I made an investment in Nicholas Financial (NICK) on 3/30/15, prior to the inception of this blog. The write-up below is as of that date.
I am increasing my holdings of Nicholas Financial at $13.70 per share because the recently completed leveraged recapitalization will substantially improve per share returns to continuing shareholders. I came across this specialty auto lender in November 2014 and had taken a small position, hoping to profit from the Dutch tender transaction that the Company was executing. However, as I followed the company more and the tender offer was successfully executed, I found it even more attractive as a longer-term holding.
Some background on Nicholas Financial, a short version of the November thesis, and the reasons for increasing my position today are given below.
Background on Nicholas Financial:
Nicholas Financial is a specialty auto lender, lending primarily to subprime borrowers. The Company generally acquires these loans from dealerships. To a lesser extent, the Company also originates direct loans and sells consumer-finance related products. Understandably, subprime lending has a very negative connotation among investors and deservedly so (recall the experience of the shareholders of New Century Financial Corporation, Countrywide, etc.) However, one must be careful not to paint with too broad a brush. While subprime home lending was one of the factors in the recent financial panic of 2008-09, subprime auto loans have a much better history, including during the recent crisis. In fact, according to Experian, about 30% of all auto-buyers in the US are in the subprime category. Lenders have long experience safely working with such loans. Collateral values are well-known, have not been observed to skyrocket beyond reason (unlike homes in the past cycle), and have proven to be an adequate basis for safe lending when combined with prudent assessment of borrower income and credit metrics.
Nicholas Financial is a specialty auto lender, lending primarily to subprime borrowers. The Company generally acquires these loans from dealerships. To a lesser extent, the Company also originates direct loans and sells consumer-finance related products. Understandably, subprime lending has a very negative connotation among investors and deservedly so (recall the experience of the shareholders of New Century Financial Corporation, Countrywide, etc.) However, one must be careful not to paint with too broad a brush. While subprime home lending was one of the factors in the recent financial panic of 2008-09, subprime auto loans have a much better history, including during the recent crisis. In fact, according to Experian, about 30% of all auto-buyers in the US are in the subprime category. Lenders have long experience safely working with such loans. Collateral values are well-known, have not been observed to skyrocket beyond reason (unlike homes in the past cycle), and have proven to be an adequate basis for safe lending when combined with prudent assessment of borrower income and credit metrics.
Notice that in 2010, GM purchased AmeriCredit (a subprime lender), in order to rebuild its in-house financing arm following the separation of Ally financial (formerly GMAC) from GM. Ally itself, now free of government ownership and able to pursue any type of lending it pleases, is looking to expand into subprime lending as its CEO recently announced.
There are many subprime industry participants who have performed quite well over time by carefully making prudent loans at the right price. Examples of such operators in the sub-prime space are AmeriCredit (purchased by GM), Credit Acceptance Corporation, America’s Car Mart (which operates dealerships and a financing arm), Nicholas Financial, etc. Despite increased charge-offs experienced by the entire industry during the 2008-2010 period, Nicholas Financial did not have a single year with a net loss. Like the industry, Nicholas did experience higher losses but these were much more manageable than those experienced by competitors and by non-auto lenders. Consider this performance against the fact that Nicholas operated (and still does) with a significant exposure to Florida, a state hit harder than most during the crisis.
Quality of Nicholas Financial’s business:
Similar to analyzing banks, I prefer to judge non-bank lenders on the basis of the returns on equity they are able to safely generate. In this regard, Nicholas Financial’s track record has been a good one as shown in the table below. It falls short of some of its competitors results (particularly Credit Acceptance). However, it’s worth noting that Nicholas used far less leverage compared to competitors. For example, as of December 2014, NICK’s financing debt to loans receivable ratio stood at 47% compared to 70% for Credit Acceptance. Please note that in any given year, some adjustments to GAAP earnings, allowance, and the provision may be required in order to judge financial performance. However, over a credit cycle, these tend balance out. Thus, when looking at a 12 year period (below) ROEs calculated based on reported numbers can serve the purpose just as well.
Figure 1 – Nicholas Financial Results FY2002 – YTD15 (As of 12/31/14)
Note: YTD15 ROE is annualized
Recent periods include the following expenses that reduce ROE:
Quality of Nicholas Financial’s business:
Similar to analyzing banks, I prefer to judge non-bank lenders on the basis of the returns on equity they are able to safely generate. In this regard, Nicholas Financial’s track record has been a good one as shown in the table below. It falls short of some of its competitors results (particularly Credit Acceptance). However, it’s worth noting that Nicholas used far less leverage compared to competitors. For example, as of December 2014, NICK’s financing debt to loans receivable ratio stood at 47% compared to 70% for Credit Acceptance. Please note that in any given year, some adjustments to GAAP earnings, allowance, and the provision may be required in order to judge financial performance. However, over a credit cycle, these tend balance out. Thus, when looking at a 12 year period (below) ROEs calculated based on reported numbers can serve the purpose just as well.
