REGIONAL MANAGEMENT CORP RM
September 12, 2014 - 12:42pm EST by
piggybanker
2014 2015
Price: 18.25 EPS $2.50 $3.50
Shares Out. (in M): 13 P/E 7.3x 5.2x
Market Cap (in $M): 235 P/FCF na na
Net Debt (in $M): 320 EBIT 0 0
TEV ($): 555 TEV/EBIT na na

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  • Regulatory Downside Risks
  • Negative Sentiment
  • Discount to Peers
  • Specialty Finance
  • Consumer Finance
  • Citron Research
  • Turnaround

Description

We believe RM represents an attractive long opportunity, with potential upside of over 100% and a significant potential catalyst just over a month away…


  • Investment Thesis
    • Regional Management (RM) is a fast-growing financial services provider trading at ~5x our estimate of 2016e earnings, and at only a modest premium to tangible book value.
    • We believe that in 18 months, the stock could trade near $40 per share, which would represent over 100% upside from current levels.
    • RM’s stock has suffered from two main concerns 1) credit-related issues over the past two quarters and 2) potential regulatory risk, stemming from recent events at competitor World Acceptance (WRLD)
    • We believe that the credit issues were self-inflicted, and have been addressed. An analysis of customer delinquencies (DQs) shows that we believe that RM management has the problem under control, and we believe that earnings are poised to surprise on the upside when the company reports their September quarter in ~1 month.
    • Additionally, we believe that investors are unfairly painting RM with the same brush as WRLD. We believe there are several differentiators between the two companies, and feel that RM has significantly less regulatory risk than WRLD. We submit that potential investors have two choices. Either buy RM un-hedged and take on some regulatory risk, or hedge an RM long position with a WRLD short position to mitigate regulatory risk and isolate the credit improvement story at RM.
  • Discussion Outline
    • In this write-up we provide an overview of RM’s business, discuss our view of RMs growth trajectory, outline our path to $3.50 in EPS in 2016e, and highlight why we believe an 11x EPS multiple is appropriate, to arrive at our target of a ~$40 stock by YE 15, or over 100% upside from current levels
    • Additionally, we discuss why we believe there is a significant potential catalyst in next quarter’s earnings report, where our analysis suggests the company could report better than expected profitability, driven by more benign credit costs.
    • Also, we compare RM to WRLD,  a competitor which trades at 2.7x tangible book value (TBV) versus ~1.3x for RM (a ~100% premium!), despite having in our view significantly more regulatory/business model risk.
    • Finally we assess what we believe to be the limited downside risk to RM, with the stock near TBV, and discuss how high credit costs would need to go in order for RM to start eroding TBV.
  • Business Overview
    • RM is a specialty consumer finance provider offering several financial products through their retail storefronts to lower- to middle- income customers. Simply put, RM is a lender to customers who for various reasons (income, credit, etc) are not desired by traditional banks.
    • RM operates ~300 storefronts in eight states, with four states (TX, SC, AL and NC) representing ~80% of total branches.
    • RM has doubled its storefronts over the past three years. Management’s stated goal is 35-45 new store openings per year, which would equate to ~12-15% growth on existing branch count
    • RMs main products are installment loans (which RM sub-divides into “small balance loans” and “large balance loans”), auto purchase loans, and retail purchase loans.
    • Small balance installment loans are by far the most important product that RM offers customers from a financial perspective. We estimate that small balance installment loans contribute ~75% of RMs total revenues. A typical small balance installment loan for RM is ~$1,000, with a range of $300 to $2,500. Nearly all of these loans are secured by the assets of the customer (generally through non-essential household goods), have a fixed interest rate and are fully amortizing over the term of the loan, which is generally 36 months. We estimate that the average small balance loan for RM carries a ~50% all-in gross yield (i/c fees and insurance). Credit losses on this product have averaged ~10-11% per year for RM.
    • Large balance installment loans average a ~$4,000 balance, generally have longer terms, and customers generally provide title to their vehicle in addition to their other assets.
    • Auto purchase loans and Retail Purchase loans round out RM’s product offering. On the auto side, RM partners with auto dealers to provide financing for customers to purchase automobiles. In retail, RM partners w/ retailers to provide POS financing on the showroom floor.
