nick
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Rating: BUY Nicholas Financial. (NASDAQ:NICK) Price Target: $16.00 Industry: Sub-prime Auto Lending
Close: 10/31/2014 Price: $12.21 52 Wk High: $10.64-$17 Shares Out (mm): 202
Mkt. Cap (mm): $149.85
Average Vol: 56,921
Source: Capital IQ,
Bloomberg
Source: ThomsonOne, Bloomberg, BCF Analysis (all values are USD)
Investment Action & Thesis The Financials team is initiating our coverage of Nicholas Financial with a BUY
rating and an initial price target of $16. Nicholas Financial is an overlooked small-cap company with consistently healthy and above-average financial performance that has been trading at a discount relative to peers. The company recently took a beating from a risk-arbitraged funds sell-off after they announced the discontinuation of a deal in July to sell themselves for $16 a share to Prospect Capital (NASDAQ: PSEC). This decision in our opinion, contrary to how the market reacted, was excellent on management’s part. NICK is able to make smart, safe loan decisions going above and beyond to make personal connections with their clients and as a result, they have achieved a low default rate resulting in an ROE unparalleled in the industry given their leverage ratio. With strong free cash flow, and average yearly growth in tangible book value of 19% since going public in 1996, NICK is a strong company that deserves a valuation above the $16 offered to them by PSEC.
We believe that as more investors start to realize NICK’s potential, the stock will rally to an acceptable price-point in-line or above the multiples its peers currently trade at. In the meantime, NICK remains a strong acquisition target that would be immediately accretive (and also serve as a tax inversion) to many larger competitors in a fragmented industry.
Key Investment Highlights:
NICK is Under-leveraged Both Historically and in Relation to Comps Historically, NICK has had an equity multiplier of 3.27, with that value reaching
Ba
sic Information
Beta: .75 Efficiency Ratio): 29.64% Equity Multiplier: 1.99x
2014 P/E(ttm): 9.47X 2015E P/BV (ttm): .92X
P/E 2015E: 9.29X
PEG Ratio: 1.89
Short Float 2.49%
Source: Bloomberg
Company Overview
Nicholas Financial Inc, through its subsidiaries, operates as a new and used vehicle financing company in the United States. Used vehicle loans account for 99% of revenues. It is engaged in acquiring and servicing automobile finance installment contracts as well as directly originating loans.
Source: Capital IQ
Analysts
BCF Financials Team: Ryan Diplock
Alfredo Leon
Paul Ramey
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High Focus on Quality Lending– NICK, unlike many of its immediate competitors, has a rigorous screening process before administering loans. The process first starts with an analysis of credit history by obtaining reports from three different independent credit reporting agencies. They then verify the client’s employment history, income and residence before engaging in a telephone interview with the potential client. For direct lending outside of dealerships, NICK will go above and beyond to interview the client in-person before accepting the loan. NICK is currently the only player in the industry which interviews potential clients, giving them an edge when it comes to making quality lending decisions. This shows with NICK’s performance during the financial crisis in 2008-2009, when they reported positive EPS and cash flow when many companies in the industry went bankrupt. Potential Acquisition Target – NICK is an attractive acquisition target due to its free cash flow position, its low price earnings ratio, and its location of headquarters in Canada. Currently, NICK spins off $20 million in free cash flow a year, and has historically never had a single quarter of negative cash flow (even in 2009). This translates into $1.66 in cash per share (with a 100% payout ratio this would equate to a 10% dividend). NICK additionally trades at a discount to peers on a price to earnings multiple of 9.34 compared to an industry average of 12.01, with NICK’s closest competitor CACC trading at 14.62 times TTM earnings. This would mean that a competitor could see attractiveness in acquiring NICK, as it would be immediately accretive to earnings (even if this is a holding company, or a company in an unrelated field, a P/E of 9.34 is significantly lower than the current S&P average of 19.09). Additionally, NICK is headquartered and incorporated in British Columbia Canada, where the corporate tax rate of 16.1% is less than half of the current United States’ corporate tax rate of 39.9%. With recent deals such as Burger King / Tim Horton’s, transacting for the purpose of tax inversion, this could prove an added incentive for a future acquirer. Sell-off Unwarranted and Misguided– NICK’s share price has fallen nearly 30% YoY, largely due to the sell-off this summer on the news that NICK was rejecting Prospect Capital’s offer to purchase NICK for $16 a share. The deal was announced in October 2013, delayed in the spring as Prospect went through accounting problems, and was finally cut loose by NICK’s board of directors in July. Once the deal fell apart, many risk-arbitrage funds who owned NICK sold the stock, with poor liquidity only aggravating the downward slide (Examples of this include AQR’s diversified arbitrage fund selling 689,000 shares after the news, more than 10 times NICK’s entire average daily trading volume). In reality, this selling reflected a change in circumstances, not a change in overall investment outlook.
