If your News Years resolution is to stay away from finance companies – go ahead and skip this. If not, I believe Nicholas Financial has been taken out to the woodshed a few too many times for the misdeeds of its bigger brothers (who of course claim they have done nothing wrong!).  All the eggnog, champagne, cognac or whatever else you can drink on New Years will likely have little effect blunting the bitter taste that remains from financial stocks in 2007.  But like every January 1 before this, the calendar does turn and it is time to look for new opportunities. 

 

NICK has been written up three times previously which definitely puts this idea in the running for a “repeat” yawner award winner.  However, I am firmly in the camp that believes the best investment opportunities typically arise only when the business appears to be at the precipice of disaster - though in fact it is not. 

 

For the uninitiated or forgetful members, NICK is ….TA DA …… a subprime auto lender.    I’ll pause to allow the wretching to subside. 

 

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Now, I could go on and on about all NICK’s positive characteristics, but frankly that would make this writeup too lengthy for the attention deficit nature of VIC at the end of the deadline period…errrrr, I mean year. 

 

Needless to say, NICK meets many of the criteria a typical value investor looks for and here are a few:

 

-          Management is aligned with shareholders through large individual holdings by the CEO. 

-          The Company does not follow the crowd – it maintains its own lending standards (does not let market dictate pricing), it runs its lending operation with an underwriting mentality (as opposed to an asset gathering mentality).

-          Management provides all the meaningful information to understand the business in a clear manner in the financial statements.

-          A historical mid teen to twenty percent ROE business is trading under book value – and the business is currently UNDER-leveraged.

 

In other words – NICK is run by people who know what they are doing and care about shareholder returns, and it is cheap.

 

 

So the question is why is it cheap?  OK guys, c’mon, work with me here – its business description includes subprime and finance.  Need I say more?   OK, I will.  Well the warts and the hair on NICK is that losses in the portfolio are likely to increase over the next few quarters as compared to recent history.  The Company’s portfolio is tilted toward Florida (which is really just an explanation of why losses are likely to increase).  The Company does not have any funding concerns.  It has been more highly leveraged in the past and NICK was able to increase their borrowings within the past month and a half on continued favorable terms.  However, I guess “favorable” funding could be a risk – though it has not in the past.  Other than that….I can’t really come up with much. 

 

I have done a lot of work on the Company and have spoken to the CFO a dozen or so times over the past 2-3 years, so I will be happy to add to the concise writeup in the Q&A for those interested. 

 

But, lets cut to the chase.  My thesis is a book value and EPS multiple story.  Pretty plain jane situation at the end of the day – but historically successful nonetheless.  Here are the stats:

 

Current multiple of book value = .93

Industry transaction multiple (assuming normalized credit market) = 2.0 – 2.5x

 

Current P/E multiple = 6.8x

Industry transaction multiple = 12x – 15x

 

The implied value using those multiples and a core earnings number of $1/sh and book value of $7.30/sh  is $12 - $18 indicating an under-valuation of 50% to 70% at current prices.  This truly is a situation where the price is your margin of safety. 

 

I have stress tested the balance sheet and income statement (using historical troughs of pretax earnings yields and loan losses) and arrived at the following:

 

Orderly liquidation value = $7ish.

Normalized earnings with continued moderate growth = $1.20/sh.

Trough earnings = .70/sh

Trough earnings with 25% portfolio writeoff = .55/sh. 

 

In a trough environment and a massive 25% portfolio writeoff I estimate NICK would still have a book value in the $5/sh range. 

 

Applying a reasonable transaction multiple to even these trough figures puts you above todays price.  And the margin of safety here is that there is no way the founder/CEO is a seller at these levels as he is well aware that any trough is going to be short lived. 

 

Anecdotally, the founder/CEO/largest shareholder (>15%) would appear to be an open minded seller of the Company given his age.  In fact, a year or so ago, NICK was rumored to have been close to selling out.  So it would reason that the CEO has somewhat of a “selling” bias on his mind.  Well, within the past month he has been adding to his already sizable position.  Clearly he sees the disconnect between the current market price and intrinsic value. 

 

I think the risk / reward is highly skewed in our favor with NICK.  I peg maximum downside at 25% (to around $5) and upside at +90% ($13).  I believe the market could value NICK well above $13 – but that is likely after a return to normal credit conditions and a demonstration that NICK can continue to grow at double digit rates.    

 

One last note/caveat – my author rating reflects my conviction for this idea in terms of how we have scaled this investment over the past month.  It’s an 8 because it’s a high conviction idea with a great risk/reward profile over the next 2-3 years.