  • Share Price / Trading History
    • RM stock went public in March of 2012 at $15 per share. The share price steadily climbed to reach $35 per share in March of 2014, presumably as investors came to understand and appreciate the growth story.
    • However, in March of 2014, two events occurred which caused a sharp decline in RM stock. On Mar 11th, RM released Q4 earnings, where mgmt noted “a tick-up in the fourth quarter of our annualized net charge-offs” (basically their borrowers defaulted on their loans at a higher rate than the market expected). The following day, on Mar 12th; WRLD, through an 8-K filing, announced they had received a Civil Investigatory Demand (CID) from Consumer Financial Protection Bureau (CFPB). These two events caused RM shares to precipitously decline from $30 per share to $23 per share in short order.
    • The second leg down for RM stock came on Apr 29th, when the company reported Q1 (March) earnings. In that release management again cited credit issues in the portfolio, specifically stating “our provision for credit losses was well above our estimate for the quarter, causing our net income to fall short of our first quarter goals”. The stock declined from $22 per share down to a low of $15.
    • The stock has since clawed back a small part of this loss to ~$18, but is still far from the highs hit back just six months ago of ~$35.
  • Investment Opportunity
    • We believe it is in most investors DNA to sell first and ask questions later. As such, the confluence of negative events in RM (two consecutive disappointing earnings reports and a negative regulatory announcement from a competitor) set up the perfect opportunity for investors to do just that in RM, and the share price reflects it!
    • It is our belief that the selloff in RM stock is overdone. Specifically, we believe that the above-mentioned credit quality issues have been addressed by management, and we believe the company is setting up to report better than expected results in their September quarter based on lower than expected credit costs.
    • Additionally, while we don’t have a crystal ball to predict any regulatory outcome, we believe that there are several characteristics of RM that are different than WRLD, which we believe lowers potential regulatory risk at RM relative to WRLD.
  • Addressing Issue #1: Credit Concerns
    • As we discussed, RM suffered increasing credit costs in the Dec ’13 and Mar ’14 quarters. Management believes that the costs were aberrant, and due to the company not increasing collections headcount in conjunction with its growth. Management cited the Accounts Per Employee metric (APE) and said that in mid-late 2013, the company let the APE grow to levels well beyond historical averages. Historically, the company has targeted 285-300 accounts per employee. In mid-late 2013, the company’s APE rose to ~330. When management noticed increased delinquencies, they added more collections officers, and by the end of June 2014, APE had returned to historical levels. Management believes that the company is now appropriately staffed.
    • If we always take management’s words at face value, we wouldn’t last too long in this business! Therefore, we try whenever possible to sanity check management’s explanation with empirical evidence. Fortunately, in this case, we could do so from analyzing disclosures from the company’s filings.
    • In their 10-Q, RM discloses the $ amount of loans that are delinquent separated by 1) age of delinquency and 2) type of loan. Using this disclosure historically, we can track the changes in DQs
    • DQs are an early indicator of future credit losses (ie, if an account becomes delinquent and stays delinquent for 180 days, without the borrower making a payment, the loan is then written off by the lender in the form of a charge-off)
    • In our analysis, we analyze the data from the Small Installment loan category. We believe looking at this one category makes the most sense as it is the largest (~60% of DQs), and a mix shift btw categories could obscure trends.
    • From RMs disclosures, one can see that total 30+ day DQs began to increase on a year over year basis in the September quarter, after declining year over year for 3 straight quarters… this trend continued with DQs spiking in the December quarter, and remaining elevated in March… HOWEVER, the YoY increase in DQs has moderated significantly in the most recent (June) quarter, which we believe signifies that credit costs are likely to return to more normal historical levels.
    • We believe this is very important because when DQs first showed increase in Q3’13, the market largely didn’t pick up on it. It wasn’t until the next quarter, when management commented on increased charge offs (which stem from the prior quarters delinquencies) that the market woke up and penalized RM by selling stock… we believe the reverse will be true this quarter. We can see DQs declining in the most recent quarter, and believe this could translate into better than expected credit costs for the September quarter, which we believe could again surprise the market, this time to the benefit of RM shareholders.
