NICK - Nicholas Financial

[wabuffo]

I tried to find a thread on this but there was only an old 3-message one from 2010 - so I thought I'd start one here.

 

This is an old (and much-written about) small-cap subprime auto lender.  Magnolia Capital (Adam Peterson - one of the two dudes from Boston-Omaha) owns almost 2 million shares (or ~24% of the common shares).  He's been continuously buying the stock over the last 2-3 years but is probably underwater on his investment, I would reckon.

 

So over the last six months, some new stuff has been happening.  They refinanced the majority of their finance receivables via a new credit agreement that moved them into a mostly bankruptcy-remote VIE structure.  The structure contains most of the receivables but 100% of the financing.  There are limited guarantees from the parent (so its not without some potential for loss).  I figured that this new structure might free up the new "holdco" to do things it couldn't do before - eg., make acquisitions, do share repurchases, etc.

 

Well - they did buy a $20m portfolio of finance receivables (and three new branches) after signing the credit agreement.  They also announced an $8m repurchase program. But at first, they didn't buy back any shares.  In fact, the recent press-release for the lastest Q out last week did not show a change in share count. 

 

But then the 10-Q came out a day or so ago and contained this little footnote.

https://www.sec.gov/Archives/edgar/data/1000045/000156459019043374/nick-10q_20190930.htm

 

.... The Company began the repurchase outstanding shares of common stock starting on October 2, 2019. As of November 8, 2019, the Company had repurchased 14,773 shares of common stock.

 

So that's kinda interesting... NICK hasn't repurchased any of its common shares since the 2014 tender, IIRC.  The business itself seems very ho-hum - but perhaps Peterson is getting more serious about erasing the discount to book value.

 

We'll see, I guess. 

 

wabuffo

[Cigarbutt]

...

This is an old (and much-written about) small-cap subprime auto lender. 

...

We'll see, I guess. 

wabuffo

Green shoots or false dawn?

 

This is a company I just discovered (Thanks). Here are some nonspecific and largely irrelevant comments on the industry dynamics and a humble take on various scenarios for the company.

 

The company now has interesting features: 1-improved underwriting profile since 2017 with an embedded lag and with a short tail that may not be fully reflected in the market price, 2-like WFC, it has been ‘hurt’ prematurely and slightly idiosyncratically during a longer than usual cycle by extrinsically induced growth suppression due to a temporary loss of way which may, paradoxically, constitute a blessing in disguise when this very unusual easy money cycle does turn and 3-they have refocused on a segment of the subprime market which may reveal itself to be more resistant than the less than pristine prime segment just above.

 

Random thoughts:

 

-The operations founded and run by the previous CEO (Mr. Vosotas) were impressive along most measures. He formed and led a consistent and solid culture. Subprime lending, in a way, is simple business. Simple but not easy. Especially in retrospect, there was an obvious lapse with the interim leadership after. I think the present CEO fits more in the mold of the initial CEO but these are difficult shoes to fill and to evaluate. This is an important aspect (+incentives) because the moat in subprime lending resides in the head office, to a significant degree.

 

-Mr. Vosotas (rightly) complained about how those with discipline have been actually penalized by poor policies before and after the credit crisis (easy money helped the buildup of excess credit across the board, helped the recovery but prevented the proper elimination of competition (incurring extra regulatory costs along the way) damped (swamped?) the upside (although NICK did quite well then relatively) and (this is the most damning part I think) allowed improper competition (the very ones ‘saved’ by the system) to come back and ruin the basis for adequate discipline based on reasonable and rational long-term return expectations). This is just the story with cycles except that the magnification aspect remains to be fully discovered. I wonder what would have happened if Mr. Vosotas had stayed at the helm. I tend to think that growth in finance receivables would have been flat, the after-tax yield would have gradually come down and the credit facility debt to equity would not have peaked as it did but I wonder if the end result (now) would not be similar (just more money funnelled to the owners instead of going through provisions etc). I also guess that the previous CEO would have dampened expectations about future prospects. However, today’s condition with a market cap of about 73M may overly reflect the muted outlook as the market does not tend to like firms that report (very) poor results for a while.

