Description
How much would you pay for a company that’s grown same quarter revenues and earnings for 65 out of it’s last 66 quarters? That’s grown EPS from 12 cents per share to $1.08 per share over the last ten years (23.6% annualized). A quality company with solid financials built solely through organic growth, (no rollup), with at least another decade of strong growth ahead in the U.S. market along. I understand, you’re a bargain type guy, and you don’t like to overpay for anything, even your wife’s engagement present. So how about if Mr. Market puts this hot little number on sale, just for a short time, at a little less than 11 times reported TTM earnings? Not interesting enough? What if earnings may be substantially understated?
Nicholas Financial (NICK) has been already subject to two excellent writeups. The first was by david101 at a split adjusted $3.06 per share in May of 2003 (46% annualized even at todays low price). Then engrm842 added another writeup a year later at a split adjusted $5.38 (36% annualized) when a secondary offering depressed NICK’s price. Kudos to both, their recommendations looked even better a few months ago with NICK near $14.50.
I recommend reading both writeups if you have the chance. What I’m going to do here is quickly layout NICK’s business model, why it’s grown so consistently, and the sustainable competitive advantage I think makes NICK a good long time hold. Then I’m going to tell you why Mr. Market recently put NICK on sale.
Nicholas Financial (NICK) is in the sub-prime automobile financing business. It has carved itself out a specialty niche, by being a very disciplined underwriter of such loans and by taking a different approach to credit verification of its customers than is customary throughout the industry.
Business Summary:
Nicholas Financial exists in the toughest part of the sub-prime auto lending business, and has a unique “hands on” approach that is responsible for high profitability and low loss rates with very low credit score clients.
Nicholas is based in Clearwater, Florida, and its core business offers auto financing through 45 branch offices in ten states, Florida, North and South Carolina, Virgina, Michigan, Ohio, Georgia, Kentucky, Indiana and Maryland. What makes NICK special is a branch office driven approach. As opposed to other (mostly larger) lenders that centrally automate their approval and collection systems with a focus on maximizing loan productivity, Nicholas handles all clients through local branch offices, in order to get to know them more closely. This means the Nicholas office is close by when clients need to make payments, new applications, and most importantly, when collections are necessary.
Competitors use credit scoring as the main determinant of credit risk, allowing their central offices to process high volumes of loan applications and approvals to keep costs low. Nicholas feels credit scoring alone is in’t the most accurate gauge of individual client risk. Two clients with identical credit ratings can offer much different risk levels. Nicholas administers phone interviews with each client. This allows Nicholas to primarily measure risk through factors other than raw credit scores, such as income level, stability, “life” trend, type of vehicle and previous credit history. Credit scores only supplement those interviews. This allows NICK to “cherry pick” clients who have lower risk than credit scores alone would indicate. Even then, Nicholas turns down 85% of potential clients.
While each branch manager is responsible for purchasing loans, every contract purchased has to meet specific company guidelines. Nicholas’s typical auto loan is $9,100 with an APR of 23.82%, for a four year old car. Typically NICK buys the loan from the dealer at a discount of 1-15% (average 8.32%), and the buyer pays 5-20% down. NICK generally will not loan more than wholesale value, and this along with the discounts provides it with a strong margin of safety on each loan. In addition, the company takes an additional reserve (typically 4%) on each loan when it’s placed on the books, and requires collision coverage with NICK as the payee on each loan.
And after the loan is approved, Nicholas branch managers and collectors will follow up relentlessly at any sign the account is slipping out of current status. During the interview, contact information was collected for friends, employers and relatives of the applicant to help with any necessary collection efforts. In the first 120 days Nicholas immediately contact the client the first day they are past due. Nicholas starts repossession proceedings at 30 days past due unless the client evidences a strong commitment to fix their delinquency. Nicholas is aggressive about pursuing legal remedies and repossession, much more so than the competition. It’s this high effort approach that allows Nicholas to have default rates similar to competitors, despite having clients who appear to be “riskier” due to lower credit scores.
Management creates static pools of loans, one per quarter per branch, to track branch office performance on a monthly basis. Each branch office is regularly audited by a company audit team to ensure loans and collateral are to company standards. Lastly, Nicholas doesn’t securitize their loans. Because they retain ownership, this provides strong incentive to only write quality loans, since NICK is stuck with them until payoff.