    • We believe that our analysis on DQs and future credit costs corroborates with managements explanation of the situation and we have comfort that the company is in fact rectifying the problem.
  • RM Growth Profile
    • Assuming that the credit issues were a temporary blip, we believe it makes sense to briefly discuss what we believe to be an attractive growth model at RM, as investors prior to March viewed this as a growth story (and hopefully will again soon!). RM has compounded revenues and EPS at a 21% and 27% rate, respectively, from 2008 through 2013. We believe that RM can continue to consistently achieve high-teens revenue growth and mid 20s EPS growth utilizing this model. We can only hope that execution of this model will allow RM stock to achieve even a semblance of the multiple awarded to any similar high growth retailer.
    • The first element of RMs growth model is increasing their store base. As we discussed, RM is targeting growth in storefronts by ~12-15% per year. New stores open with a productivity of ~50%, therefore RM can expect ~7% revenue growth from new stores annually.
    • Additionally, stores opened over the past several years, which are ramping up to maturity should add an additional ~10% growth to revenues annually. The math behind this is as follows. RM has ~300 branches, with ~1/2 of them not yet mature (ie less than five years old)… a mature store has an average of ~75% higher receivables balance than a non-mature store. Assuming receivables in non-mature stores bridge the gap to mature stores over the next three years, this equate to ~37% growth over the next 3 years (50% x 75%), or a bit over 10% per year.
    • Summing the ~7% receivables growth from new stores and the 10% growth tailwind from the maturation of existing stores, we arrive at a ~17% expected growth rate in receivables, which should translate into ~17% revenue growth. This assumes mature store receivables do not grow, and yields on new receivables are at system-wide levels (we believe both of these are reasonable/conservative assumptions)
    • On the expense side, we believe that the company should be able to obtain a degree of operating leverage from corporate overhead and certain office expenses (occupancy, staff salaries, etc) which should allow RM to obtain mid 20s% EPS Growth on a sustainable basis.
    • In terms of runway, we can point to WRLD, which has ~1,100 branches in the US (compared to ~300 for RM), and has grown offices and receivables at a 9% and 14% CAGR 2004-2014, respectively. Importantly, we believe this comparison validates not only the potential growth RM can achieve in terms of growth of offices, but since WRLD has grown receivables at a faster pace than offices, it also lends credence to our view of revenue growth through the maturation of non-mature stores at RM.
  • EPS Estimates / Valuation
    • Now that we have outlined our view of the potential growth trajectory for RM over the next several years, we will discuss how we arrive at our estimate of ~$3.50 in 2016e EPS
    • First, we assume high-teens growth in receivables in 2015, based on our analysis above. This equates to ~$670mm average receivables balance for YE 2015.
    • We assume a 39% yield on average receivables, based on guidance by management.
    • We assume a 9% provision rate, which is based on net-charge-offs of 7.5-8.0% (historical range) and our estimate that provision will be 1.2x NCOs as RM grows the portfolio.
    • We assume G&A expenses of ~16.5% of average receivables, which is in line with management’s target of a 40-45% efficiency ratio (16.5% / 39% yield = ~42% of revs)
    • We assume 3% interest on average receivables, based on RMs current debt profile at 2-1 debt to equity, and their current 4.5% rate.
    • These assumptions arrive at a ~10.5% Pre-Tax Return on Receivables (39-9-16.5-3), or a ~6.6% Net Return on Receivables, using a 37% tax rate.
    • Multiplying the 6.6% Net Return x the Avg Rec of $670 gets ~$45mm, which on ~12.9mm shrs equates to a 2016e EPS of ~$3.50
    • In terms of the multiple for this stock, we assume 11x in the base case. We believe this is conservative, as RM traded at an average of ~13.5x from June of 2013 to March of 2014, before the credit and regulatory-related issues. We also believe this would be a very inexpensive multiple for a 20+% earnings compounder, especially if the regulatory environment becomes less murky.
