Reader’s Take on Nicholas Financial
One of my readers wrote up his take on Nicholas Financial ($NICK) and I offered to run it here:
What Would You Pay For This Company?
by DTEJD1997
What would you pay for a company with the following dozen characteristics?
* Has a return on equity of 17.7%
* Has a return on assets of close to 9%
* was profitable through the 2008 financial meltdown
* Has made profits every year that it has been publicly traded
* Has increased profits in eight of the last ten years
* Has increased EPS at a compound rate of 13.71% for the past 11 years
* Has grown book value EVERY year for the past 10 years
* Has grown book value at a 16.75% COMPOUND rate for the past 10 years
* Has increased sales EVERY year for the past 10 years
* Has increased sales at compound rate of 11.68% for the past 11 years
* Has more shareholder equity than debt
* Is very conservatively managed compared to its peers
From the above financial metrics, we can see that this is a profitable, well-managed company.
Would you be willing to pay 10X earnings?
Would you be willing to pay 12X earnings?
Would you be willing to pay MARKET earnings?
Would you be willing to pay a small PREMIUM to market earnings?
Great! Well what can we buy into this company for? How about a 6.8 P/E ratio and a price to book of about 1.1X?
I almost forgot, it has a dividend yielding over 3%.
Sound interesting?
What is this mystery company? Why it is:
Nicholas Financial ($NICK)
I posit that this company is generally misunderstood and not given proper credit, resulting in an abnormally low valuation.
NICK will be eventually be valued at a more normal valuation level once it is commonly understood what a good company this is.
NICK’s Business Model
NICK has field agents that go to “buy here, pay here” auto lots. They work out of branch offices. They will look at the book of loans that the lot has and make an offer on what they believe are good credit risks. Typically NICK will pay about 91 cents on the dollar for the loans. The loans have average interest rates of about 24% and have loan life of about 48 months. The average amount financed is $9,700. NICK is looking for people that have temporarily bad credit or life circumstances that are temporary in nature. NICK does most of their underwriting using metrics OTHER than a FICO score. As a result of this, NICK’s buyers are very finicky and will only purchase maybe 1 in 25 loans that they look at.
Management also has a database on car values and the likelihood each one will enter in default. Certain models attract lower quality buyers. Certain models also hold their resale better if repossessed. Their proprietary database of vehicle defaults and liquidation values adds to their underwriting prowess.
A further addition to the margin of safety is that NICK typically pays only 91 cents on the dollar for the loans.
NICK is very aggressive about repossessing vehicles. They make it very clear that they will do so shortly after the loan is delinquent.
Here is my line of reasoning:
It is very probable that we will see a situation analogous to what transpired at America’s Car-Mart ($CRMT). (I owned and traded CRMT in the past but no longer own it.)
To briefly describe the situation: CRMT is the largest publicly traded “Buy Here, Pay Here” auto dealer. They operate in a slightly different manner than NICK, but operate in the same industry, sub-prime auto financing. CRMT’s management is also fairly conservative, and has traditionally had similar returns on equity and ROA as NICK has. CRMT has gone in price from about 11 to 44 in the past five years. They have increased earnings per share from $1.39 in 2006 to $3.06 in 2012. CRMT’s P/E ratio has gone from mid to high single digit (8 or 9), to low to mid teens (13 or 14).
What brought CRMT that higher valuation was sustained, steady growth in revenue and earnings. This resulted in increased investor awareness. CRMT became more recognized in the financial community with articles and mentions in VIC, Motley Fool, Investor’s Business Daily, Forbes, Seeking Alpha, and others. Increased revenue and earnings brought higher awareness, higher awareness has brought a higher valuation.
CRMT now trades for about a 14 P/E ratio. I think that CRMT’s valuation is about right and fully valued. If NICK can make it to CRMT’s valuation levels, it would be a double immediately. NICK does not have to reach CRMT’s valuation level to make it a market beating investment, it just needs to come close.
The end result was that CRMT increased its business and eventually found increased investor awareness and acceptance. It took many years for CRMT to accomplish this. NICK is ready to do the same thing.
NICK is conservatively run and unique in their industry for a variety of reasons.
* They review a large number of loans before purchasing, purchasing about 1 in 25 loans reviewed.
* NICK measures risk through factors other than raw credit scores, such as impressions made during an interview, income level, stability, type of vehicle and others. This is why the company has a lower charge-off rate.
* They hold the loans till they get paid off or default, there are no resales, and no loan securitization.
* Employee pay is based off of quality of cash flow from purchased loans.
* NICK is not heavily leveraged with debt. Debt is about $110 million versus shareholder equity of about $140 million.
* NICK remained profitable throughout the financial crisis.
If NICK were not well run, they would not have been able to post the numbers they have over the last 10 years.