 

-I like the way Mr.Marohn (47) has taken over. The place had become messy. The tables he includes show the parameters he focused on and how the improvement in operations is tied to those key parameters (higher gross yields, discounts, lower amounts financed per car, stronger LTV ratios and shorter term durations). Going back to the previous charge-off policy to return to charging off accounts that are 121 or more days past due or upon bankruptcy is comforting even if it optically hurt results in 2019, when, in fact, this belongs to previous periods when discipline slipped. In the 1920s ("There he goes again..."), the Federal Reserve (which at least occasionally made sense then) was cautioning banks against extending loans “to people buying cars for pleasure”. It’s interesting that NICK decided to refocus on customers who buy reasonably valued cars for the primary purpose of going to work. There is an area (huge) in the auto loan business now that is considered less contaminated but that includes a significant part of the population who buy way too much expensive cars, who carry way too elevated loans for way too long terms, in comparison to their earning power but this time is different and that’s another story even if that means that the subprime population may grow perhaps the same way that fallen angels from the BBB population will massively migrate to the unpromised land, eventually.

 

-It’s interesting to look, going forward, at potential margin pressures on the yield differential from gross yield to after-tax net earnings. Car repossession is now much more ‘efficient’ with technology and sale at auctions but there may be downward pressures in the used car segment along the way. The legal landscape for "collection" activity may also offer occasional bumps on the road. Dealers also now have a built-in expectation to make money on the financing part perhaps more than on the actual sale of the merchandise (car) and that part may be sticky.

 

So far, this is all useless verbiage with almost no numbers but the rough copy of this post is full of numbers and tables which I’m simply too lazy to paste. But here are some numbers for valuation and then some scenarios.

 

A useful exercise is to compare years 2011, 2012, 2018, 2019 and Q2 2019. The new debt facility needs to be looked into for robustness but my take now is that a certain amount of flexibility (longer term) is exchanged for a potential exposure to variable and higher rates and to various credit 'enhancement' measures.

 

                                                        2011            2012            2018            2019            Q2 2019

end FR                                              230.2          242.3          266.6          202.0            222.3*

avg FR (net of UI)                              251.0          273.0          327.8          270.1            232.0*   

pre-tx yield (%)                                  10.8            13.3            0.9              (1.7)              1.0

end SE                                              115.2          135.3          108.4          104.9            105.8             

end facility debt                                  118.0          112.0          165.8          145.0**        119.5 

interest expense/avg debt (%)              4.9              4.2              5.4              7.0              6.9

# branches                                          56                52                60                53                51*

 

* reflects the acquisition of three branches

** does not reflect excess cash of about 25M on balance sheet

all results absolutely unaudited

 

 

Scenario #1, sort of a baseline scenario

The new normal continues and somehow NICK plays a slightly above average game. In the next 5 years, finance receivables grow by 3% per year and pre-tax yield gets to 8%, tax rates revert back and after-tax yield gets to 5%. Then the market attributes a PE of 8 to 12. Debt to equity remains constant and free cash flow is used for buybacks bringing down share count to about 7M. Under these assumptions, one gets a CAGR of 10-20%.

 

Scenario #2, sort of like when history rhymes

Timing is difficult to ‘predict’ but the credit cycle may eventually impose discipline in correlation to the overall recklessness and then, if the last credit crunch is any guide, share price may be divided by 4 or whatever and it may take something like five or six years for the price to recover even if your appreciation of the intrinsic value doesn’t change that much along the way. In a way, NICK is better prepared this time but the transition may require unusual alertness and creativity on the funding side.

 

Of course, this is work in progress and there are many other scenarios but the stock has been put on an opportunistic watchlist.

A very long post for such an illiquid name but c’est la vie.

 

[wabuffo]

CB - welcome aboard.  I've owned this off and on since 2007(!)  Please feel free to post some more as you get more familiar with this name.  I don't think these guys have any particular advantage when the industry has loads of capital.  The only time they really made hay was post-GFC when capital fled the industry.

 

I like the new ownership and CEO (though the CEO was a past no.2 who left in 2013(?) when he didn't get the top job after Vosotsas retired).  Back then, the job went to the then-CFO who made a hash of things.  Marohn came back and has been cleaning up the mess.

 

As I said, what's got me interested is the new structure.  In this case, I think structure follows strategy - though mgmt has not told us what this new strategy might be.  Peterson does seem to be a Buffett-wannabe.  But just because folks can quote Buffett, that doesn't always translate into solid operational knowledge about running an actual business  8)

 

wabuffo

[SharperDingaan]

You might want to look under the hood.

 

Sub-prime auto-lending is a viscous spread business. You hope the credits can keep paying their bills, you can re-possess quickly and with little damage, and that most accidents are outright write-offs (insurance payouts in full) vs fender benders. End of lease cars are typically poorer quality than average, and fetch less at auction.

 

Good operators need to buy the 'end of model year' cars, in bulk, all at a single time, and at cents on the dollar. They also need to continuously mismatch assets & liabilities in a big way, stay in the low-end cars. Helpful if you can sell paper at higher prices during the good times, and buy it back cheap as soon as the economy experiences a hiccup.

