November 19, 2016 - 2:24pm EST by
2016 2017
Price: 9.85 EPS .95 0
Shares Out. (in M): 8 P/E 10 0
Market Cap (in $M): 76 P/FCF 0 0
Net Debt (in $M): 205 EBIT 0 0
TEV ($): 281 TEV/EBIT 0 0

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Nicholas Financial is a well-run niche subprime auto lender trading at 70% of book value and
approximately 10x severely depressed earnings. Nicholas has historically earned returns on equity in the
Most subprime auto lenders have portfolios in the billions, and run underwriting and collections from a
central location. This portfolio size gives them the benefit of scale, and the centralized operational
model gives them low operating costs. However they tend to have high loss rates because this scale
model is more suited for a scattershot approach to lending than a selective approach.
Nicholas, in contrast, runs a portfolio that is just $400M in size. The company has individual regional
branches for underwriting, and up until recently, collections as well. The branches allow for more
informed underwriting, reduced dealer fraud, and easier repossession. The company is a skilled
underwriter, with a deep and long-running culture of conservatism. The company has never lost money
in a fiscal year. It earned a healthy profit even in 2009.
So why is the stock cheap today?
Easy access to capital and low interest rates have massively increased competition for
subprime auto loans. Subprime auto was historically regarded poorly by investors, but the asset class
performed well during and after the crisis, and now lenders of all types (money center banks, private
equity firms, credit unions, start-ups, etc.) have pushed into the market in search of yield. I think many
of them will eventually leave bloodied, but until that happens, the profitability of the industry has been
and will be very depressed.
Increased competition has had a number effects. The gross interest yield paid by the borrower is down.
The price paid by the lender to the dealer for purchase of the loan is up. Loan sizes are larger, and loan
terms are longer. Since loan terms are longer, cars have more time to break down, and when they break
down, the borrower usually stops paying. And in some cases, borrowers who are behind on a loan are
being encouraged by another lender to default on the existing loan and instead take a new loan from this
other lender.
The table below shows the financial effect on Nicholas of the increased competition. In short, gross yield
on loans is lower by 150-200bps, and loss provision is up by 300-400bps. The combined effect has more
than cut profitability in half, from 900bps to 400bps.
  Historical Current
Contractual APR 24% 22.5%
Discount at which loan is purchased from dealer 9% 7.4%
    Gross interest yield 28% 26.4%
Cost of borrowed funds -5% -4.3%
% of portfolio financed with debt 48% 61%
    Interest expense -2% -2.6%
Loss provision -6% -9.5%
Employee costs and overhead -11% -10.4%
    Net pre-tax portfolio yield 9% 3.9%
ROA 6.3% 2.5%
ROE 13.8% 7.8%
Leverage ratio 2.2x 3.0x
The numbers are ugly, but this chart actually gives me hope. Nicholas has always earned more profit per
loan than the industry as a whole: I would estimate the company’s average historical pre-tax yield at
about 900bps (of the portfolio), compared to something like 400-600bps for the industry as a whole. If
Nicholas is only earning 400bps today, then many lenders must be earning razor thin margins, especially
if they are reserving properly. I suspect that when the economy goes into recession, many lenders will
find that their portfolio is not worth par. They will stop lending, competition will decrease, and Nicholas’
margins will move back up. However, this process will take time, and likely will require a major event
(such as a recession or the bankruptcy of large lender) that acts as a catalyst.
In the meantime, the company is bordering on overcapitalized, and because growing new loan
originations is not attractive in the current environment, I expect the company will look to return capital
to shareholders through buybacks. The current CEO, Ralph Finkenbrink, became head of the company in
2014, after serving as CFO and/or SVP of Finance since 1992. He has stated a preference for repurchases
over dividends. His first major action as CEO was to effect a tender offer for 38% of the outstanding NICK
shares at $14.85. Although the stock price is lower today, I believe the tender was nonetheless done at a
price well below intrinsic value, and thus was a large act of value creation.
Using historical profitability, Nicholas’ current portfolio would be earning something like $2.50 in EPS
today. Perhaps part of the increased industry competition is permanent, and margins will never reach
their previous highs. But even if this is the case and NICK only earns $2.00 or even $1.50, the current
price is still very cheap, and I am confident that NICK will continue to build intrinsic value over time
through smart use of retained earnings.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Recession, buyback, bankruptcy/crisis at competitor

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