Description

This idea was very well covered in May of 2003 by david101 (I encourage those interested to go back and look at his comprehensive write-up). Since that time NICK rose from $4.60 to as high as $12.24. In the last month the stock sold-off (for specific reasons to be detailed later) and settled on Friday at $8.05 per share. I believe today NICK represents just as good an investment as it was a year ago, especially in light continued improvement in earnings and fundamentals (also in light of the run in the overall market).

The Basics:
- Trading at 8.4x TTM diluted EPS
- Trading at 7.5x run-rate diluted EPS
- Trading at 8.0x our estimate of FY 2005 (ends 3/31/05) diluted EPS (this estimate includes some dilution from a recent offering offset by lower interest expense from the reduced balance on the line of credit)
- Has reported record increases in revs and EPS in 54 of the past 55 quarters
- Has reported record increases in revs and EPS every year for the last 13 years
- Company is consistently a 15%+ revenue grower and a 20%+ EPS grower. Given branch openings and based on our recent discussions with management, we believe these rates of growth will continue for a number of years
- Has a unique and VERY disciplined approach to their market. Their competitive advantage is based on years of experience and know-how – something that is not easily be replicated
- Year-over-year they beat competitors across almost any metric - ROE consistently above 20% with relatively conservative financial leverage

Across our universe of companies NICK probably represents the best value. We see this value both in terms of absolute multiples (which by our measures are very low) but also in terms of a high quality business that has improved performance in an extraordinarily consistent manner in both good times and in bad.


What’s the catch?

- Well, some investors simply don’t invest in specialty finance companies (some pretty bad memories from the mid to late 1990s. Fair enough, we don’t either really. But, this company is unique enough and our diligence thorough enough that NICK is has become a core holding.
- Some investors are under the impression that recent and expected increases in interest rates will hurt NICK – we will explain below why this is not the case.
- NICK has just finished an offering that increased the float significantly. This should bode well in the long-term but of late has created overhang taking to the price from $12 to $8 in about a month.

What does NICK do and in what market do they operate?

Simply put, NICK buys sub-prime auto finance paper. This is a very large market with $220BN in annual sub-prime auto sales ($130BN new, $90BN used). At first glance financing such purchases might appear to be a pretty commodity-like business. After all, the auto dealers don’t really care who buys the paper, they just want the best price and least stringent lending criteria. Admittedly, like any insurance or finance market, capital can flow to this space very quickly (and possibly in an undisciplined manner). This happened in the mid to late 1990s and a host of companies went bankrupt (First Merchandise, First Enterprise, Jayhawk, Eagle Finance, Mississippi Finance, Keller Financial…). Just for the record, during this period NICK battened down the hatches, wrote loans more conservatively, slowed branch growth, and continue to post record revs and EPS.

So why is NICK better at this than other companies?

- First, most large sub-prime underwriters primarily use algorithms with quantitative inputs as well as credit scores as the primary tools to their underwriting process. This allows them to buy lots of paper in an efficient manner. If their systems and actuarial estimates are good, then they should be able to control their loan losses and make ok money. Having said that, some of these large companies tend to run into trouble every few years and are forced to take large write-downs. NICK does look at credit ratings but the majority of their underwriting is a function a ‘high-touch’ model. By this I mean that they get to know the specific situation of the individual to whom they considering for a loan. They do this by interviewing the potential borrower and understanding where that person is in life. They also ask very specific questions that elicit responses allowing NICK to determine likelihood that someone will repay their loan (a key here is that they are looking for a number of potential red flags that experience has taught them are precursors to non-payment). They also call and confirm what they are told in the interview by speaking with employers and other references. This may seems like a somewhat unstructured or perhaps non-quantitative method for lending – especially in a world where a credit report on a single piece of paper can supposedly tell a lender everything they need to know about a person’s ability to pay. That’s the whole point though. In order to lend successfully in the sub-prime area – one must know the borrower. Credit reports are backward looking and don’t tell you that much about the sub-prime borrower These people all pretty much have bad credit, this why they are buying sub-prime in the first place. NICK over the years has become very good at understanding what types of people, at what stages in their life, are most likely to fulfill future obligations. Their financial track record is a testament to that fact.

- The above paragraph might not seem wholly as important if NICK was not going to keep the loans on their books. But, in contrast to most large sub-prime specialty finance companies, NICK does not securitize their portfolio. Every loan is on NICK’s books. In their words, “We own everything we underwrite. This is OUR money we’re lending”. The first thing this does is it really creates a sense of ownership within the organization. Lending criteria are based on quality and not quantity as securitization often encourages. Second, NICK does not have to face the finicky credit market as frequently as other firms do. One might argue that securitization has been in part to blame for the boom-bust cycle experienced at some finance companies.

