Description

Nicholas Financial is a specialty lender that has generated 20+% growth in earnings, 20+% growth in book value and an average 20% ROE over the last six years. Despite their success, NICK can be bought for a slight premium to book value or 5.7 X ttm EPS that seemingly ignores the benefits of a major expansion in 2002 that will be reaped in the coming years.

Nicholas Financial buys sub-prime auto sales contracts from both independent and network used car dealers. To give you an indication of how sub-prime, the weighted APR of the contracts purchased in the quarter ending 12/31/02 _fell_ to 23.66% and the average customer earns $20,000 per year. This niche has had its share of operators that have blown up or gone bankrupt. The returns can be phenomenal but it requires that management always being on top of things. NICK has set itself apart by being conservative and doing the following:

1. No securitizations
2. Aggressive payment monitoring
3. Strong underwriting discipline
4. Buy contracts at a discount to loan amount
5. Adequate Reserves

No Securitizations: This aspect really stands out because every other sub-prime lender is a serial securitizer or GOS accounting junkie. Instead, NICK retains the contracts in their portfolio. The implication of this is that any gains realized on the contracts are real, and do not occur until reserves are accreted. It also means that NICK is less subject to the whims of the credit markets by floating notes. I will provide more detail on their debt in a separate paragraph.

Aggressive Payment Monitoring: NICK uses proprietary in-house software that tracks loans and customer history. The company considers their software an important competitive advantage in this regard, as it provides real-time processing so the home office worker has the same up-to-date information as the branch. The first six months are critical in a contract and NICK calls customers if they are a day late during that period. Another interesting fact is that delinquencies drop dramatically over 60 days because Day 61 is when they start their collection process. They will even take non-payers to court and have their wages garnished. There is an anecdotal newspaper story of one dead-beat that skipped town and NICK employees searched the trash he left behind. They learned where his father lived, set up surveillance and seized the car there and took the guy to court - all for $1,000 owed.

Strong Underwriting Discipline: NICK uses a strict scoring system in their software based on the age and mileage of the vehicle, as well as the credit and employment history of the customer, to underwrite each contract. The result is that NICK rejects 85% of the applications they receive. NICK maintains an internal audit unit that audits each branch, on average, every three months. The audits are used to ensure that the information entered into their scoring system matches the actual vehicle and customer profile, and that company guidelines were followed. New or weak branches or new branch managers are audited more frequently, about once a month. Established branches and managers are audited up to every six months. Employee bonuses are based on profitability and meeting delinquency targets. Delinquencies at NICK have tended to be well below industry norms. NICK's current delinquency rate has been running between 3-4% for the last four years, whereas ACF and TFCE now have double digit delinquencies, but is in line with ONYX and FIFS.

Buy Contracts at a Discount to Value: NICK typically buys contracts at a discount to face value of from 1% to 15%, with 8% being the median. NICK never pays more than the wholesale value of the vehicle under contract. This helps limit the downside risk somewhat. They have a good record on their recoveries, and are willing to invest a couple hundred dollars in minor or cosmetic repairs because they will more than get it back at auction.

Reserves: Absolute key to sub-prime auto lending is adequate reserves. NICK has a consistent record of accreting reserves. Currently, reserves represent about 13% of gross receivables. Delinquencies can be obscured in a growing portfolio, but NICK separates its contracts into pools by quarter and by branch. They monitor almost 400 pools with their software on a monthly basis. This allows them to monitor different markets, trends and branch performance. It is important to adjust quickly to changing local conditions, and to monitor how each branch is doing. Most of their peers seem to only group contracts by year, without distinguishing between markets or branches.

Debt: Almost all of NICK's $60 million debt stems from a revolving credit facility that is secured with account receivables. It is a consortium led by Bank of America, followed by Hibernia and First Tennessee. I spoke with the CFO, Ralph Finkenbrink, about this. He said that BofA has provided this for the last ten years and they have a good relationship with the bank. The facility is interest only, which lets them plow principal repayments into purchasing new contracts. I asked about whether they would consider more permanent debt, and he said they have considered it. They will not do securitizations, but they have yet to find financing that is better. They do have interest rates hedges on a notional basis of $50 million; the average cost of borrowing is now around 7%.

Major Shareholders: Officers and directors own 41.3% of the company, with the 61 year-old CEO, Peter Vosotas owning 31%. Options are not excessive and the CEO and CFO have been buying stock on the open market, albeit in small amounts because of the restrictions based on the low average daily volume. Also, Marvin Mahan controls 31.5%, and this is a friendly relationship. Mr. Mahan provided the subordinated debt back in 1992, which included a conversion option to stock - hence the large stake.

Expansion: NICK has 28 branches, including 6 added in 2002 (five in OH and one in SC). The new branches are not fully developed and thus are not contributing to the bottom line yet. Their goal is to have each new branch contributing $300K in pre-tax income within 3 years. It takes 12 months for a new branch to earn a monthly profit and about 18 months to recoup start-up costs. The new branches will begin contributing to the bottom line by the end of the fiscal year that ends 3/31/04. They are also now expanding into Michigan. Besides growing earnings and book value, expansion has helped reduce their concentration in Florida to 60% of the portfolio. Expansion also allows NICK to leverage their existing back-office support and fixed cost expenses.

Other Operations: About 5% of NICK’s portfolio consists of direct consumer loans, 90% of which have or have had contracts with NICK. They use their software to mine the database of past and present customers to cross sell these loans. The thrust of this operation is to extend the relationship with a known customer, and not cold call the local trailer park. They also receive commissions from selling add-on coverages, such as warranties, credit life insurance, etc. The software subsidiary that develops and maintains their in-house software typically posts a small loss; it also does software for the pest control industry.

Outlook: Management has given FY 2004 guidance that they will grow top and bottom lines by 15%. While the days of 20%+ growth have past, management sees 15% annual growth as sustainable. This is a highly fragmented industry, with many small companies, both public and private.

Catalyst

- They will begin reaping the rewards of their 2002 expansion
- Cheap 15% annualized grower
- Multiple expansion as the uncertainty of their portfolio dissipates