Wednesday, January 3, 2007

Nicholas Financial (NICK)

Note: I originally posted a longer version of this write-up on, 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 U.S. market along. I understand, you’re a bargain type guy, and you don’t like to overpay for anything, even your wife’s engagement present. So how about if Mr. Market puts this hot little number on sale, just for a short time, at a little less than 11 times reported TTM earnings? Not interesting enough? What if earnings may be substantially understated?

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.

The Opportunity:

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.

1 comment:

Randy said...

Scorpion Man posted the following note that started.

"I am not surprised the stock has sold off. I am somewhat surprised it has not sold off more. The credit trends are quite scary in the Q from what I read.

This, in particular, looks bad - I know its hard to read here, but its page 20 of the 10Q, and the key is to look at the percentages, which are increasing right to left (last yr to this year). THese are large increases. In a finance company, this is quite a big deal."

Followed by a quote from the 10Q showing how nearly all it's loss percentages have increased over the last year. My response is, yes, that's why it's on sale. I'm not panicked because I think these losses are relatively normal for their business.

Here is a better way to look at things (ignore direct loans as they are a tiny portion of the business).

Total Delinquencies %
2006 (Q3) 2.72%
2005 (Q3) 1.99%
2004 (Y) 1.54%
2003 (y) 2.20%
2002 (Y) 2.32%
2001 (Y) 1.90%
2000 (Y) 2.49%
1999 (Y) 3.03%

Charge Off Percentages
2006 7.26%
2005 5.83%
2004 7.26%
2003 8.13%
2002 7.63%
2001 6.16%
2000 5.88%
1999 6.84%

2006 is the worst year in Delinquencies since 1999, but 2.72% is not much higher than the average of 2.27% over that span. And chargeoffs of 7.26% are only about slightly above the 6.87% average over the eight years. I'm not happy about delinqencies being so high, but not yet spooked. Remember that these loans are generating about 25% per year in interest/fees. That leaves room for a pretty costly infrastructure (branch offices in small towns) and the loss rates you would expect from sub prime borrowers.

My biggest concern is that we aren't in a recession yet, unemployment is low, but delinquencies are climbing. Some of this is probably due to greater competition, and problems ramping new offices (bad new hires write bad paper).

Nicholas has gone through periods where the bigger competitors have loosened their underwriting standards and made life difficult for NICK. But NICK has made it through in the past while establishing that stellar growth rate.

So why do I still hold NICK? I don't see that anything has changed in their business model. If losses continue to increase I'd have to re-evaluate. But right now I have faith that Ralph and Peter will keep the ship on course, maintain their tight standards and slow growth if necessary instead of writing bad paper. I don't see any reason why they can't continue to open branch offices and grow their business successful.