Note: I originally posted a longer version of this write-up on ValueInvestorsClub.com, Nicholas is one of my favorite companies and is currently one of my largest positions.
How much would you pay for a company that’s grown same quarter revenues and earnings for 65 out of it’s last 66 quarters? That’s grown EPS from 12 cents per share to $1.08 per share over the last ten years (23.6% annualized). A quality company with solid financials built solely through organic growth, (no rollup), with at least another decade of strong growth ahead in the
Nicholas Financial exists in the toughest part of the sub-prime auto lending business, and has a unique “hands on” approach that is responsible for high profitability and low loss rates with very low credit score clients. As opposed to other (mostly larger) lenders that centrally automate their approval and collection systems with a focus on maximizing loan productivity, Nicholas handles all clients through local branch offices, in order to get to know them more closely. This means the Nicholas office is close by when clients need to make payments, new applications, and most importantly, when collections are necessary, which helps reduce losses.
Competitors use credit scoring as the main determinant of credit risk, allowing their central offices to cost-effectively process high volumes of loan applications. Nicholas feels credit scoring alone is not the most accurate gauge of individual client risk as two clients with identical credit ratings can offer much different risk levels. Nicholas to measure risk through factors that supplement raw credit scores, such as income level, stability, “life” trend, etc. This allows NICK to “cherry pick” clients who have lower risk than credit scores alone would indicate. Even then, Nicholas turns down 85% of potential clients.
One of the most attractive qualities of Nicholas is that they do not securitize their loans. This makes their balance sheet clean and easy to understand, and contributes to their quality of earnings. By not securitizing, they actually take long term ownership of their loans. This provides a strong incentive to underwrite conservatively. Because of this, accounting is also conservative, loan discounts are kept as loss reserves and aren’t recognized until the pool is liquidated or the pool is determined to have excess reserves.
Leverage is very low (1.35-1 Debt to Equity).
Historically the ratio has been higher but a secondary offering in 2004 substantially increased equity. So the risk in the balance sheet revolves around the quality of loan reserves, and the fact it is borrowing short-term, to loan longer term. Since I believe the reserves are strong, and the balance sheet is so lightly leveraged, I see both risks as limited or manageable.
The lower leverage since 2004 has had the effect of lowering ROE, which has declined into the 17% range since the secondary. From a conversation in early 2006, management expects the debt to equity ratio to increase as they grow and add more loans, but to stay under 2.5-1 for the next three years. They feel comfortable with any ratio of 3.5-1 or below.
Nicholas’ real competitive threat is irrational pricing in the market. The sub prime financial business has gone through irrational pricing periods, until there is a shakeout and some firms go under. This has not happened since 1996-98 when cheap public money flooded the segment. So far, today’s competitors are more rational about pricing. If pricing turns unreasonable, Nicholas has been disciplined enough in the past to give up bad business rather than lose underwriting discipline. Evidence of this is found in 1997, revenues grew only 10% and profits 20% during a period of irrational price competition.
On Nov 2nd, NICK reported disappointing earnings (by it’s standards) in it’s second quarter. Net income only increased 10% year over year, and was actually down over first quarter (27 cents vs 29 cents). In response, the stock declined to the low $11 range, and only recovered a little bit since.
A variety of factors are squeezing their results. Borrowing costs are up a half percent, while loan rates are static. Write-offs and charge-offs have increased. NICK has benefited in the past from a rosy economic climate, and it appears to be in the worsening part of the cycle. Finance receivables have only increased 15% year over year, and operating costs are up slightly proportionately. This leads me to suspect that several recently opened branches aren’t up to speed yet and this may be a drag on quarterly comparisons.
The question to ask, has anything material damaged their business? I don’t believe so.
The key number for me is that 15% growth in finance receivables. Even 15% per year is still excellent, and justifies a much higher PE ratio than it's currently trading at. There are no real limits to their growth at this stage, with many more states to expand into, as well as more markets in current states. My belief is that we may have to deal with some slower growth in the short run if credit losses are higher, but in the long run earnings will keep up with financial receivables growth. Even if EPS growth over the next ten years averages 15% per year, NICK would deserve a much higher PE ratio than 11, I’d think closer to 20. So right now I believe it’s trading at quite a discount to intrinsic value.