As high as 5.07 in 1997. This compares to NICK’s current equity multiplier of 1.99, an all-time historical low. In comparison to competitors it is helpful to look at the auto lending industry as a whole, in addition to isolating just the subprime lenders. As prime lenders make lower spreads on their loans, they leverage themselves to a greater extent in order to achieve competitive profitability and ROE. These prime lender’s, on average, have an equity multiplier of 10.57. Looking at just the sub-prime lenders, their equity multiplier is lower at 5.07, yet still much higher than NICK’s 1.99. NICK is able to operate with such low leverage because they have higher performing loans and record less net charge offs than competitors, giving them more bang for their buck. In essence, NICK is getting the best of both worlds; the yield of a sub-prime lenders with similar asset quality of prime lenders.
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While NICK was no longer a candidate for a risk-arbitrage hedge fund, it was actually an even better investment opportunity, as the sale to Prospect would have squandered many of NICK’s inherent positive qualities, including their low leverage ratios (PSEC was highly leveraged, which would have wasted the potential opportunity for NICK to leverage themselves further at low cost and unlock shareholder value). Trading at Significant P/TBV Discounts both Historically and in Relation to Competitors- NICK currently trades at 1.01x Price to Tangible Book value, in comparison to its peer average of 2.12x, and its closest competitor CACC’s 4.37x. NICK has been able to grow tangible book value at an average 10-year annualized rate of 13.5%, and current Tangible book value is $11.98. The figure below shows the relationship historically between tangible book value and price; from a historical standpoint, the only times NICK has traded below book value have been during the financial crisis, and then for a brief period in 2011 where a similar situation happened with a rejection of an offer to sell the company. The current pricing of the stock in our opinion represents an opportunity based on historical trading levels to buy at a discount.
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Investment Risks:
Insider Sales and Resignation of CEO – After the rejection to sell NICK by its board of directors in July, Peter L Vosotas, the founder of the Company and Chairman of the board for over 30 years resigned. In the ensuing press release by NICK, the reasons given were unrelated to the deal break-up. Mr. Vosotas as of October 21st of this year has also sold 500,000 shares (he still has over a million making him the largest shareholder of the company). When Investor Relations was asked why Mr. Vosotas sold such a large portion of his shares, they responded by claiming that Mr. Vosotas was aging, wanted to put money in charity and do a number of different travel related activities with his wife; he has been in the company for a long time, and in all likelihood wanted to unlock a large portion of his wealth. That being said, any future sales he chooses to engage in, could be negative for the stock and raise additional concerns from investors.
Increased Competition due to Lower Interest Rates and More Liquidity in the Market— With interest rates at historically low levels, many financial firms have been looking for yield in unorthodox areas, one of them the sub-prime auto lending market. With this trend, many credit unions, and smaller financial service firms are entering the industry in their search for yield, driving competition up, and forcing NICK to administer loans that they otherwise normally would not. Additionally, because rates are so low, many companies in the industry have been able to leverage themselves further off of cheap financing, additionally increasing competition for NICK. This is largely why NICK’s earnings growth and free cash flow yield have been stagnant over the last several years, and why their write off percentage of total loans is 6.44%, much higher than what they would optimally like. Moving into the future, NICK sees rising rates as a great opportunity for some of the less experienced players in the industry to be weeded out. As rates rise, many companies will likely also look elsewhere for yield, as the sub-prime auto loan industry poses grave risks in economic downturns. NICK is in great position for rising rates as they actively use swaps to hedge their long term cost of financing, as well as to hedge interest rate hikes for many of their fixed rate loan pools.
Increased Regulation- Currently in the United States, many states have laws capping the level of interest that can be charged on loans. Right now, that range (at its lowest) hovers around 30%, with NICK having an average APR of 23%. This could pose some threats to NICK if these laws become more stringent, or if rates rise to levels where NICK begins bumping up against the 30%. That being said, a 600 basis point rate hike is likely not going to happen anytime soon and new legislation is not in the works in any of the 50 states’ legislative chambers.
General Market Risks and Poor Liquidity: NICK, like any other company is exposed to the potential threat of security data breaches, general market health and indicators as well as new competition in the auto-lending industry. NICK is especially sensitive to economic downturns, as shown in the stock’s performance during the previous financial crisis. NICK is additionally somewhat illiquid as a stock, with a daily average volume of only 625,000 shares traded.
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Overview of NICK: Business Overview
Nicholas Financial is listed on the NASDAQ under the ticker NICK and has a market capitalization as of October 29th, 2014 of $149.25 million with total assets of $283 million. NICK acquires and services installment sales contracts for purchases of new and used automobiles and light trucks primarily in the Southeast United States via a network of 66 company owned and operated branch offices. The company was founded in 1985, and retains a solid and safe reputation in the industry with experienced management and an excellent track record of consistent growth.
NICK is a holding company incorporated under the laws of British Columbia in 1986, and has been listed on the NASDAQ since 1995. Business activities are conducted through NICK’s two fully owned subsidiaries, Nicholas Financial and Nicholas Data Services (Nicholas Financial accounts for over 99% of revenue) located in Florida.