- Due to NICK’s branch network, they have in-depth knowledge of their markets and the dealers within those markets. This local presence is key in the often murky world of sub-prime auto sales. NICK mangers spend a lot of their time on dealer lots getting to know sales managers and learning who originates the best paper. Unscrupulous dealers will sometimes teach a potential buyer how to game the credit review system and therefore be able to buy a more expensive car. NICK mgt. credit their in-market presence with a lot of their success. In fact, they have wondered aloud how anyone can underwrite in a market without an intimate understanding of its employment dynamics and the dealers there. This belief is evidenced by the way NICK enters new markets. They typically put a good underwriter into the market to go out and learn about the dealers there. He will start to buy some paper in that market to see if it’s an area in which NICK can find good loans. In this way, NICK can test a new market without committing significant capital or resources.

What are the transaction economics and how are the loans tracked?

Starting with a vehicle with a $8500 purchase price – assume it cost the dealer $6500 at auction. Someone paying cash would likely get the vehicle for $7500. The dealer essentially charges more on sub-prime transactions. Let’s say the buyer puts down $1200 so $7300 needs to be financed. Nick will buy the note at a discount – for say, $6500. Thus the dealer makes $1200 ($1200 cash plus NICK note of $6500 minus cost of car at auction of $6500) and nick gets a $7300 face value note for $6500. Nick puts the loan on their books at $6500 and as they recover the loan they accrete the discount into earnings.

NICK also takes a reserve in excess of the note discount. Usually the note discount is about 9% and the extra reserve is 4%. Thus, there is a reserve plus discount of 13%. Collections in excess of book value of the loan (book after discount and additional reserves) are accreted to earnings. NICK is very conservative about this – they consider it a mortal sin to ever have to reverse earnings. The SEC even reviewed NICK’s methodology for reserves – if anything they were concerned that NICK’s approach is too conservative. Ultimately the SEC agreed the NICK approach was ok although teetering on too conservative.

Loans are tracked in pools --- one pool per branch, every 90 days. An average pool is 70 to 80 loans and NICK is currently are tracking about 475 pools. This gives NICK very good granularity on branch performance. They can get a sense relatively quickly if some particular branch or some market is not performing the way it has historically. For a small company NICK seems to have very sophisticated systems with all the branches linked by a single MIS. This system feeds information to management at HQ on every pool on a daily basis.

Nick has very good loss recovery rates. Part of the reason for this is that, as in the example above, they will never finance more than the auction/wholesale value of the car. Thus, if someone does not pay they simply repossess the vehicle and turnaround and sell it at auction for little loss if any. Also, since a lot of their customers come into NICK branches to pay in person, NICK has a lot of interaction with their customers. They are quick to detect delinquencies and can start the recovery process quickly.

How sensitive is NICK to changing interest rates?

In the long term, NICK’s cost of borrowing will be a function of underlying interest rates as one would expect. In the medium term, NICK is swapped-to-fixed on $60mm of their $75mm line. In fact, their blended cost of borrowing should come down as a May 2000 swap comes off and they replace this with lower cost financing.

Also, as the economy improves, the performance of NICK’s loans tend to improve. As jobs are created (and more importantly people are not as likely to lose their jobs), NICK realizes lower defaults. Therefore, this improving economy will help NICK and climbing interest rates will not hurt NICK.

If you want to see evidence of this, look at the last 10 years of NICK you’ll see that the difference between NICK’s gross yield and their average cost of funds stays pretty constant. One can also see slight improvement in delinquencies and defaults in improving economic times.

What are the branches like?

- NICK has 32 branches mostly in the east and southeast. They opened three branches in FY04. They have already opened 3 in FY05 and may open as many as three more representing over 20% branch growth
- NICK typically establishes the economic viability of a branch before committing to a physical location. They send an individual in-market to buy paper and establish relations with dealers
- Capital investment only $20k-$25k (desks, phones, 2 fax machines). We’ve been to a few of these branches – they are clean and well lit but one does not have to worry about NICK management wasting extra money on build-outs
- A branch typically employs 3 to 6 people. Consists of a Branch Manager, Customer Service Reps and Collections Specialists
- A new branch takes about 12-15 months to break even and 18-20 months to recoup all costs (i.e. $0 retained earnings)
- Branches are typically 95% mature after three years
- A good mature location will contribute $45k-$60k per month in pre-tax


What is the mgt. team all about?

We like them very much. Generally they are very understated, non-promotional, heads-down and execution focused. They are also responsive to shareholders. We have many goods things to say on this front.

Recent stock offering:

On Friday (May 14) NICK completed a secondary. This offering consisted of 1.1mm new shares and 900k of founders’ shares. This is a rather sizable offering to sell into the market given that previous to offering NICK only had 5.5mm shares outstanding. We think this explains much of the recent 35% fall in the stock price – this discount was necessary to get such a large deal done in such an under followed stock.