Value of NICK’s Business
NICK’s management thinks that the sub-prime market is at least $250 billion in size in the US. Unfortunately, I think sub-prime auto lending is going to be a huge growth industry for the foreseeable future. In five years could the sub-prime auto loan market be $300 billion? I bet it could. Could NICK eventually get 1% of that? If they could, the company would grow approximately 10X. NICK has no operations on the west coast, plains states, or New England states. NICK’s field office now includes, sixty (60) offices located in Florida, Alabama, Georgia, Kentucky, Indiana, Maryland, Michigan, North Carolina, Ohio, South Carolina, Tennessee, Virginia, Illinois and Missouri. Thus, there is plenty of geographic expansion opportunities.
NICK is going to be opening 3 new branch offices in the upcoming 1st quarter of fiscal year 2013. So that will be growth of maybe 4% from new locations, as new locations take a bit of time to get fully up to speed. I strongly suspect they will open new branches in every subsequent quarter, maybe 1 each quarter. The existing 60 branch offices will probably grow to 65 locations by the end of the year. The existing branches should also be able to grow loan growth in the low single digits. Add it up and you can easily get 9% growth in loan volume. That might even be a bit conservative.
I am sure NICK could grow at a faster rate if they took on more underwriting risk.
It is clear that NICK is growing its business at ABOVE market rates. NICK also has plenty of room for future expansion.
NICK does not have large amount of debt relative to assets. They have more shareholder equity than they have in debt. As a result of this conservative level of leverage, NICK is not reliant on lenders to grow their business. NICK can grow out of retained earnings. NICK has about $136 million in shareholder equity, with an offsetting debt level of about $121 million. Compare this level of equity to your average bank! The average cost of NICK’s debt is about 4.25%.
Even with this low amount of financial leverage they are able to earn 18% ROE and a 9% ROA. NICK’s management is organically growing the company at about 9% a year.
NICK’s business has allowed them to produce SUPERIOR economic returns year after year, in up and DOWN markets. Clearly, NICK’s financial results are not a one time event. Nor are they are a result of management’s “luck”. NICK’s results are the result of talented management and workers, and a superior business model.
Businesses growing at ABOVE market rates and ABOVE market returns are what most investors are looking for.
A plausible argument can be made that NICK operates in a difficult market, and thus should have a discount. A plausible argument can be made that NICK is a small-cap company and should further trade for a discount. How much of a discount is warranted?
The S&P 500 is trading for almost a 16 P/E ratio. I would grant that NICK should trade for a discount because of its industry and size. Take off 1 P/E point for each and you’ll come to a 14 P/E. A 14 P/E is what CRMT is trading for. I think CRMT is a comparable company to NICK. Take off another 2 points just to be conservative and you’ll come to a 12 P/E. At the date of 5.4.12, a 12 P/E would put NICK at a price of $22.20, which is almost 10 points higher than where it currently trading for!
What could go wrong?
NICK operates in a business that is somewhat objectionable. Senior management is getting up in years and will probably be looking to retire and cash out in a few years. I don’t think they will take too low a price as they have already rejected a few buyout offers. There is a risk that up & coming management will not be as good as current management who started the company (and own most of it).
NICK is susceptible to downturns in the economy and most of their business is in the south-east (Florida) and the mid-west. NICK’s customers are very economically sensitive. A downturn in the general economy will hurt NICK’s customers.
NICK could be subject to regulatory scrutiny. However, I don’t think that is too much of a problem. After all, Congress did away with most usury laws.
NICK is vulnerable to other competitors in the industry acting irrationally. (Come on down to Jimbo’s used car lot! Just sign and drive! Every one gets financed! I’ve lost my mind! EVERYONE GETS CREDIT, JUST SIGN AND DRIVE!) This was a major problem in the past. Eventually, undisciplined, irrational companies run out of capital and go bust.
Conclusion:
The end result is that NICK should be trading at a much higher price-to-earnings ratio.
As time passes, NICK will continue to grow its assets. NICK will continue to increase earnings. NICK will increase its dividend.
Earnings of $0.50/share were reported for the last quarter. I think the company will easily top $2/share in earnings for the upcoming 12 months. It is only a matter of time before the market takes notice of this and bids the price of NICK up.
An investor is thus going to make money when:
A). There is an increase in the P/E ratio from under 7, to maybe a range of 12 or 14.
B). NICK is growing about 9% a year organically.
C). NICK is paying a dividend of about 3%, it is likely to raise it in the future.
I think an investor could easily receive a 20% IRR over the next 4 to 6 years.
*Please do your own due diligence. I and my family own shares in NICK and may trade them without advance notice.
Posted by Eddy Elfenbein on May 10th, 2012 at 1:19 pm
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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