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SWOT Analysis
Strengths
Strong core business
Experienced management
High operating margins
Weaknesses
Increased competition
Deteriorating loan quality
Lack of diversity in business model
Opportunities
Growing into other non-auto related segments of lending
Rising interest rates
Acquisition offer
Threats
Hostile takeover at undesirable price
New Competitors
Economic downturn
Management Overview and Ownership Peter L Vosotas, as mentioned, stepped down as chairman of the board and CEO this past July. His replacement was the former CFO Ralph T Finkenbrink. The current COO is Kevin D Bates, and CFO Katie L Macgillivary. All three have over 25 years of experience working at NICK, and we have strong confidence in their ability to execute strategy and grow the company moving forward.
The stock is 62% institutionally held, with top holders of the stock in order being; Southpoint Capital Advisors (8.43% and stable), Peter Vosotas (8.26% and selling), The Mahan Family LLC (5.32% and stable), Longfellow Investment Management (4.48% and buying), Mahan Children LLC (3.6% and stable). Other sizeable investors include Blackrock, Renaissance Technology Corp, and Ralph Finkenbrink. Many smaller hedge funds have been buying the stock recently, and hedge funds as a category account for almost 30% of the stocks ownership.
October 21st Announcement On October 21st, NICK publicly announced that the board of directors is considering various strategic financial initiatives to increase return on shareholder investment, including (but not limited to) a share repurchase, a cash dividend program, exploring other expansion opportunities or increasing its current credit facility.
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Industry Outlook and Growth Trends The Auto leasing and loans industry in the United States is expected to grow 7% over the next five years to reach $137.2 billion. The industry as a whole entered a “turn –around” phase in the latter half of 2012, according to several industry reports. The industry is tightly tied to consumer confidence, and the overall health of the economy. Market share concentration in the industry is very low, and the market is fragmented. The top four companies account for only 27.2% with that number decreasing at a rate of 1-2 percentage points a year. According to AutoTrader, used car prices have increased at an annual rate of 16% since plummeting in 2008, also something very positive for the used auto lending market as this means recovery value will increase in the event of a default.
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Price Performance: Looking at the price performance, the sell-off described above as a result of the acquisition break-up is shown in the one year price chart below. The stock is down 23.92% this year.
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Valuation:
Comparable Companies Analysis- For competitors in the industry we used Credit Acceptance Corp (CACC), Carfinco Financial Group (CFN), Santander Consumer US (SC), Marlin Business Services (MRLN), Microfinancial Inc (MFI), Regional Management Corporation (RM), Ally Financial (ALLY) and Consumer Portfolio Services Inc (CPSS). Comps were all chosen from the auto-lending industry
Precedent Transactions In 2013, White River Capital (RVR) managed to sell itself for 1.8x book value and an ROE of 11.07% (below NICK’s current ROE of 13%) to Parthenon Capital. White river was about half the size of NICK, and had a similar equity multiplier of 2.14 at the time it was bought out. The similarities of White River Capital and NICK are astonishing, as their free cash flow and operating margins were almost identical. If NICK were to be valued at 1.8x price to book, the same valuation White River got,
its stock would trade at $21, a current upside of 72.63%.
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Summary: In conclusion, we see NICK as a strong company with a consistent track record of free cash flow and earnings growth that has been given an unfair valuation by the market due to risk arbitrage fund sell-offs. The company operates in an increasingly competitive industry, and while growth will likely be non-existent in the next several years, rising interest rates act as a positive catalyst to kick-start growth and expand operating margins. With the October 21st press release, we see NICK taking actions over the next year to significantly increase shareholder value, and prove to the market that they should not be trading where they currently are. In the meantime, they are a prime acquisition target, and if valued in-line with comps and precedent transactions, an almost 80% upside exists for the stock. We are very bullish on NICK’s future and immediate share price.
Financial Statements:
Income Statement:
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Income Statement (cont.)
Multiples Analysis:
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Balance Sheet:
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Statement of Cash Flows
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Important Disclosures:
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The Babson College Fund (BCF) is an academic program in which selected students manage a portion of the Babson College endowment. The program seeks to provide a rich educational experience through the development of investment research skills and the acquisition of equity analysis and portfolio management experience. Please visit http://cutler.babson.edu for more information.
Analyst Contact Information
Ryan Diplock
1-413-695-6343
Contacts and Sources:
As there is currently no sell-side coverage of the stock, I was able to speak with the head of Investor Relations Mike Murrico. Mike talked to me about write off trends, how NICK’s reporting method (grouped in pools) is much more accurate than competitors’ reporting methods (calculating charge-offs on a net basis), and how this allows them to hone in on problem areas or trends much quicker.
I additionally tried getting in contact with several of the hedge funds that have been buying and selling the stock but had no luck getting past secretaries, and several e-mails I sent went un-answered.
I used Bloomberg, IBIS world, Seeking Alpha, and the investor relations page of the company to gather the majority of my information.