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Nicholas Financial: Quality on Sale

October 18, 2011 | About:
Rishi Gosalia

Rishi Gosalia

41 followers
Nicholas Financial (NICK) ($9.74 on Oct. 17, 2011) is in the business of making subprime auto loans. Owner-operator Peter Vosotas has run the company for over two decades by conservative underwriting and reserving.

Since 2001, the company has not only grown its loan book organically at a CAGR of 12.6%, but also stayed very profitable through the entire period; for the entire period, ROAE stayed above 10% with the exception of 2008 when ROAE dropped to 6%. It has achieved these admirable results without taking on excessive leverage. NICK has gradually deleveraged itself from a debt/equity of 3 times in 2001 to 0.95 times in June 2011.

It is trading at reported book value, which you will see is grossly understated relative to liquidation value in a run-off scenario, and at 6.3 times trailing P/E. Furthermore, unlike the other financials, you can read its 10-K from front to back without getting confused or feeling queasy. For a highly profitable business that continues to have attractive growth prospects for at least another five years, its current valuation is very cheap. The current valuation ($9.74) provides a very attractive upside of 70% to 150% ($16.5 - $24.5), and a strong downside protection backed by a very conservatively reported book value.

NICK-1YearChart.png

Business Model:


NICK operates its business through a branch network of 56 branches in 15 states. The branches purchase loan contracts from auto dealers in their local markets, and to a very small degree make direct loans.

This business is very competitive, because auto dealers do not care who buys the loans they originate, and they just want the best price for the least stringent lending criteria. NICK’s branch model is the key to their underwriting success; it helps the branch underwriters monitor local employment conditions, the resulting lending standards by the auto dealers and the competition for the loans they make.

The company’s typical customer has a credit history that fails to meet the lending standards of most banks and credit unions. Among the credit problems experienced by the company’s customers that resulted in a poor credit history are: unpaid revolving credit card obligations, unpaid medical bills, unpaid student loans, prior bankruptcy, and evictions for nonpayment of rent. Sounds scary! But what makes this “risky” lending process work is NICK’s high-touch process of interviewing candidates on the phone by asking them specific questions that they have learned over time determine the likelihood of non-payment given the customer’s specific situation. In addition, they collect and verify contact information for employers, friends and relatives to help with any necessary collection efforts if the account slips out of status.

Once contracts are purchased from the dealers (or directly originated), NICK retains them until maturity. The company monitors and evaluates the underwriting performance of a branch by segregating loans into static pools where each pool consists of loans underwritten by the branch in the quarter. This fosters a sense of accountability and ownership within each branch, eventually lending to the track record that is evident from its 10-year financials. As of June 2011, the company has 1,176 active static pools. The average pool upon inception consists of 63 contracts with aggregate average finance receivable, net of unearned interest, of approximately $610,000.

In addition to its careful screening process, the company builds another margin of safety in its lending process by negotiating a discount to the original purchase price being financed by the purchaser of the automobile. The discount varies from contract to contract from 1% to 15% based on credit risk of the customer, but historically since 2001, it has been in the 8% to 9% for the aggregate of contracts purchased in a fiscal year.

Furthermore, it builds yet another layer of margin of safety, by setting aside future loan loss provision reserves. Historically, since 2001, loan loss reserves have ranged in the 2% to 8% range (as percentage of average finance receivables, net of unearned interest, outstanding in that year).

These three factors have been more than enough to offset net losses charged since 2001. This is what has caused NICK to continue to stay profitable in one of the worst decades for the financial sector since the great depression.

Here are a few quotes about their lending philosophy from their annual reports: “We own everything we underwrite. This is OUR money we are lending.” When competition gets out of whack and pricing becomes irrational, NICK pulls back: “When yields on loans look temporarily high, we always try to remember that the return of your money is more important than the return on your money.”

PortfolioStats.png

Balance Sheet: Loans are carried on balance sheet as finance receivables, net of interest that is expected to be earned over the remaining life and net of allowance for future credit losses.

FinanceReceivables.png

Allowance for credit losses are accounted for as explained in the business model section — to the beginning of the year allowance, add discounts acquired on new contracts purchased, add loan loss set aside on the income statement for future losses, subtract losses incurred, add recoveries from selling collateral acquired, and subtracts any discounts accreted at the end of loan life.