Figure 1 – Nicholas Financial Results FY2002 – YTD15 (As of 12/31/14)
Note: YTD15 ROE is annualized
Recent periods include the following expenses that reduce ROE:
1. One-time professional fee expenses related to the failed sale of the Company to Prospect Capital (see background below) in the amount of $2.3 million (FY2014) and $0.4 million (YTD FY2015).
2. Dividend tax withholding charges of $1.2 million (FY2013) incurred under the Canada-United States Income Tax Convention, which imposes a 5% withholding tax on any dividends paid. During FY 2013, the Company paid a special dividend of $2 per share which is not expected to repeat.
3. Elevated loan-loss provision in 2015 due to the higher competitive activity and looser market lending standards at the current stage of the credit cycle, as observed by the Company.
There are certain nuances of Nicholas Financial’s business and accounting (dealer discounts, loss provisions, charge-off experience, interest rate swaps, etc.) which are important to analyze. I have left their detailed analysis out of the write-up in order to keep the length of this article manageable. Having considered these factors, though, they did not lead me to change the basic takeaway that Nicholas’ credit experience has been better than the industry. The high ROEs above are a reflection of prudent underwriting and not a reflection of leverage (often used in large quantities by other lenders) as Nicholas Financial was much more conservatively leveraged than competitors (see more comments on this below) during this period.
When analyzing allowance for loan losses and loss provisions, readers should take note of the error-correction made by the Company during FY13 (Form 10-K, Footnote 2). The impact on the balance sheet and the income statement was not material on a net basis. However, understanding this is important in analyzing the loan loss reserving. If, after doing your own analysis on these items, you would like to discuss any aspect, I would be happy to do so.
Rationale for the November 2014 purchase at $12.50:
When analyzing allowance for loan losses and loss provisions, readers should take note of the error-correction made by the Company during FY13 (Form 10-K, Footnote 2). The impact on the balance sheet and the income statement was not material on a net basis. However, understanding this is important in analyzing the loan loss reserving. If, after doing your own analysis on these items, you would like to discuss any aspect, I would be happy to do so.
Rationale for the November 2014 purchase at $12.50:
In December 2013, Nicholas Financial reached an agreement for a tax-free stock-for-stock merger with Prospect Capital at $16 per share. Some shareholders decried this valuation as too low for the quality of Nicholas’ business. At the same time, the SEC raised some questions regarding Prospect’s historical practice of not consolidating certain entities. Due to this SEC development, Prospects’ registration statement could not become effective on time to close the deal and the deal was called off in June 2014. As a result of the failed merger, Nicholas’ stock price dropped below book value, eventually nearing $11 per share. In October, management announced that they had begun to look into various alternatives for returning cash to shareholders and/or selling the business. At this time, buying the stock around $12.50 looked appealing given several factors:
1. If a sale occurred, it would be at a price of at least $16. The growth of the business, between the December 2013 Prospect agreement and November 2014, had built up the value from $16 per share to at least $17 or $18.
2. With the stock trading near book value, if a sale did not occur, purchasing at this price would give the investor respectable returns (recall that recent ROEs were around 15%). Through a leveraged recap or special dividend, management could safely increase leverage closer to the competitor average and boost ROEs. This would greatly enhance per-share value of continuing shareholders.
3. Given the small size of Nicholas’ footprint (Nicholas operates only in 16 states and has 66 locations) compared to the large size of the auto-loan subprime market and the growing sales experienced by the auto industry following the lean years of the recession, the business could continue to grow (i.e. reinvest earnings) without requiring many changes.
Rationale for March 30, 2014 purchase at $13.70:
In December 2014, Nicholas announced a tender offer (i.e., #2 above materialized). The size of the tender offer was large, $50-70 million compared to a market capitalization of $160 million. It was financed with 4%-interest debt (subject to change with LIBOR). But there was a catch: the offer was conditioned upon Nicholas obtaining all of the shares it sought, i.e. there would be no tender if all of the desired shares were not available to purchase (i.e. “all or none”).
In early March, the results were announced and the tender offer was successful, resulting in a reduction of approximately 38% of the stock outstanding at a price of $14.85 per share. This has greatly increased the economics of the current business for the continuing shareholders.