 

It can be very profitable - but to do it reliably you need to buy out somebody, immediately put them into runoff, and fund on a revolver with a very low cost of funds. And negotiate for a commission to put the newly displaced (& now improved credits) into a specific car-makers vehicles.

 

Used to be a treasurer in a former life - one of these every 2 years is a nice little ROE booster ;)

 

SD

[Cigarbutt]

You might want to look under the hood.

...

Subprime lending is indeed not a topic that will be popular at cocktail parties, at least some of them.

@wabuffo

Perhaps I'm missing something or drinking the kool-aid (again) but it does not seem that there is a link between an evolving strategy and the change in funding.

Overall, delinquencies on auto loans (more so for the subprime segment and more so with more recent vintages) have been slowly creeping up and traditional banks, especially since 2016, have started to tighten standards and shadow-banking securitization has taken up some slack. That may say something about overall trends but, for NICK, it may be simply that bank terms and rates became less favorable and NICK looked elsewhere for alternatives. The new financing facility comes with negatives and positives and, so far, it's not clear how this, in itself, may affect capital allocation decisions.

Also, even if the overall wind eventually turns, terms and rates may tighten some more, but I suspect that the underlying performance of the asset-based securities of the new facility are unlikely to trigger capital commitments and what not. We'll see, I guess. 

 

[wabuffo]

CB - the new facility gives them some operational and strategic flexibility that they didn't have before.  They have basically "sold" the receivables they placed in the new structure - retaining the equity and first 10% of creditor losses above the equity tranche.

 

They didn't put all of their receivables in the new structure - so what is the plan here?  Is this portfolio in run-off?  Are they shrinking?  Are they going to acquire more on-balance sheet loans outside of the NF-Funding-I-LLC Off-Balance Sheet Structure?

 

The new structure also gives the "holdco" financial flexibility to do acquisitions, share repurchases, etc. all of which was very limited before when the financing was co-mingled on the balance sheet with all of their assets.

 

So perhaps - its just about giving them optionality in a very competitive industry where sometimes you need to zig when everyone else is zagging...  I dunno. 

 

But its definitely different.  Different could be good (aggressive repurchasing of common shares) or it could be bad (diworsification).  Its got my attention.

 

wabuffo

[Cigarbutt]

CB - the new facility gives them some operational and strategic flexibility that they didn't have before.  They have basically "sold" the receivables they placed in the new structure - retaining the equity and first 10% of creditor losses above the equity tranche.

...

But its definitely different.  Different could be good (aggressive repurchasing of common shares) or it could be bad (diworsification).  Its got my attention.

wabuffo

Hi wabuffo,

 

I disagree and, by trying to prove you wrong, want to learn.

I also want to divert my attention from an investment that is feeling like a thorn in my side.

 

In fact, this has to do with a different interpretation of the underlying facts which may be slight but also material if you think that the new funding structure signals something.

 

In short, I don’t think that NICK developed a grand plan with the securitization as a tool to reach that plan. NICK has reached a stage (in the turnaround) that allows them to now consider other capital allocation decisions but I see the new funding structure as an extrinsically imposed option and the new credit facility does not provide that much additional and material flexibility, by itself, on a risk-adjusted basis. This new credit facility is different but it just feels as if the company had been able to obtain, somehow, new bank-type debt from another syndicate, on slightly different, more adapted and perhaps better terms overall.

 

Why?

 

1-Funding pressure from the banks has built up in the interest expense numbers for NICK in correlation to what is happening in the aggregate and tightening standards hardening has outpaced the improvement in NICK’s finance receivables operations. More specifically, the disclosure reveals that multiple waivers have been obtained and it looked like 2019 had potential modified covenant breaches coming up:

“The Company’s operating results over the past two years provide indicators that the Company may not be able to continue to comply with certain of the required financial ratios, covenants and financial tests prior to the maturity date of the Line of Credit in the absence of an amendment to the corresponding credit agreement or waiver.”

 

And then the credit facility was reduced to 140M. So, it seems that NICK was ‘encouraged’ to evaluate other funding alternative and I wonder if the securitization was not a default option.

 

2-There is a component of a technical “sale” in the securitization but, in substance, the 'deal' is equivalent to a secured debt structure with financial receivables assets designated as collateral, with a specific 82.5% limit of the debt based on a certain definition of transferred receivables and advances. Also, no gain or loss were recognized at inception and both the assets and debt remain consolidated on NICK’s balance sheet. That’s because the VIE 1-carries with it retained exposure to negative and positive developments, 2-is effectively controlled by NICK and 3-Nick clearly remains the primary beneficiary.