LossProvision.png

BalanceSheet.png

I would draw your attention to the deferred tax asset on the balance sheet that has grown from about $4 million in 2006 to $9 million in 2010. IRS does not recognize credit loss provisions until losses actually occur. Thus, NICK’s taxable income is higher than its U.S. GAAP income, leading to higher cash earnings relative to EPS and higher cash taxes relative to accounting tax provision. This leads to a growing deferred tax asset, which theoretically will be reversed in the future when actual credit losses occur. However, as you can see, the credit losses have consistently been lower than provisions, leading to an ever-growing tax-deferred asset base. In fact, you will see this trend, even if you go back to 10-year data (not shown). This shows in yet another way that NICK's reserving is very conservative.

Income statement: Revenue is largely comprised of interest income, expenses consists of interest expense on debt, salaries and benefits, provision for future credit losses (that were transferred to balance sheet in calculating net loss allowance), and other minor expenses.

IncomeStmt.png

Credit Quality: The table below shows that net losses charged off has consistently been below loan loss reserves on balance sheet

CreditQuality.png

Valuation:

Let’s first look at past growth rate for average finance receivables, net of unearned interest (but before loss allowance).

ReceivablesGrowthRates.png

Based on growth rates for last five years, a full cycle, we can use 10% CAGR growth rate for net receivable growth from here out to 2015 as the mid case. For low case, we will use CAGR 6% and for high case, we will use CAGR of 12.5%. Relative to its market size, NICK is still quite small, and it can grow its branch network to achieve these rates for the next five years, without compromising on loan quality.

Besides, when the economy is weak, the one thing that Americans still need is a car to get to a job. One can downsize to living with parents or roommates, but since public transportation is very weak in most U.S. cities, getting to a job (90% of employed Americans) requires one to have a car.

ReceivablesForecast.png

Next, we estimate 2015E shareholders’ equity:

2015E-BV.png

As a sanity check, we estimate 2015E EPS using estimated average net receivables from above and income statement ratios as percentage of net receivables based on historical data

2015E-EPS.png

Either way, we get a downside that is well protected and an upside of 70% - 150%.

Lastly, we can run another sanity check to validate our valuation by checking against liquidation value of the business in an orderly liquidation.

LiquidationValue.png

Allowance for credit losses stand at 15.8%, but losses in the last 10 years peaked at 10.5% in 2008. Let’s assume that charge-offs experienced during the liquidation process stay at 10% (which is quite dramatic relative to experience of the last 10 years). So, the remaining 5.8% reserves are released and accrue to the shareholders.

Next, as the receivables are run-off, the unearned interest is earned. Gross unearned interest stands at $108 million, but this will be earned in a period of four years (average life of loans is about 48 months), so we discount at 6% to get present value. Then we add back the principal paid off. We add back current cash, and take off all liabilities to come up with liquidation value before the expenses incurred to liquidate the portfolio (which ought to be quite small). The upside is in the mid range estimated using the other two approaches.

Management:

There is no better way to evaluate a financial's management team other than to look at its historical results over the last 5 to 10 years, given that the past 5 to 10 years have been a good stress scenario for all financials. And NICK passes with flying colors here. It is also evident that we have an owner-manager orientation at the company through share ownership. Mr. Vosotas, the CEO, owns 15% of outstanding shares, and all directors and officers as a group own 18% of the shares.

The management team has de-risked NICK by lowering leverage to a mere factor of two times and recently started a quarterly dividend of 10 cents. At these levels, the current yield is a whopping 4% and it is more than well covered.

I'll take NICK over any other mega financials trading at huge discounts to tangible book, not because they don't represent value, but because of my lack of skills to read and comprehend a 400-page 10-K.

Risks:

Although the combination of discounts of 8% on contracts acquired and a loan loss provision of 2% have been enough to offset net charge offs historically (which peaked at 10.5% in 2008), they may not be enough in case of persistently long unemployment and low-to-no growth of receivables environment. I view this as a highly unlikely event, but it’s a financial — never say never!