Below are some pro-forma calculations showing the effect of the leveraged recapitalization on Nicholas’ per share ROEs, book value, and EPS. A few things to note in those calculations:
Figure 2 – Selected Financial Results, Pro-Forma for Tender
Note: Tender reduction includes estimated fees of $800,000
Due to the tender above book value, the implied premium above book value for continuing shareholders has increased, i.e. price/book ratio has increased due to a reduction in book value. However, ROEs and EPS have been substantially improved on a go-forward basis making the shares attractive even at a higher price/book valuation. In the current environment it’s rare to find a company earning ROEs of 18-20% trading at 1.25x book value. Also Nicholas’ balance sheet does not contain any intangibles. Consider that American companies as a whole (whether measured by the Dow Jones, S&P 500, or Fortune 500), have generally earned ROEs around 12%-13% for many decades. For comparison purposes, the current price-to-book of the S&P 500 is about 2.7. Thus, it appears that ownership of Nicholas financial is attractive from a statistical standpoint.
Following the tender, the stock rose briefly and then began falling. I believe the principal reason for this is the oversubscription of the tender offer. Not all of the shares tendered were accepted for payment by the Company. Those of you involved in our earlier odd-lot tender arbitrages are aware of this “proration” factor. According to SEC filings, approximately 618,738 shares were not accepted. These were shareholders (or arbitragers) hoping to tender but unable to do so. The average volume of trading of Nicholas Financials’ shares was about 45,000 shares per day before the tender, which is quite low compared to the average large company stock. After the tender, this will presumably reduce even further because of the smaller float. Thus the unsold shares of those hoping to tender create downward pressure on the price as these investors or arbitrage funds begin to liquidate their shares in the open market. This phenomenon is present in many tender offers.
Another reason could be frequent coverage given to subprime auto-loan backed securitizations by several newspapers. Issuance in this market has risen substantially causing some to speculate whether a bubble exists in the securitization market for auto loans. However, Nicholas Financial does not participate in the securitization market as either an issuer or a purchaser and management is well aware of the currently loosening credit standards in auto lending.
Whatever the reasons for the lower price, the current price of $13.70, i.e. 1.25x post-tender book value and 7x estimated post-tender EPS is fairly attractive (1) compared to other options now available in the market, (2) given the historically disciplined and profitable credit underwriting of Nicholas’ management and, (3) a chance to continue growing the business gradually over time.
Downside protection analysis:
From a down-side protection standpoint, one can think of the company in three parts, each of which represents value the business could generate (similar to how some insurance companies may be evaluated
Since a downside protection analysis must be conservative by its nature, I assigned a value of ‘0’ to the third item above. (Readers might recall this is similar to the Symetra analysis from March 2012). Adding together the other two items gives total run-off value of $126.5 million. This compares to a market value of $105 million. Thus it appears that adequate downside protection exists. Even taking loan charge-offs to 10% would cause the aggregate run-off value to be $113.5 million, in line with current market capitalization.
Risks and other considerations:
As noted above and frequently seen in the news, at this time in the credit cycle, credit standards for auto lending are loose. It’s possible the loss experience in the coming years will be worse than has been the case in the last few years. However, Nicholas Financials’ management seems alert to the situation and has noted, in its SEC filings, that they are already taking actions in response. There is no doubt that if the underwriting cycle worsens Nicholas will have its share of losses. However, I believe these will be less than the industry and will not threaten Nicholas’ existence. Through one of the worst credit bubble bursts of our generation in 2008-09, management has shown their ability to profitably run the business through cyclical troughs. The performance was especially admirable given that a large portion of the loan book was in Florida which was one of the worst hit states during that crisis. A down-cycle may even provide an opportunity to increase the position at lower prices.
There is always a certain temptation to “wait” for such a credit problem to occur in the industry and then buy attractive securities (such as Nicholas Financial). However “waiting” is often simply wishful thinking in disguise. Guessing whether loosening credit standards will rise to the level of a “bubble” in the future is a gamble and not an investment approach. When a good business, with a good management, and a good price is available, the right thing to do is to buy it rather than trying to guess unknowable factors that may or may not occur. If adverse developments do occur and the stock trades down, one can take advantage to average down the purchase price. Over an entire cycle, if earnings are higher than over the previous cycle, the company will be worth more over time. Any ripples to disturb the tide during a given cycle could be used to increase the position if cash is available to the investor.
