Description

The Finance Company (TFCE) is a niche-oriented consumer finance company that operates in two distinct segments of its industry, auto loans to enlisted military personnel (approximately 90% of outstanding loans) and regular consumer loans. It trades at .37 times book value and approximately 5x trailing twelve months’ earnings. Unlike its public peers, TFCE is not using gain on sale accounting and passes all costs and expenses through its income statement and balance sheet. While the sub-prime lending industry has a negative connotation to investors and the Federal Reserve has been cracking down on the industry, TFCE is a profitable, conservatively run company. I believe that an investment in TFCE is relatively safe and will be profitable over the long term due to either an industry turnaround or the probability of somebody buying TFCE’s platform and leveraging it into a larger asset base.

The Business.

The first and largest segment of its business is auto loans made to enlisted military personnel who are looking to finance their purchase of an automobile. Since 1977, TFCE has operated in this sub-segment of the sub-prime auto loan industry. It claims to be the leader in this niche and has the systems and personnel needed to properly acquire and manage accounts in this market. The reason that this type of loan falls into the sub-prime category is that approximately 50% of people who enlist in the US military are bounced out within the first two years.

TFCE operates loan production offices in most of the large military cities in the US. It has relationships with the dealers who originate the loans. Each dealer goes through a credit check on both the dealership and its owners before TFCE will establish a relationship. After a relationship is established, TFCE will do a small amount of loan volume with the dealer until it establishs a track record of dealing reputably with its customers and TFCE. There is some credit risk in this process due to the delay in the title of the car passing from the dealer to TFCE. Depending on the state, it can take between 1 and 3 months for this to occur. If title does not pass in the prescribed period, the dealer must buy back the loan it originated.

TFCE finances it loans under a revolving line of credit and a securitization aggregation facility. When sufficient loans have been issued to form a new securitized pool, the company issues asset backed notes. The company restricts a portion of the cash it receives to ensure adequate collateral for the notes. The remaining funds are used to pay down the revolver and aggregation facility so that new loans can be underwritten.

Each new loan has rigid documentation standards, which include a letter from the base commander that soldier is in good standing with no disciplinary actions. TFCE has permission from each new customer (soldier) to call the base and speak with the commander to confirm employment and good standing. Once the loan is approved, TFCE purchases the loan at a discount (approximately 25%) from the dealer. The military person agrees as part of the loan to have the payment directly debited from their pay, so that TFCE is not waiting for a check to arrive and be handled. If for some reason the customer stops debiting their payment, TFCE uses the military base’s commanding officer to help them dun and collect their receivable.

The main credit risk comes from people who are terminated from their military employment. These people are usually discharged for performance issues and become sub-standard credit risks. TFCE has extremely well defined collections standards and uses a centralized collections facility in Norfolk, Virginia to go after its receivables. Predictive dialers call customers in the 30, 60 and 90 day delinquent pools and well trained collections agents then handle the calls with carefully designed and battle tested strategies. Turnover among collections staff is almost nil, with most supervisors having at least 10 years of collections experience at TFCE.

Employee morale is among the highest I have ever seen at a company. The employees, who run the Company dining room, use the profits from its vending sales along with raffles to decorate TFCE’s facilities and provide for parties. As part of this team building exercise, the Company also sponsors quarterly contests for their collections agents to beat certain targeted goals. If achieved, the Company will pay for an event for this group of employees. Reflecting this teamwork, TFCE’s collections results have been excellent despite the weak economic picture. Year over year delinquencies over 60 days have dropped 102 basis points from 5.6% to 4.58.

The second line of business is called First Community Finance. It is a traditional consumer finance company with 20 branch offices in Virginia and North Carolina. It holds approximately 10% of assets and uses the same back office facilities as the auto loan business.

TFCE has been profitable every quarter for the last 19 quarters after having a blow up in 1996 due to poor underwriting standards. The current Chairman and Founder, Bob Raley, had stepped back from operations and let the CEO at the time run the Company. After realizing the issues at hand, Mr. Raley, who has 42 years of experience in the sub-prime industry, came back to oversee the operations on a daily basis. Since that time, underwriting standards and bad debts have normalized at high standards.

One weakness with the current management team is the lack of a solid CFO. The President and COO, Ron Tray, is a solid operating guy but lacks the financial background to bring TFCE back to Wall Street’s good graces. The second level of management that operate the collections and generation of loans are top-notch operators with decades of experience.



The Issues and opportunities

The sub-prime auto loan industry has been a troubled industry for years. Bad accounting, weak economic markets, poor underwriting standards and the Federal Reserve’s crackdown on the sub-prime lending market have left the industry with poor funding sources. Other than Americredit (ACF), most smaller sub-prime auto lenders have been unable to grow loan volume and have even had to shrink their asset base. TFCE has been no exception. Their main lender, GE Capital, announced almost two years ago that they were backing away from lending to sub-prime auto companies. TFCE has been unable to replace GECC and has been working with GECC to reduce the loan balance each year. This has allowed GECC to charge TFCE higher financing fees and interest than they would normally charge in a competitive market. Insiders have loaned the Company $1.9MM on a subordinated basis to help alleviate some of the funding needs.

This lack of capital has forced TFCE to reduce it new loan generation and to shrink their asset base. It also means that TFCE’s funding cost for its loans is high when compared to similar companies. Herein, lies the opportunity for a strategic acquirer. TFCE’s cost of borrowing of 8.51% is 400 to 500 basis points higher than that of a major bank or finance company. Assuming that this acquirer levered TFCE’s $53MM in equity capital 8x (12.5% equity to assets) versus the current 3.7x, they could generate between $23MM and $27MM in pretax profits per year on this platform. This analysis gives no benefit to the operating economies of running additional loan volume through the business.

The question of how to value TFCE is rather straight-forward. If you were to liquidate the portfolio over time and hold the cash for final distribution, I believe that the Company is worth about $4.10 per share. The analysis is as follows (numbers in $ ,000):

Current Loans Receivable 202,894 (1)

Revolving line of credit 64,208
Asset Backed notes 106,879
Subordinated notes 13,059
Restricted cash (28,594) (2)
Total Debt 155,552

Loans Receivable less Debt 47,342
Net Receivable per share $4.10

(1) Loans have been fully reserved against.
(2) Restricted cash provides additional security for the asset backed notes
The forgoing assumes that other assets and liabilities largely cancel each other out and that the cost of collecting and servicing the loans receivable would be covered by the interest received on the portfolio during the liquidation process. I believe these assumptions are easily achievable.

The value to a strategic buyer would be dependent on their required rate of return, borrowing costs and any value they might ascribe to their ability to generate profits on the portfolio. Assuming no growth in loans outstanding and a buyer’s ability to bring the borrowing cost down by 300 basis points (lower than my target of 400 to 500 basis point improvement), TFCE would generate approximately $11MM in run rate after-tax earnings. Using a target of a 12.5% return on equity, the Company would be worth $7.5 per share to an acquirer. Since no acquirer will give TFCE full credit for this pickup, I believe that a realistic starting point for a negotiated deal would be to sell the Company for a price between this number and liquidation value of $4.10 per share.

Catalyst

1. New financing arrangements that allow the Company to begin growing assets once again.
2. Prospective buyer for the Company, who can finance and grow assets better than current management.