NICK is lending at maximum state allowable interest rates and borrowing at interest rates that have continued to stay low, causing net interest margin to expand. It's one of the few financials that is not facing net interest margin compression. Long-term interest rates going up is a risk, but NICK hedges its interest rate exposure. With Mr. Bernanke promising to keep rates low to 2013, NICK has enough time to put on the hedges (if it doesn't already).

It borrows in the short term using a line of credit extended by a group of banks (Wells Fargo, Capital One, First Horizon, Montreal) which doesn't expire until November 2013. Liquidity risk is limited, because it can raise cash simply by running off its portfolio.

Catalyst:

Mr. Vosotas is 69 years old and is looking to exit the business at some point soon. Shareholder value will be realized if NICK is sold at reasonable multiple of book (1.2-1.5x), or if no acquirer is interested given its “unique” high-touch model, the business is liquidated in an orderly fashion.

Disclosure: Long NICK

I appreciate your questions and comments.

About the author:

Rishi Gosalia
Rishi Gosalia is a private value investor based in Cedar Park, TX. Rishi currently works in a management position in the software industry. Rishi graduated from the University of Texas at Austin in 2003 as a Distinguished Scholar with an undergraduate degree in both Computer Science and Pure Mathematics.

Rating: 4.0/5 (26 votes)

Comments

FrogsKiss
FrogsKiss - 2 years ago
This is such an ugly business on the face of it, but you do a great job showing how strong it really is. Great job!
rgosalia
Rgosalia - 2 years ago
Thank you Andrew [FrogsKiss] for your kind comment
cdubey
Cdubey premium member - 2 years ago
Hi Rishi,

I looked at the company and have a few questions to ask. I will be grateful if you can answer some of them.

1. Who are the competitors of NICK in this area ? What is NICKs' market share ? It would have been nice if you had shown where NICK stands on a relative basis to the industry it is in. As I gather from the business model, the market is very competitive. The auto dealers do not care who buys the loan as long as they can transfer the risk for the highest price. Now what will happen to the insurance industry in a recession ? As Buffet points out

"At some point - we don’t know when - we will be deluged with insurance business. The cause will probably be some major physical or financial catastrophe. But we could also experience an explosion in business, as we did in 1985, because large and increasing underwriting losses at other companies coincide with their recognition that they are far under-reserved."[i][/i]

So, when the recession hits, good insurance companies see their business go up because the bad ones will not be able to write competitive policies. If we look at NICK and say TWGP (this is in property and casualty insurance, but as I do not have another company with the same industry as NICK, I am at a loss) then NICK's revenue has remained static (50m in 2008, 53m in 2009 and 56m in 2010), while TWGP has exploded from 484m in 2008 to 983m in 2009. This is not necessarily bad but does point out that NICK was not a go-to insurance company during these years. Which makes the point of an industry comparison more relevant.

2. There has been no growth in FCF since 2009 and it has stayed at 21m (morningstar), although the revenue has increased from 50m to 63m. Can you say why ?

3. Why do you think that the exit of Mr Vosotas is a positive catalyst ? As you point out, he has done a phenomenally good job managing the company during the worst of financial markets. I am also impressed by the very small amount of stock dilution and stock rewards to the board. Furthermore, the executive compensation also seems very reasonable. I would say that losing him will be a bad thing for the company, isn't it ?

4. Since 1997 when the company was founded or went public (as I can't see the price chart before that), the stock is selling at a multi-year high. The highest price it has ever achieved is $12.6 and now it trades at $10. Obviously, as you point out, it is worth a lot more. But in the current environment of the general panic, wouldn't it better to stay away from the stock until it goes down a bit more ?

If you decide to answer any of these, thank you ! Also, thank you for providing an excellent company with what seems like a very good management for my watchlist. I will defnitely digg deeper once I have some time on my hand.

Regards,

-Ch
rgarga
Rgarga - 2 years ago


Hello:

First of all, Rishi thank you for an excellent easy to understand article with clear articulation of why this is a good idea. Secondly, I agree with CDubey above. I don't quite understand why net margins over last year are higher than ever though operating margins are unchanged. Also, if auto sales do not come back as they are large ticket item just after housing, would that affect the real growth we can see in this company.

Thanks. Rahul
rgosalia
Rgosalia - 2 years ago
Ch,

Thanks for the questions.