Regulation presents additional risk. Recently, much has been made of the CFPB’s direct supervision of non-bank auto finance companies. With more than 10,000 aggregate originations, Nicholas may qualify as a “larger participant” in the auto-lending market and thus be subject to CFPB regulation once a final rule is issued. Until a final rule is issued it’s difficult to estimate its impact on Nicholas and costs of regulatory compliance. I believe the discount from fair value (i.e. the margin of safety) in the purchase at $13.70 is sufficient to cover any eventualities of the final rule-making. If future costs of regulatory compliance turn out to be quite high, and impact earnings in a significant way, I will have to revisit the investment thesis. Regulatory compliance costs up to $1 million annually would not change my thesis.
For financial firms it’s also especially important to consider liquidity risk. To finance the recapitalization, the Company expanded its line of credit from $150 million to $225 million (contingent on successful completion of the recapitalization). The maturity was extended from January 2015 to January 2018, which reduces refinancing/liquidity risk. There is no other debt. The Company also does not finance itself in the auto loan securitization markets which further reduces liquidity risk.
Please note:
Under NO circumstances should any content or communication here be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. PLEASE do your own due diligence prior to investing.
Nicholas Financial has fairly limited liquidity. If, after your own due diligence, you decide to transact in this security, I would suggest using limit orders rather than market orders to purchase shares.
Please note that any dividends paid by the Company in the future (currently none are paid) would be subject to Canadian withholding taxes.
Disclosure: Long NICK
Below are some pro-forma calculations showing the effect of the leveraged recapitalization on Nicholas’ per share ROEs, book value, and EPS. A few things to note in those calculations:
1. The Company expects the costs of executing the recapitalization to be $800,000. These have been added to the $70 million tender amount below.
2. FDSO (Fully diluted shares outstanding) are estimated using the SC TO-I/A dated 3/19/15 filed with the SEC.
3. Interest expense of the debt issued for the leveraged recapitalization is calculated at 4% on $71 million of debt incurred.
4. Operating income excludes professional fees incurred in the failed sale of the Company to Prospect Capital and changes in FV of rate swap.
5. The first EPS calculation (2nd table) starts off with prior year (FY14) operating income adjusted for changes in #3 above and the second EPS calculation (3rd table) starts off with YTD’15 figures on an annualized basis, also adjusted for the changes in #3 above. The major reason for the reduction in the Operating Income between these two tables is a higher provision for loan losses recorded by the Company due to the higher competitive activity in auto loans at the current stage of the credit cycle and the resulting looser industry-standards observed by the Company.
Note: Tender reduction includes estimated fees of $800,000
Due to the tender above book value, the implied premium above book value for continuing shareholders has increased, i.e. price/book ratio has increased due to a reduction in book value. However, ROEs and EPS have been substantially improved on a go-forward basis making the shares attractive even at a higher price/book valuation. In the current environment it’s rare to find a company earning ROEs of 18-20% trading at 1.25x book value. Also Nicholas’ balance sheet does not contain any intangibles. Consider that American companies as a whole (whether measured by the Dow Jones, S&P 500, or Fortune 500), have generally earned ROEs around 12%-13% for many decades. For comparison purposes, the current price-to-book of the S&P 500 is about 2.7. Thus, it appears that ownership of Nicholas financial is attractive from a statistical standpoint.
Following the tender, the stock rose briefly and then began falling. I believe the principal reason for this is the oversubscription of the tender offer. Not all of the shares tendered were accepted for payment by the Company. Those of you involved in our earlier odd-lot tender arbitrages are aware of this “proration” factor. According to SEC filings, approximately 618,738 shares were not accepted. These were shareholders (or arbitragers) hoping to tender but unable to do so. The average volume of trading of Nicholas Financials’ shares was about 45,000 shares per day before the tender, which is quite low compared to the average large company stock. After the tender, this will presumably reduce even further because of the smaller float. Thus the unsold shares of those hoping to tender create downward pressure on the price as these investors or arbitrage funds begin to liquidate their shares in the open market. This phenomenon is present in many tender offers.
Another reason could be frequent coverage given to subprime auto-loan backed securitizations by several newspapers. Issuance in this market has risen substantially causing some to speculate whether a bubble exists in the securitization market for auto loans. However, Nicholas Financial does not participate in the securitization market as either an issuer or a purchaser and management is well aware of the currently loosening credit standards in auto lending.
Whatever the reasons for the lower price, the current price of $13.70, i.e. 1.25x post-tender book value and 7x estimated post-tender EPS is fairly attractive (1) compared to other options now available in the market, (2) given the historically disciplined and profitable credit underwriting of Nicholas’ management and, (3) a chance to continue growing the business gradually over time.