Of the 900k of founders’ shares sold, a number were held by the CEO. The deal takes him from 30.5% ownership of the company to 16.2% ownership. He’s been a core holder for 15 years and still has substantial ownership. We don’t begrudge him a bit seeking some liquidity (he is 61) and are fully comfortable with his continued commitment.

Most of the rest of the shares were those of the Mahan family. The patriarch of this family was key to funding NICK back in its infancy. They’ve wanted some liquidity for a while – they still own a healthy chunk of shares. In our view, the market should be pleased that the Mahan’s are partially out since it had been believed for some time there were intergenerational differences in the family about how much NICK stock to hold. This created some overhang on the stock. There was fear that if the younger members of the family were bequeathed all the shares, they would sell into what has been a rather thinly traded market for NICK shares. This concern should be largely alleviated with this recent transaction.

The other benefits of the transaction are that it should bring more institutions into the stock and generate greater liquidity in the shares.

Lower leverage and higher share count will generate a slightly lower ROE and will be somewhat dilutive to earnings. This will be partially offset by the lower interest expense as the balance on the LOC is lower. Also, this gives NICK more room with respect to the LOC which is essential given the rate at which they are growing branches.

Overall we see this as a very healthy transaction given where NICK is right now. In addition, the secondary has created an opportunity to buy the stock at a very attractive valuation.

So, what the heck could go wrong?

Specialty finance companies sometimes run into trouble when they securitize their portfolios
- Often engenders a culture of trying to get money to work as fast as possible – the focus ends up on quantity rather than quality
- Securitizations often more expensive than other forms of borrowing
- NICK does NOT securitize their receivables, “We own every loan…treat it like its our money we are lending…a lot of it is”

Could they face a dramatic change in lender sentiment and lose their line?
- Line of credit increased 7 times since 1991
- Bank of America has been their lead on the LOC for 11 years (also have First Tennessee and Hibernia). NICK is adding Bank of Scotland to take the line from $75mm to $85mm.

Could they face a dramatic increase in interest rates?
- NICK is locked in on swap to fixed on $60mm. Blended rate to come down when more expensive May 2000 swap rolls off in 2 months
- Higher interest rates typically equate to a better economy and lower personal bankruptcies and thus better portfolio performance

Could other lenders in the space become irrational in their underwriting practices?
- Possibly, but NICK has managed through such an environment before
- Enough companies (First Merchandise, First Enterprise, Jayhawk, Eagle Finance, Mississippi Finance, Keller Financial…) went bankrupt in the mid to late 1990s that hopefully the industry has been rationalized and disciplined


Other things to note:
- There is a recent lawsuit in Ohio regarding NICK’s repossession practices. Our understanding is that NICK did need to revise a small part of their policy (dealing with escrow and ability to cure repossession). They have done so and will probably settle for less than $100k.
- On April 13 NICK announced the opening of two new branches, one in North Carolina and one in South Carolina.. Then on May 4th they opened a new branch in Pensacola, FL. This is a total of three branches already in FY 2005 (ends 3/31/2005).

Our due diligence:
- Our due diligence has included two visits with management in Clearwater, FL.
- Visits to two NICK branches.
- A meeting with their southeast regional manager.
- A number of conversations with other NICK personnel including branch managers and collections managers.

During our diligence everything told to us by Mgt. was confirmed by other members of the organization. Everyone seemed genuinely focused on buying the highest quality loans and actively managing the collection of those loans. In addition, there was a consistent belief that the best way to lend money is to know the specific situation of the person to whom you are lending – not just what happened to them previously but where they are presently in life and where they’re going.

In Summary:
- Very cheap company with strong and consistent growth. To us NICK is a growth company trading at deep-value multiples. (We’ve seldom if ever seen this type of consistent growth 15% revs / 20%+EPS trading around 8x EPS)
- NICK is without many of the key issues/concerns that sometimes warrant skepticism when looking at specialty finance companies. More specifically, we think (see our “What could go wrong” section above) NICK does not have substantial execution risk and can continue opening new branches and generating the same or higher returns for years to come.
- At these multiples and the underlying growth rate we see very little downside here. Maybe the stock could tick down $0.50 to $1.00 but even that seem hard to imagine. Even after the recent offering NICK should make over $1.00 this year. Given a 20% long term EPS growth rate we think that at least a 12x to 15x multiple is warranted. That translates into a stock price of $12 to $15. We see this as a very favorable risk-reward tradeoff.

Catalyst

Catalyst:
- The realization by the market that climbing interest rates will not hurt NICK and if anything the improving economy will help
- Reduced selling pressure now that the secondary has hit the market. This secondary will also raise institutional awareness and increase the liquidity/float of the stock
- More investors understanding the earnings power and compelling valuation of NICK