1. NICK is a tiny player in a very fragmented market - even the top 20 lenders of used car financing only hold a 40% market share. NICK's relative market position is probably something that I think even the CEO doesn't know. But here is the some data that you might find useful to put my comment in perspective:

As per Experian's Latest State of Automotive Finance Report (link), there are about $657 billion in auto loans outstanding. Out of which, $227 billion are held by banks, $196 billion by captive auto finance companies, $141.9 billion by credit unions, $92.1 billion by others. Out of these, 20% loans are considered subprime. So the market that NICK is operating is about $131 billion. NICK's has a total outstanding loans of $235 million, which accounts for 0.18% of total auto loan market.

Coming to your comment on ability to grow in recession, first, I think the numbers you quoted for revenue don't match the ones in 10-K. The numbers I have are from the 10-K, and as per them:

Growth Rate

Revenue (Interest Income)

YOY: 11.2%

3 Year Average: 7.8%

5 Year Average: 8.0%

Loans Outstanding (Net Finance Receivables)

YOY: 14.24%

3 Year Average: 10.13%

5 Year Average: 10.36%

Secondly, I will comment that NICK's model is one where lots of hands-on work is done to make loans, unlike the big auto lenders that use a standard automated application process that goes through decision making in minutes. My understanding is that limits NICK's ability to grow too quickly. Besides, I am happy with these growth rates, and I would rather they stick with their knitting rather than chase growth by compromising what has worked for them for decades.

Lastly, even through the recession, industry wide net charge-off rates (defaults - recoveries from repos) held up quite okay relative to say something like subprime mortgages. These are completely two different markets. Americans don't finance used cars on subprime to speculate on them, but to get to work due to lack of public transportation in most cities. In the case that they couldn't hold on to their jobs, cars would get repossessed and sold by the finance company. In the recession, used cars held up their values well due to relative higher demand compared to new cars. So, the recession that occurred in this market was one of the credit market closing down and the inability to securitize loans held on books by captive finance companies like Americredit. Some did go belly up, but in a super fragmented market with many of the competitors doing relatively okay, it wasn't like competition for NICK completely disappeared.

Furthermore, NICK's customer is one that couldn't find financing at the conventional outlets (banks, credit unions) due to their poor credit history. I believe that as the economy stays weak there will continue to be a market for these kinds of loans. Besides, in my best 2015E, NICK needs to go from 235M to 450M of loans, which in my opinion, is quite independent of the larger market due to the relatively tiny size that NICK is aiming to do relative to the market size. It doesn't have to clear 7 foot hurdles, but just stay on track with opening new branches in the same careful way it has done for the last years.

In the case of an insurance industry, what happens is that often catastrophic events affect the capital positions of the companies that had been making out policies at poor pricing during the prior part of the cycle. With the weakened capital position, these players are unable to "supply" policies (due to regulatory requirements of having adequate of the required capital to make these policies) at the same rate, causing a demand supply in balance, which is beneficial to the players who have been disciplined in prior part of the cycle. Due to excess capital position, these players come in filling in the missing supply at higher rates.

2. It's a good question, but looking at free cash flow for a finance company doesn't make much sense. The financing part of cash flows is critically a core operating part of what a finance company does, so looking at fcf means you are ignoring the financing cash flows, which is core to the business. Maybe if you elaborate why you are looking at fcf, I can try to answer your question.

3. I am not suggesting that the CEO exit is the catalyst. In April 2011, NICK completed a review process to look at alternates - meaning they were looking for buyers of NICK, but they didn't find one at the price they were seeking. I meant that this particular event shows that the CEO wants to sell the business since he is almost 70 years old. Americredit, a much larger subprime auto lender, was sold to GM at 1.4x book value. If NICK is able to make the sale, I am expecting they will be able to achieve similar multiples, even though it is much smaller, mostly because they book is understated due to the over reserving of losses.

4. As a value investor, I have no ability to pick bottoms. This is one of the very few financials that does 5%-7% ROA, 10%-15% ROE, grows 10% - 15%, never had a negative year in 10 years, and does with a super low leverage of 2x. Find me another company with similar or better business performance that is trading at book, which arguably is much lower than liquidation value. If you have a way to filter for these criteria, see how many financials show up in that list (and send me the list). I am happy to own it at this price, and I will be happy to average down if Mr. Market does me the favor - "Price is what you pay, value is what you get!"

