Wednesday, September 19, 2007

Nicholas Financial Inc. (NICK)


NICK purchases sub prime automobile loans from car dealers in the south eastern U.S. through its branch office network. The company also makes direct loans to current or former customers. Direct loans made up about 7% of loans originated during 2006.

NICK has 47 branch offices, 19 are in Florida. Before opening a branch office NICK will study the market to determine if its strict underwriting criteria will be successful in that market. The branch officer will attempt to establish relationships with local automobile dealers. Their goal is to have each new branch contributing $300K in pre-tax income within 3 years. It takes 12 months for a new branch to earn a monthly profit and about 18 months to recoup start-up costs.
NICK’s branch network allows it to establish relationships with clients. The office network requires more employees and higher expenses but the company has much better relations with borrowers. The result is delinquency rates that are incredibly low about 2% on average.
The current CEO Peter Vosotas founded the company in 1985. It is obvious that he has impeccable morals. In an industry where quality is sacrificed for quantity and next quarters earnings are more important then next year’s, it is really amazing to see a company like NICK.
See the chart below for historical growth and profitability metrics.

Strict Underwriting Discipline

"When yields on loans look temptingly high, we always try to remember that the return of your money is more important than the return on your money." - Inside cover of 2007 annual report

"The Company will not sacrifice credit quality, its purchasing criteria or prudent business practices in order to meet the competition." - Page 10 of 2007 10-K

NICK’s discipline is obvious, they are the only sub prime auto. lender that holds the loans on its books and doesn’t securitize them. The branch manager’s bonuses are tied to the performance of the loans that they made.

Competitors use credit scores as the main indicator of credit risk, allowing their central offices to process large volumes of loan applications and approvals to keep costs low. Nicholas feels credit scoring alone isn’t the most accurate indicator of individual borrowers risk. Two clients with identical credit ratings can offer much different risk levels. Nicholas administers phone interviews with each client. NICK places a high value on impressions made during the interview process. Nicholas primarily measures risk through factors other than raw credit scores, such as income level, stability, type of vehicle and previous credit history.
"We try to finance people who may have had trouble because of a divorce, medical problems or job loss, as opposed to 'credit criminals,'' said CFO Ralph Finkenbrink.
Amazingly, Nicholas turns down 85% of potential clients. NICK’s unusual credit review process allows it to purchase loans that most competitors wouldn’t touch but actually offer a better credit risk.
NICK is also amazingly strict when it comes to delinquent borrowers. The company will call the borrower the first day the loan becomes delinquent. Once, a deadbeat skipped town and the collections officer at the local branch office went to the home of the borrower and dug through the trash until he found the address of the borrowers parents. NICK installed a surveillance camera outside the home and repossessed the vehicle. All for $1,000. Historically the Company has recovered approximately 10-15% of deficiencies from such customers.

NICK purchases its loans at a discount to the loan amount usually 1-15% with the average being 8.5%. It accounts for this discount as a reserve for credit losses. Then when the loan is nearly paid off it accretes the portion of this reserve not charged off, to income. This could be a strong case for understating net income. Recently however, with the increase in delinquencies the amount accreted has dropped and this has negatively affected earnings.
NICK has done very well over the long run. During the weaker parts of the credit cycle NICK simply slowed its branch openings and waited it out while weaker competitors went bankrupt. The poor credit market we are in will benefit NICK in the long run.

Here is some historical info on NICK:

Click here for a larger version

The Investment Opportunity

Obviously, the issues in the credit market are negatively affecting NICK’s results and its stock price. But, unlike other sub prime lenders NICK didn’t make risky loans or leverage up. NICK currently has a debt to equity ratio of 1.3 which is amazingly conservative. For the first quarter of this year NICK earned 2.8 million compared to 3 million in the first quarter of 2006. The reason was a 48% increase in reserves for credit loses and lower accretion of discounts. NICK’s pre-tax yield as a percent of finance receivable was about 10%. So, in other words, of the 24.2% average interest rate that NICK’s customers pay on their loans, NICK’s pre tax earnings on that are 10% of the net finance receivable. NICK can withstand a lot if its operating margin is still at 38%. There is a nil chance that NICK will run into any serious problems because of the current credit market. Unlike their competitors they don’t have to worry about margin calls on their debt. And because of their conservative lending they will be the one that benefits from their competitors recent mistakes.
"There's always opportunity when there's distress and carnage," said chief financial officer Ralph Finkenbrink. "You've just got to figure out where it is. It hasn't happened yet, but we expect there will be availability from companies exiting the business or just putting portfolios up for sale."

If we take the average net portfolio yield over the last 11 years, which is interest income - interest expense and provisions for credit losses as a percent of net finance receivables, which is 20.5%. Then subtract 10.5% for expenses and subtract a 38% tax rate and the result is net income of 6.2% of net finance receivables. 6.2% multiplied by 184 million (net finance receivables) =’s net income of 11.4 Million. So this is a company trading for less then 8 times earnings that will benefit from the current credit crisis, has management that has proven that they do what’s best for shareholders and with a growth rate that should continue at over 20% a year as it has for the last 5 years.
The author has an investment in Nicholas Financial.