company has individual regional
branches for underwriting, and up until recently, collections as well. The branches allow for more
informed underwriting, reduced dealer fraud, and easier repossession. The company is a skilled
underwriter, with a deep and long-running culture of conservatism. The company has never lost money
in a fiscal year. It earned a healthy profit even in 2009.
So why is the stock cheap today?
Easy access to capital and low interest rates have massively increased competition for
subprime auto loans. Subprime auto was historically regarded poorly by investors, but the asset class
performed well during and after the crisis, and now lenders of all types (money center banks, private
equity firms, credit unions, start-ups, etc.) have pushed into the market in search of yield. I think many
of them will eventually leave bloodied, but until that happens, the profitability of the industry has been
and will be very depressed.
Increased competition has had a number effects. The gross interest yield paid by the borrower is down.
The price paid by the lender to the dealer for purchase of the loan is up. Loan sizes are larger, and loan
terms are longer. Since loan terms are longer, cars have more time to break down, and when they break
down, the borrower usually stops paying. And in some cases, borrowers who are behind on a loan are
being encouraged by another lender to default on the existing loan and instead take a new loan from this
other lender.
The table below shows the financial effect on Nicholas of the increased competition. In short, gross yield
on loans is lower by 150-200bps, and loss provision is up by 300-400bps. The combined effect has more
than cut profitability in half, from 900bps to 400bps.