Hope this helps

- Rishi

rgosalia
Rgosalia - 2 years ago
Rahul,

"I don't quite understand why net margins over last year are higher than ever though operating margins are unchanged".

Can you repeat the question with actual numbers that you have a question about. Thanks

"If auto sales do not come back as they are large ticket item just after housing, would that affect the real growth we can see in this company"

The reply I gave to Ch has some of my thoughts on this question, so forgive me for repeating myself. NICK is operating in a niche market - making loans to Americans who have a poor credit history and are unable to get a loan at conventional outlets. So, why are these folks trying to get a loan. Most likely, it's not because they want to as a discretionary spend, but because they have to. NICK is making average loans are $9800 at 25% for 4 years - Plug this into a loan calculator, and you get $324 per month. If this is the only way these folks can make it a job, they will make a payment and crash in with room mates or parents if affording rent becomes difficult with this payment. For the ones who cannot, in 18 months, they have recovered $5800 (through principal and interest) and the rest they can recover from the car repossession.

These are not my words, but as spoken by Mr. Seth Klarman, when he spoke to students at the Canadian Ben Graham School of Investing students in March 09:

"We have looked at the debt of auto finance companies. They are captive and their equity does not trade. Right now (2008-2009) the default rates on auto loans have not gone up much. These companies are running an annual loss rate of 2%-4%. That is less than the default rates on houses in many markets and less than high credit card defaults. We don’t have a very good reason for why its so but we suspect it is because (i) very few loans are subprime, (ii) people have a tendency to hold onto their cars if they paid into their loan for a few years, (iii) it is (currently) hard to get new car loans, people don’t have the money, so they don’t let go off their old cars easily, (iv) and, if one has to get to job, they need the car to drive to the job. So, we have reasons to believe that car loans will continue to perform, but we are modeling it to get worse from here on. We ask ourselves what would be a really bad scenario – a base case scenario is for the annual car loan loss rate to quadruple. So, what would happen if it quadruples. The bonds we are buying are fifty cents on a dollar will be still worth ninety to par. Now lets assume that the loan losses go up eight fold, which is armageddon. We would have 40% loss rate over the life of a car loan, 40% loss over the life of a lease, 40% loss on the new cars sitting in dealer showrooms, all of which these companies lend to, but our bonds are still worth sixty to par compared to a our purchase price of fifty. I don’t know how many things you can buy that are worth 20% more than the purchase price even in an armageddon and this is the closest to armageddon we can get. There is no historical precedent to anything close to that ever happening.”

I believe that for NICK to do $235M of loans to $450M of loans, it has stay on track and continue doing what it does - disciplined opening of new branches. It is quite independent of the overall market because of its tiny size of overall market and the niche market it operates in (which a stressed economy contributes to).

- Rishi
rgosalia
Rgosalia - 2 years ago
Rahul,

I would like to add one more thing to your question about consumer's deleveraging:

Assume that NICK cannot make a single new loan in the next four years because of the super low demand for loans. Assume that the macro economy is so bad that it experiences the 2008 peak default rate of 10% on the current loans outstanding. This is exactly the liquidation scenario shown in the valuation section. You still experience an upside of 80%.

Now let's make it even more dramatic - say the macro environment get's so bad that it experiences default rate of 15% on the current loans and cannot make a single new loan. In the case, the entire reserve is wiped out causing a liquidation value that 68% higher than current market cap.

So, what kind of default rate it needs to experience for you to start losing money based on the market value quoted above? The current gross receivables (principal + interest unearned) are 343.1M, net liabilities (total liabilities - cash) of 125.6M, so that gives you 217.5M net. Market cap quoted above is 116.4M which is 53% of the net of 217.5M left over from principal and interest unearned after liabilities. All of the remaining ~100M can go towards default, which is 42% default rate on current principal balance - an armageddon, and still not lose money even if the cars repossessed are complete junk and of no value. Hence, Mr. Klarman's comment is quite applicable to NICK, in my opinion.

Hope this helps

- Rishi
cdubey
Cdubey premium member - 2 years ago
Thank you ! A very detailed and to the point reply.

One more question, where do you get the data for the insider holding ? Morningstar says 1.8% ... It seems that it is not accurate.