Key Financial Issues:
One of the most attractive qualities of Nicholas is that they do not securitize their loans. This makes their balance sheet clean and easy to understand, and contributes to their quality of earnings. By not securitizing, they actually take long term ownership of their loans. This provides a strong incentive to underwrite conservatively. Because of this, accounting is also conservative, loan discounts are kept as loss reserves and aren’t recognized until the pool is liquidated or the pool is determined to have excess reserves.
Loans are carried as “Finance Receivables, net”, reserved for as follows.
|
|
September 30, 2005 |
|
Finance receivables, gross contract |
$237,193,476 |
|
Unearned interest |
-$65,217,551 |
|
Finance receivables, net of unearned interest |
$171,975,925 |
|
Dealer discounts |
-$11,559,119 |
|
Allowance for credit losses |
-$9,872,513 |
|
Finance receivables, net |
$150,544,293 |
At the end of Q2 the carrying value of all loans was $150M vs. a face value of $172M, a nearly 13% discount. There is also a 37% discount to gross contract value, i.e. face value plus unearned interest. Over the last two fiscal years $6.3M has been reserved for credit losses. Taxable income is actually higher than GAAP income since the IRS defers recognition of credit losses until incurred, this has created $3.9M in deferred tax assets. Netting out these two factors provided $8M in excess cash flow over reported income over the two years (80 cents per share). As long as Nicholas continues to grow profitably and over-reserve, excess FCF should continue for most years.
Nicholas funds all of it’s loans through a large revolving credit line with Bank of America (and three other participating banks), held since 1993. The revolver currently carries a rate of Libor plus 175 bp.
Leverage is very low in relation to its competition (1.35-1 Debt to Equity). Historically the ratio has been higher but a secondary offering in 2004 substantially increased equity. So the risk in the balance sheet revolves around the quality of loan reserves, and the fact it is borrowing short-term, to loan longer term. Since we think the reserves are strong, and the balance sheet is so lightly leveraged, we see both risks as limited or manageable. Part of the equity raised was no doubt raised to more aggressively expand the branch network. In the past 10 years, the company has doubled its branch network every 5 years. We expect this to continue, although it’s reasonable to expect at a lower rate.
The lower leverage since 2004 has had the effect of lowering ROE, which has declined into the 17% range since the secondary. From a conversation in early 2006, management expects the debt to equity ratio to increase as they grow and add more loans, but to stay under 2.5-1 for the next three years. They feel comfortable with any ratio of 3.5-1 or below.
One last interesting financial observation is that Nicholas does not appear to be trading much higher than a simple liquidation value calculation. Using current gross contracts (which includes all future interest) of $237M, and taking a 10% write-off rate leaves $213M. A 10% write-off should be conservative, since it’s not only well above today’s rate of 7.65%, but also above their historical high mark of 9.3% from the 2003 recession. Adding back cash of $1.7M and a 50% haircut to the remaining assets brings total assets to $219M. Deducting $10M for liquidation expenses (one year of salary expense) and $96M in balance sheet liabilities leaves $113M. This corresponds to a $11.30 per share liquidation value. Discounting (6% per year) for a four year liquidation process, gives a present day value of around $9.84..
Of the comparables we found, NICK has the highest ROE, the lowest debt to equity ratio, and the lowest PE ratio. Its loss ratio appears to be the lowest as well, though there is some apples to oranges variations in how different companies calculate that. Its price to book is essentially similar, despite the higher quality of its earnings. Its the only company we found that does not securitize its loans. NICK offers to investors a captive high yield portfolio, while other companies unload this risk and opportunity to third parties at significant discounts. Nicholas charges almost twice the interest rate (28%, while most competitors charge between 11-16%). This is due to the lower credit quality of Nicholas’s clientele (and older vehicles on average than the competition). Competitors growth rates are difficult to compare, because they have all shown losses and lumpy results, while Nicholas’ earnings are more steady because lack of securitization activities and high recurring interest income.