Downside protection analysis:
From a down-side protection standpoint, one can think of the company in three parts, each of which represents value the business could generate (similar to how some insurance companies may be evaluated
1. Value of net assets as of 12/31/14. For this we will use book value as a proxy since practically all of the significant items are liquid with an adjustment to be made for the deferred tax asset. Loans are stated as cost and could currently be liquidated at a premium to cost given the current market conditions and interest rates. However, for the sake of conservatism, these are considered at cost without any adjustment. Future interest to be earned in considered separately in ‘2’ below (if the loans were sold the present value of this future interest would show up at a premium to par in the price received and ‘1’ and ‘2’ could be considered together). Book value stands at $85 million as shown above less an adjustment for DTA of $1.6 million (due to the allowance being of a size smaller than that required for the entire DTA to be used). In total, this item ‘1’ is $83 million.
2. Future cash-flows in run-off (i.e. future revenues less expenses assuming the Company ceases extending new loans and lets the existing loans liquidate as they are paid off). As of December 31, 2014, the Company had approximately $135 million in unearned interest (i.e. interest expected to be earned from loans currently on the books) and dealer discounts of $17.5 million. I assume an average loan life of 3 years, loan charge-offs of 5% with a loss given default of 80% (this charge-off is in addition to what the Company has already reserved in the allowance), ongoing non-interest cash operating expenses of $16 million a year, interest expenses of $8 million a year (4% of $200 million LOC balance), and a 37% effective tax rate. Based on the above, aggregate income (3 years combined) in runoff would be approximately $39 million plus $4.5 million for the deferred tax asset, including the adjustment given above.
3. Value of future business to be conducted. This would include interest and discounts on all loans to be purchased from now until judgment day less all expenses. Value of customer relationships, existing contracts, assembled workforce, going-concern business value etc. are all items included in this item.
Risks and other considerations:
As noted above and frequently seen in the news, at this time in the credit cycle, credit standards for auto lending are loose. It’s possible the loss experience in the coming years will be worse than has been the case in the last few years. However, Nicholas Financials’ management seems alert to the situation and has noted, in its SEC filings, that they are already taking actions in response. There is no doubt that if the underwriting cycle worsens Nicholas will have its share of losses. However, I believe these will be less than the industry and will not threaten Nicholas’ existence. Through one of the worst credit bubble bursts of our generation in 2008-09, management has shown their ability to profitably run the business through cyclical troughs. The performance was especially admirable given that a large portion of the loan book was in Florida which was one of the worst hit states during that crisis. A down-cycle may even provide an opportunity to increase the position at lower prices.
There is always a certain temptation to “wait” for such a credit problem to occur in the industry and then buy attractive securities (such as Nicholas Financial). However “waiting” is often simply wishful thinking in disguise. Guessing whether loosening credit standards will rise to the level of a “bubble” in the future is a gamble and not an investment approach. When a good business, with a good management, and a good price is available, the right thing to do is to buy it rather than trying to guess unknowable factors that may or may not occur. If adverse developments do occur and the stock trades down, one can take advantage to average down the purchase price. Over an entire cycle, if earnings are higher than over the previous cycle, the company will be worth more over time. Any ripples to disturb the tide during a given cycle could be used to increase the position if cash is available to the investor.
Regulation presents additional risk. Recently, much has been made of the CFPB’s direct supervision of non-bank auto finance companies. With more than 10,000 aggregate originations, Nicholas may qualify as a “larger participant” in the auto-lending market and thus be subject to CFPB regulation once a final rule is issued. Until a final rule is issued it’s difficult to estimate its impact on Nicholas and costs of regulatory compliance. I believe the discount from fair value (i.e. the margin of safety) in the purchase at $13.70 is sufficient to cover any eventualities of the final rule-making. If future costs of regulatory compliance turn out to be quite high, and impact earnings in a significant way, I will have to revisit the investment thesis. Regulatory compliance costs up to $1 million annually would not change my thesis.
For financial firms it’s also especially important to consider liquidity risk. To finance the recapitalization, the Company expanded its line of credit from $150 million to $225 million (contingent on successful completion of the recapitalization). The maturity was extended from January 2015 to January 2018, which reduces refinancing/liquidity risk. There is no other debt. The Company also does not finance itself in the auto loan securitization markets which further reduces liquidity risk.
Please note:
Under NO circumstances should any content or communication here be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. PLEASE do your own due diligence prior to investing.
Nicholas Financial has fairly limited liquidity. If, after your own due diligence, you decide to transact in this security, I would suggest using limit orders rather than market orders to purchase shares.
Please note that any dividends paid by the Company in the future (currently none are paid) would be subject to Canadian withholding taxes.
Disclosure: Long NICK