Is there a way to find out the insider holding on gurufocus, I wonder !
rgosalia
Rgosalia - 2 years ago
Cdubey,

I prefer to just get the data from the source rather than third party data providers. I looked at NICK's latest DEF 14A filing:

http://www.sec.gov/Archives/edgar/data/1000045/000119312511184222/ddef14a.htm

Rishi
rgosalia
Rgosalia - 2 years ago
Cdubey,

Out of curiosity, I built a M* stock screen (premium member) with the following criteria:

ROA % - TTM >= NICK ROA% - TTM

and ROA % - Y1 >= NICK ROA% - Y1

and ROA % - Y2 >= NICK ROA% - Y2

and ROA % - Y3 >= NICK ROA% - Y3

and ROA % - Y4 >= NICK ROA% - Y4

and ROA % - Y5 >= NICK ROA% - Y5

and ROE % - TTM >= NICK ROE% - TTM

and ROE % - Y1 >= NICK ROE% - Y1

and ROE % - Y2 >= NICK ROE% - Y2

and ROE % - Y3 >= NICK ROE% - Y3

and ROE % - Y4 >= NICK ROE% - Y4

and ROE % - Y5 >= NICK ROE% - Y5

and Revenue Growth 3Yr >= NICK Revenue Growth 3 Yr

and Equity / Total Capital % >= NICK Equity / Total Capital %

and Price / Book Ratio<= NICK

and Stock Sector = NICK Stock Sector

Guess what? How many companies show up - exactly two. NICK and an insurance broker in China.

Rishi
TheBourqueReport
TheBourqueReport - 2 years ago
The problem with that screen is that NICK has fully reinvested all of its money while other financial firms have often paid out a lot of their earnings as share buybacks and dividends. A financial stock with a normalized return on equity of 12% is worth approximately 1x book according to Buffett, as that is the return on equity for the average american company over the past 60 years. It's selling pretty close to book value, which makes me think it is too close to being fairly valued to consider for purchase. You should expect to earn its longterm ROE on this stock so if 12% seems fair to you, that's okay, but it's definitely not cheap enough to be a Buffett stock.
rgosalia
Rgosalia - 2 years ago
BourqueReport,

Thanks for the comment. You are right on the comment on the screen not being appropriate because of other financial firms paying out their earnings in dividends. I am curious to know if know of other financials that have performed similar to NICK that are at or below book value (or know of a way to screen for)?

However, I disagree on your comment on NICK being fairly valued, mainly because its book is grossly understated due to overly conservative reserving. The actual NAV is liquidation value as calculated in the valuation section, which is 80% above reported book value. Then you top it with the fact that it can grow at 12% ROE.

Disagreements?

- Rishi
rgarga
Rgarga - 2 years ago


Rishi:

This is an awesome discussion.

Here is the data you asked for from Gurufocus financial info.























Annuals (Year End)Quarterly
Fiscal PeriodMar02Mar03Mar04Mar05Mar06Mar07Mar08Mar09Mar10Mar11Latest Q.Dec10Mar11Mar11Mar11Jun11
Return on Equity (%)21.8019.4019.0017.3018.1016.6012.305.5011.1014.6017.5016.2016.6016.6016.6017.50
Return on Assets (%)5.104.805.006.707.106.705.102.405.106.908.507.607.807.807.808.50
Debt to Equity (%)--------------------------------
Debt to Revenue (%)--------------------------------
Gross Margin (%)99.6099.6099.7099.8099.90100.0099.90100.00100.00100.00100.00100.00100100100100.00
Operating Margin (%)51.2049.0048.8051.7050.9052.8044.4027.9039.2052.1059.8053.9056.5056.5056.5059.80
Net Margin (%)19.4019.1020.4024.6024.7024.8019.308.9019.2026.8031.9028.0029.6029.6029.6031.90
As you can see Net margin is higher than ever, and I dont understand why. If you normalize it, to approx 20%, you end up with PE of 9 which is not great. Question is whether the margin is sustainable...