Nicholas’s branch based model, and the company’s historical proprietary database, provide an interesting proprietary aspect, or at a minimum seem to define its unique strategy. Competitors would need to radically change the way they do business, invest heavily to open local branch offices and train staff, while building up their own proprietary database of “high touch” interview factors to discern good clients from bad, and successfully compete for these loans. One comment that management made on a recent interview is that one of their biggest difficulties limiting Nicholas’ growth is finding good branch managers. They are not interested in hiring from some competitors if they believe the competitors employees are too “one dimensional”, lacking the entrepreneurial ability to manage all facets (account i.e. dealer management, loan origination, collection, hiring, etc) of a small business.
Nicholas’ real competitive threat is irrational pricing in the market. The sub prime financial business has gone through irrational pricing periods, until there is a shakeout and some firms go under. This has not happened since 1996-98 when cheap public money flooded the segment. So far, today’s competitors are more rational about pricing. If pricing turns unreasonable, Nicholas has been disciplined enough in the past to give up bad business rather than lose underwriting discipline. Evidence of this is found in 1997, revenues grew only 10% and profits 20% during a period of irrational price competition.
Management:
The two key executives are Peter Vosotas and Ralph Finkenbrink. Mr. Vosotas, age 64, is Chairman of the board, President and CEO. He founded the company in 1985. Mr. Finkenbrink, age 43, is CFO and SVP- Finance. He joined in 1988, and helped start the finance operation, becoming VP Finance starting in 1992.
There is a strong level of insider ownership. The CEO owns 16.4%, the CFO around 1%. The Mahan family helped fund the Nicholas through a convertible offering in the early 90s, has lowered their ownership to about 11% of the business. Most of this occured during a secondary offering in May, 2004.
The Opportunity:
On Nov 2nd, NICK reported disappointing earnings (by it’s standards) in it’s second quarter. Net income only increased 10% year over year, and was actually down over first quarter (27 cents vs 29 cents). In response, the stock declined to the low $11 range, and only recovered a little bit in the last few days.
A variety of factors are squeezing their results. Borrowing costs are up a half percent, while loan rates are static. Write-offs and charge-offs have increased. NICK has benefited in the past from a rosy economic climate, and it appears that we are in the part of the cycle where things are worsening. Finance receivables have only increased 15% year over year, and operating costs are up slightly proportionately. This leads me to suspect that several recently opened branches aren’t up to speed yet and this may be a drag on quarterly comparisons.
For specific items, increased interest costs are responsible for about a penny per share in lost earnings. They also lost about 5 cents per share due to interest rate swaps they use to hedge against their interest rate exposure, while the 2005 quarter benefited about 4 cents per share.
The question to ask, has anything material damated their business? I don’t think so. Periodically NICK has had to deal with higher default rates, and in the past it managed to always do this while continuing to grow at a strong pace. It's also likely that NICK’s future growth can't keep it's historic pace and this quarter might be the start of that.
The key number for me is that 15% growth in finance receivables. Even 15% per year is still excellent, and justifies a much higher PE ratio than it's currently trading at. And if this quarter was just a blip due to some branch openings, they should be able to do a bit better. They are still far from any real limites to their growth, as they still have many more states to expand into, as well as more markets in existing states. My belief is that we may have to deal with some slower growth in the short run if credit losses are higher, but in the long run earnings will keep up with financial recievables growth. Even if EPS growth over the next ten years slows to 15% per year, NICK should still be worth over $20 (a 20 PE) today. That's a heck of a discount to intrinsic value and a heck of an opportunity.
Catalyst
This has been a tremendous pick twice already without any real catalyst, so I don’t feel I need to offer one, so instead I’ll offer two. One of the reasons I own this stock is a believe in PE expansion. NICK is only a $110M market cap company, which I believe precludes it’s ownership by many institutional investors. I’m betting that NICK will be able to double earnings within four to five years and that larger market cap will put NICK increasingly on the radar of funds hungry for quality growth at a reasonable price. I think they’d find NICK a bargain at any PE below twenty.
The second potential catalyst is a private equity buyout. The CFO has been quoted in an interview this summer as saying they are being approached so regularly by private equity firms that it’s a standard point of discussion at their board meetings. The CEO is getting older and might want to retire. So it’s possible a deal may happen, but if it does I can’t see it happening unless it’s at a premium to the all time stock price high. My guess is at least $16-$17 per share today.