    • Putting this all together, we believe RM could be ~$40 stock by the end of 2015
  • Addressing Issue #2: Potential Regulatory Risk
    • So far, we have discussed several things about RM… the most recent credit issues, and our view on how they are likely temporary, the growth profile of the company, and our view of earnings power. However we have not yet focused on the regulatory environment, which in our view is the biggest wildcard for RM.
    • To be clear, RM to our knowledge is not currently in any active regulatory investigation, however, as we discussed, WRLD, their competitor in small balance installment lending, received a CID from the CFPB in March. WRLD disclosed that the CID stated that “the purpose of this investigation is to determine whether finance companies or other unnamed persons have been or are engaging in unlawful acts or practices in connection with the marketing, offering, or extension of credit…” and that “The CID contains broad requests for production of documents, answers to interrogatories and written reports related to loans made by the Company and numerous other aspects of the Company’s business.” WRLD stated that it is in the process of providing information to the CFPB and believes that its practices are lawful.
    • Much has been written about WRLD in the investment community, both before and after this CID was announced. The company was written up two times as a short on VIC (Dec 2010 and Sep 2012), has been criticized by Citron periodically over the past several years, and was the subject of an investigative journalism report by ProPublica, which chronicles borrowers and employees experiences at WRLD. We have included links to Citron reports and ProPublica piece below and encourage all to read them, as well as the VIC posts and comment threads.
    • Clearly, the CID puts WRLD in the regulatory crosshairs, and RM, as a competitor to WRLD in Installment Lending, appears to be guilty by association in the eyes of the market.
    • In this write-up, we are not going to handicap the regulatory risk at RM, as we simply cannot predict the outcome with any certainty.
    • However, we can outline what we believe to be a few plausible scenarios on the regulatory front. From worst to best for RM, below are some potential regulatory outcomes:
      • 1) RM could be the next firm targeted by the CFPB. They could receive a CID tomorrow and be subject to the same unknowns as WRLD. Obviously, this would not be a good outcome.
      • 2) an adverse outcome of the investigation on WRLD could have a negative impact on the industry, thus indirectly harming RM. In this scenario, the impact to RM could be minimal, or it could be significant. Given the characteristics of both RM and WRLD we discuss below, we believe that in this case, any impact on RM should be less severe than on WRLD
      • 3) the CFPB could penalize WRLD for its behavior but leave the rest of the industry (including RM) operating under the status quo. In this case, RM could actually benefit as it could conceivably take market share from WRLD in the markets in which they overlap.
    • We believe that potential investors can take two approaches in this situation. 1) Buy an un-hedged long position in RM and take the regulatory risk. While it is difficult to handicap the regulatory risk, we believe investors are being compensated to some degree for this risk, as we believe the multiple is compressed due to this regulatory overhang. Alternatively, 2) potential investors can sell short WRLD stock as a (full or partial) hedge to a long position in RM. We believe that this strategy should go a long way to neutralizing the regulatory risk, and isolating the potential for better than expected credit costs at RM (Unlike credit costs at RM, WRLDs charge-offs have been stable for the past three quarters). Investors in this trade could also win handsomely in a situation where certain practices at WRLD are severely penalized but the small installment loan industry and RMs business model remain largely intact
    • Having spent time on WRLD as well as RM, we will offer what we believe are a few interesting comparisons between the two companies. We believe that these comparisons offer support to the notion that RM should have a lower probability of encountering regulatory issues than WRLD.
      • First, simply, RM is much smaller than WRLD. WRLD operates ~1,100 offices in the US, v ~300 for RM. RM is also more diversified among financial products, offering auto and retail loans as well as installment loans, whereas WRLD is a monoline. We believe it is possible that regulators will make an example out of the largest company in the space, whose lending practices have been chronicled and criticized numerous times in the media.
      • Second, WRLD’s loans generally have a higher yield (~65% v 46% for RM small installment loans), and on an apples to apples basis their borrowers are DQ at a higher rate than RM (30+ Day DQs of 12.7% v 7.2% for RM small installment loans). It appears that WRLD caters to a lower demographic borrower than RM, and charges higher rates, which could be a factor in drawing scrutiny from regulators.