RG
rgosalia
Rgosalia - 2 years ago
RG,

Here is an alternate way of looking at the data that will throw an insight on why their margins have expanded:



The primary reason is that % of indebtedness as well as interest costs have gone down over the decade. If interest rates were to go back to the level of 2001, but leverage stayed the same then, it would do the following to margin:

2010 indebtedness = 113,833,641

(x) 2001 avg cost of funds = 7.66%

(=) interest expense = 8,717,160

(=) as % of 2010 revenue = 13.9%

(-) actual 2010 int. % = 8.9%

(=) op margin compression = 5.0%

The increased interest expenses, after taking into account the tax benefit, will reduce 2010 net income to 14.9M instead of 16.8M, or 2010 diluted EPS from 1.41 to 1.25 (about 7.8x P/2010E).

Provision expense has come down relative to 2001, but I would argue that NICK is more than adequately reserved.

This is what is known as a liability-sensitive balance sheet - meaning if interest rates go down, then net interest margin (NIM) goes up and the other way around if interest rates go up.

The management is aware of the long term risk of rising interest rates and I am assuming, given their general prudence, they will put on interest rate hedges to protect against this risk. But this is definitely a risk that I already pointed to the risk section to be aware of.

rgosalia
Rgosalia - 2 years ago
BourqueReport,

Based on your comment on my previous screening, I built another one:

Stock Sector = Financial

and ROE TTM >= 0

and ROE Y1 >= 0

and ROE Y2 >= 0

and ROE Y3 >= 0

and ROE Y4 >= 0

and ROE Y5 >= 0

and Revenue Growth - 3 Year >= 0

and Price / Book - Current<= 1

and Financial Leverage - Current Quarter<= NICK

Only 4 companies show up:

NICK

CME Group

CNinsure

Prospect Capital Management

Is this screen fair, in your opinion?

- Rishi

cmiller
Cmiller - 2 years ago


Hey thanks for the analysis a good comp to NICK to check out is CACC
rgosalia
Rgosalia - 2 years ago
Cmiller,

I looked at CACC recently. I am a member of VIC and someone just posted a write-up on CACC on Monday. Thanks for pointing out.

Banco Santander recently sold 25% of its auto lending unit to private equity for a huge gain. http://www.structuredfinancenews.com/news/santander_auto_privateequity-224424-1.html. The reality is that even though this looks like an ugly business, it is a phenomenal business that is wildly profitable for almost all the players in this industry. GMAC didn't go down because of auto lending but because of their forays in home loans.

I prefer NICK to most players due to their conservative capital structure. If they were to sell the business to a private equity firm, NICK could easily be levered it up a bit more. The book value is super conservative. Using the AmeriCredit transaction and applying a multiple of 1.4x to its GAAP reported book value is nonsensical because NICK is worth more dead than alive. NICK's liquidation value is higher than 1.4x of reported GAAP book value. Given the owner orientation of the CEO, he is not going to sell out at 1.4x of reported GAAP BV.

- Rishi

TheBourqueReport
TheBourqueReport - 2 years ago
Sorry for the slow response, it seems the email account I have with gurufocus was putting all of their emails automatically in my junk bin.

I took another look at Nicholas Financial. I agree roughly with your Mid range estimate, but for me, that doesn't seem particularly cheap. Don't get me wrong, earning 11-14% a year isn't bad, I just don't think it's in that "value" range. Maybe a 10-30% margin of safety to earn 10% a year? In today's environment I'd rather own Berkshire Hathaway which I'd expect has a 35-40% margin of safety, combined with vast corporate culture and instant diversification to earn 10% a year. Safer and cheaper, in my humble opinion.

When you say it's liquidation value is 80% above its book value and it has a 12% roe, I disagree. It's kind of one or the other, just like insurers and banks. The liquidation value is typically higher than book value due to the nature of those "unearned interest" (being discounted) and "provision for credit loss" (being more conservative than reality), but that is for cash earnings in the future. The 12% roe comes about mostly because of the future unearned interest being earned and the provision for credit loss reserves being released. New business is put on with future assumptions too. So it's the combination of all 3 to create the 12% roe. And I typically value a stable business like that by by dividing the average roe (assuming proper reserving, etc) by 10% (average longterm return on businesses, might be around 9% today due to low interest rates but it's typically been from 10-12% for the last 100 years), so in this case for a book multiple of ~ 1.0 to 1.3 x.