 

-----

 

The new funding did come with some flexibility and some of that helped to complete the small Molina acquisition. My understanding is that NICK could contribute additional finance receivables to the VIE in order to obtain dollars in exchange but the flexibility is relatively limited and I would say NICK’s potential energy has been increasing but it remains tied to a relatively tight leash. It seems also that they should shop around for protection against unexpected variable credit spread widening that could occur in the foreseeable future. But who I am to say?

 

[ratiman]

This is a really basic question but if Nick makes a loan for $10,000 and NICK turns around and transfers that to Ares, NICK is exposed to the first 17.5% of losses? So if NICK has $200M of receivables the max loss is around $35M?

[KJP]

This is a really basic question but if Nick makes a loan for $10,000 and NICK turns around and transfers that to Ares, NICK is exposed to the first 17.5% of losses? So if NICK has $200M of receivables the max loss is around $35M?

 

I assume you're getting the 17.5% max exposure from the fact that borrowing under the credit facility is limited to 82.5% of the assigned receivables.  But NICK has also provided a limited guaranty, making a portion of the debt recourse.  So, I believe the structure works like this:

 

NICK originates $100 million in receivables and sells them to wholly owned SPV for $82.5 million, which the SPV obtained by borrowing under a secured line of credit that the SPV has with Ares.  The purpose of this structure is to make those receivables assets bankruptcy remote from NICK.

 

If, for example, the receivables ultimately were worth only $50 million, then all the receivables in the SPV would go to Ares, resulting in a $17.5 million loss to NICK, i.e., the difference between the initial $100 million value and the $82.5 million NICK already received from the SPV for them (this initial "loss" amount isn't show in NICK's consolidated financials at the time of the sale to the SPV because the SPV's financials are consolidated).  NICK also would be liable to Ares for a portion of Ares's remaining $32.5 million loss under NICK's limited guaranty of the SPV's liabilities.  You have to look at the guaranty (which was disclosed in an 8-K) to see what those amounts would be.   

[ratiman]

OK thanks. Certainly that deal is looking pretty good now, although buying the $20M portfolio in late February doesn't look so good. Pederson has no intention of being a long-term passive shareholder in a small indirect auto lender, right? The goal here has to be to buy NICK at some point. Well, right now is as good a time as any.

[Cigarbutt]

^i would say the transfer of receivables to the SPV is not a true sale. In substance, it's equivalent to a secured facility. NICK is ultimately responsible for the losses, has to provide guarantees and potentially NICK's assets are considered collateral.

Looking at what happened around 2008, when exposure (net FR) was similar in quantity, from 2007-8 to 2009, provision for credit losses went from 3.7M to 7.8M to 16.4M. The quality of the portfolio is probably not as good although the underwriting profile has changed for the better with the new CEO and only the last layers of the previous tenure still need to be run through. The credit facility has a three year commitment and, even with rising recognition of credit losses, NICK could slow down, for the time necessary, the purchase of contracts. The overall leverage (debt to equity, debt to end FR) is relatively low especially at this stage of the cycle. The typical subprime client for them needs a car for basic functions of life and may be more resilient than in other credit segments.

 

The following is submitted for valuation purposes (year 2008 chosen because it's relevant)

IMO present earning power is muted and there are expectations (founded but that may be overestimated) of rising credit losses.

Unaudited numbers in M

 

                              2008(yr-end)              2019(yr-end)              2020(Q1,2,3)

int+fee income                50.0                          71.3                          47.2

oper. expenses                20.4                          33.5                          25.8

provisions for losses        7.8                          32.8*                        13.0

interest expense              6.3                            9.5                            6.7

 

pre-tx income                15.6                          (4.5)                          1.7 

 

*includes an amount recognized which was a non-recurrent item in order to revert back to previous conservatism.

[wabuffo]

NICK this morning issued an 8-k that formalizes the interim CFO's employment contract and gives her the same change-of-control provisions that the CEO has (his employment contract was also updated and extended).

 

Is NICK about to be sold?  Its up a bit in a generally-down market.

 

wabuffo

[wabuffo]

https://www.sec.gov/Archives/edgar/data/1000045/000156459021003940/nick-ex991_6.htm

 

Great earnings report.  Used car resale values are booming.  Surprising good credit loss metrics during a pandemic - so much so that it appears they reversed some loss reserves.  New VIE structure has also allowed them to repurchase shares on a regular basis and now is a good time to be buying back shares when price-to-book is low.

 

wabuffo