      • Thirdly, WRLD appears more prolific in refinancing loans than RM. 74% of WRLDs loans outstanding have been refinanced whereas ~50% of RMs originations in FY13 were refinancings. Refinancing at WRLD was a focal point of Citron, and we believe it is logical to assume the regulators are looking into this practice as well. Any limitation on refinancing would likely harm both companies, but would appear likely to have a more severe impact on WRLD.
      • Fourthly, WRLD is more exposed to insurance income than RM. It has been speculated that a focus of the regulators could be insurance products offered to consumers by installment lenders. We estimate that insurance income was ~50% LTM for WRLD v ~30% of LTM PBT for RM. In our model, we have modeled this income stream at RM declining to a mid teens contribution by YE 2015, as other parts of RMs business grow more rapidly. This would imply that any curtailment of profitability due to regulatory actions would be much more deleterious for WRLD than RM.
      • Additionally, reserves (as we define as Allowance per DQ loan) are much more robust at RM v at WRLD (98% v 63%), despite lower overall DQs at RM. While there may be a fundamental reason for this (although we cannot think of one), or this could be a sign of more aggressive accounting practices at WRLD.
      • Also on the accounting side, WRLD reports DQs as a % of gross loans (before unearned interest); RM cites their ratio as a % of net loans. Using a higher denominator makes WRLD delinquencies optically look lower than RMs, even though they are actually significantly higher (nearly double!) apples to apples.
      • There are also a few other matters that WRLD is dealing with currently, including the recent retirement of their 43 year old CFO, and the resignation of their auditor.
      • Finally, the tangible book value per share (TBVPS) for both of these companies is starkly different. RM trades at 1.3x TBV, while WRLD trades at over a 100% premium, a whopping 2.7x. We believe this is an extremely important distinction, as we will discuss below.
    • In summary, we have two companies, both offer similar products to customers. Company 1 is under an active investigation by a Federal regulator, just had their CFO retire and their auditor resign, and has a lower quality customer base and accounting and business practices that are seemingly more aggressive than Company 2… and Company 1 trades at an over 100% premium to Company 2! What?? Mr Market, are you there?
    • In case that wasn’t clear, let us put it another way. Lets assume the CFPB decides it wants to stop installment lending all together (to be clear we do not think this is the case), and makes it so onerous from a regulatory/compliance perspective that no lender will ever write an installment loan again… In that case, it would make sense for both RM and WRLD to close up shop and wind down their books. In this case, all these companies are left with is the value of their book of business. If both stocks traded to tangible book value, RM shares would decline by 27%, while WRLD would decline by 63%. Also worth noting in the case of WRLD is that the remaining TBV you would be trying to collect is in the form of lower quality loans with higher delinquency rates, and the company has less reserves against the loans than RM, so the act of actually turning that TBV into cash would be much more onerous, and the margin of error on collections would be lower.
  • Downside Case / TBVPS
    • We think it makes sense to look at a downside case as a multiple of TBVPS, which we project to be ~$14.40 at year end. RM, at its current trading price, trades at a P/TBV of ~1.25x.
    • A scorched earth regulatory scenario aside, we look at how high credit costs would have to be for RM to lose money, and therefore erode TBV. Our analysis suggests that based on 2014E receivables; the provision would need to be ~18% for them to begin losing money. For reference, provisions / receivables peaked in 2009 at 10.1%, and the historical range from 2008-2013 has been 6.8% to 10.1%
    • In our view, it is difficult to see a stock which is accreting BV trading sub TBV, so we view the $14-15 TBV level as a solid margin of safety/floor to the stock
    • It is also interesting to note that while TBVPS has been and should continue to accrete at a rapid pace for RM, TBPVS has declined at WRLD over the past six quarters. This is due to the fact that WRLD is levering up to buyback shares at prices that are significantly dilutive to TBVPS. As these trends continue, the TBVPS differential between RM and WRLD should continue to widen.
  • Relevant Links
  • DISCLAIMER
    • The author of this posting and related persons or entities ("Author") currently holds long and short positions in the securities mentioned above. The Author makes no representation that it will continue to hold positions in these securities. The Author is likely to buy or sell long or short securities of these issuers and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of these issuers. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

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