Maybe my explanation is a bit convoluded. Let me put it another way. Let's say you are a company and you are going to loan money to me. You buy my car loan, that has a face value of $10 000 and an interest rate of 10%, for $9000. You expect there's a 5% chance that I default (when in reality it's less than that). Let's say the loan is for 5 years.

When you get the loan:

- you add $450 to provision for future credit loss

- you create an unearned interest account (let's say undiscounted) for (10 000 + 8000 + 6000 + 4000 + 2000)*0.1 = $3000

So if I don't default, your future cash flows (assuming negligible costs for checking up on the loan) are:

Year 1

$1000 interest + $50 credit release + $200 (change to account for purchasing loan at a discount to face value) = $1250

Year 2

$800 + $50 + $200 = $1050

etc (the reserve release and loan discount change might not accrue identical to this but it's close enough for demonstration purposes).

So you're starting book value is $9000, and you earn $1250 in year 1, $1050 in year 2, etc until year 5 where you get paid back the $10 000.

As you can see your ROE for year 1 is 13.8% (1250/9000), year 2 is 13.5% (1050/7750), etc. This means you earn roughly 13-14% on that "liquidation" book value of $9000. But if you didn't have the the capital tied up in this "book" value, you wouldn't be earning that return. I believe you are double counting - or said in another way, I believe you are not discounting future cash flows from your estimated liquidation value back to the present at an appropriate discount rate.

My written explanations aren't always the clearest, I know I seen an article that described the concept better than I described it here. I'm pretty sure it was one of Geoff Gannon's articles. Maybe it was this one:

http://www.gurufocus.com/news/122022/warren-buffett-a-return-on-capital-investor

To reiterate, I don't think you are wrong, I just think the hop from $11 to $13.50 which is what I roughly estimate is Nicholas' Financial fair value to earn 10% a year isn't large enough. I think there are better opportunities out there.

Happy to discuss further through email or on here.

Chris Bourque

TheBourqueReport@gmail.com
rgosalia
Rgosalia - 2 years ago
I understand your comment on double counting. Let me clarify - I was trying to make two points.

(1) If the CEO dies and NICK starts to liquidate tomorrow, then you realize a liquidation value over next four years which when discounted to the present using 10% is slightly higher than $9.74 (the price when I wrote this up - not fair to use $11 from today). So in this case, you still make a 10% CAGR over next 4 years.

(2) In the more likely scenario, I believe that NICK can continue to grow at a healthy rate of 10% CAGR. I believe that it can do 6% ROA (currently it is higher) and at 2x leverage can do a 12% ROE (2x leverage is super low for a financial that has proven it knows how to manage risks over two decades - a private equity could safely turn this up to 3x and do a 18% ROE but let's not bother even though the most likely thing to occur is a sale to a private equity or a captive in the next few years). In my mid case I used a 8x P/E, but its not unreasonable to assume that it can trade at 10x. Dividend yield based on $9.74 purchase price is 4%.

Below I show you how I do the math, but Total return (TSR) realized over 5 years is 2.25x. Let's discount TSR by 1.1^5 = 1.61 (even though the dividends come in the interim years) you get a fair value that is 40% higher than the trading price.

If I went back to the multiple I used in the mid case, TSR is 1.84x and fair value is 13% higher. So I see your argument about it not being "cheap", but is 8x the fair multiple for a financial that does a 6% ROA? I don't think so given that CACC a comp to NICK trades at 11x today and you have mega banks like WFC that are barely able to do 1.5% ROA trading at 8x.

We don't have to agree on this - that's what makes a market. But I don't see how I can lose money here and a very high probability of making 15% CAGR if you include the dividend yield. Ill take my chances!

- Rishi

Appendix:

Price = Market Value / Number of Shares

= Earnings x PE / Number of Shares

= (ROA) x Assets x PE / Number of Shares

TSR = Price_2 / Price_1 + Div Yield * Number of Years - 1

= [(ROA_2 x Assets_2 x PE_2) / (ROA_1 x Assets_1 x PE_1)] x [N1 / N2] + Div Yield*5 - 1

In our case, we use

ROA_2 = 6%

ROA_1 = 7%

PE_2 = 10

PE_1 = 6.3

Div Yield = 4%

N2/N1 = 1

Since we assume assets grow by 10% CAGR

Assets_2 / Assets_1 = 1.5


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