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Nicholas Financial, Ever Heard of It?
What happens when an investor gets ahold of an under performing lending business anchored down by too much capital employed?
Disclaimer: I have a position in Nicholas Financial
"It’s quite smart to identify some investors you regard as very skilled, and carefully examine everything they’re buying, and copy what you please." - Charlie Munger
My goal for this post is for you to see why the company has become an interesting situation. This post is not a deep dive into the company specifically. Rather, it is more of a detailed description of the timeline of events that brought the opportunity to life. It also covers why I believe the players involved found this company interesting enough to buy 33% of it. A separate post will be written about the company and what I believe will be a good estimate of intrinsic value.
Thank you and I hope you enjoy.
A dollar is a dollar is a dollar. It all spends the same and doesn’t matter how you get the idea, all that matters is whether you’re right. I have made it a personal habit to study the investors I admire and do as Munger said. Thankfully Dataroma makes it incredibly easy. But there are some out there that are not on the website that deserve a follow, for me, The Magnolia Group and manager Adam Peterson is one of them.
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Adam is also the Co-CEO of Boston Omaha, $BOC, which I am an investor in. I have been following the Boston Omaha crew for about 6 years now and have come to trust them with my capital. I find them to be ethical and rational when it comes to capital allocation and I think they are building something special. If you’re interested I did a write-up on Boston Omaha that you can find here:
Adam still runs the Magnolia fund and makes investments from there for his partners. It’s pretty concentrated with about 12 positions in the book, the top 5 being over 75% of the portfolio. I plan to spend time analyzing the top 5 at some point but the one that caught my attention was one of his smaller investments that makes up only 2% of the book but personally the group owns 33% of the entity. I was tipped off to this information by this tweet:
It didn’t make much sense on the surface but I thought, “Okay, if Adam owns 33% of this company there is a real interest here. I should take a closer look” and boy did I find a thread to pull.
Founded in 1985 Nicholas Financial has been in the business of subprime auto lending. They focus on individuals who have enough creditworthiness to get a small loan to finance the purchase of a vehicle that is used as the primary mode of transportation to and from work. They don’t finance 2nd cars, luxury vehicles, or recreational products. They did, however, begin to make direct loans to current or former customers that ranged in size between $500 and $11,000. These loans represented a better credit risk given the history of the company, but they make direct loans (Not to jump forward but they no longer make direct loans, more on that later.)
Normally, these types of companies are not on my radar because there are a lot of things that can go wrong. The underwriting needs to be tight and they usually mark up more losses during downturns than the normal bank given their customer set. I have also read many $CACC reports and understand that this is a service needed and if done right, can be profitable.
Do I like the idea of giving someone with a credit history that screams “do not lend to” a 20% loan on a primary mode of transportation? Not necessarily but someone needs to lend to these people so I do believe the business of it is needed in society. I should also note the size of these loans merits them higher interest rates. On the most recent 10-Q, the average loan size was ~$12K with an average APR of 22.7%.
With that being the reality, why in the world would Adam want to own 33% of this company? It doesn’t scream anything special and the ROE has averaged 1.7% over the past 5 years. I think he saw 2 things. An asset he understood and excess capital that could be put to better use elsewhere.
Magnolia took their stake in the company during the 2017 fiscal year. During that year the company traded in a range between $12.50 and $7.59 and during that year the book value was $13.30 a share. Given this considerable discount to Book Value and his prior knowledge of the banking industry, especially auto lending, shown by BOC 0.00%↑ ’s 15% ownership of Crescent Bank (which does a lot of auto lending business) and Magnolia’s very large position in Nelnet NNI 0.00%↑ (which Adam sits on the board), ALLY 0.00%↑, CRMT 0.00%↑ , and ABG 0.00%↑ . I believe this looked like an attractive opportunity for him and his fund.
Magnolia has been involved going on 6 years now and in the first few years some change needed to happen. When they took their initial stake NICK 0.00%↑ wasn’t in a great place, the business that started as a subprime lender slowly began to venture outside its own circle of competence and begin lending bigger loans with smaller APRs to chase growth and keep volumes growing. Well, it didn’t work out well.
Within a few months of Magnolia coming in the current CEO resigned at the end of fiscal 2017 and was replaced by a Gentleman named, Doug Marohn. Doug was given the task of getting NFl back on track and bringing them back to their roots of profitable, subprime auto lending. Overall, it seems that Doug did what he was brought in to do and got the company back on track. He stepped in during declining profits and sat through two tough years of losses but returned the company back to profitability in 2019, 2020, and 2021.
Doug did the best he probably could have given the situation he stepped into. But it wasn’t enough.
The Tide Turning
At the end of NICK’s fiscal year, they announced the resignation of Doug and on May 10th appointed Mike Rost as intern CEO. On May 24th, 2022 the company reported results for the 2022 fiscal year and on the 25th the Board of Directors released an annual letter. This I thought was an interesting thing given boards usually don’t write shareholder letters but when I clicked on the document, it became clear who actually wrote the letter.
I am not going to say Adam wrote the letter but I am also not going to say with confidence he didn’t write the letter.
It goes on to outline why the changes needed to be made and what the plan is for the company in the future.
To the Shareholders of Nicholas Financial, Inc.,
For the fiscal year ended March 31, 2022, Nicholas Financial, Inc. (“NICK”) earned net income of $3.0mm. Book value per share grew 3.2% during the twelve months, increasing from $14.95 to $15.42. The Board of Directors, fellow shareholders owning over 35% of shares outstanding, and management do not find the fiscal 2022 growth rate in equity capital to be adequate.
Saying that, we have an abundance of equity capital at NICK, relative to our finance business’ size, and that excess capital acts as an anchor on overall performance when it sits idle, as it has for the past year. Our job as stewards of NICK is first to protect our collective shareholder’s equity capital but also to search out ways to put our equity into producing assets at sufficient investment returns.
This excerpt confirmed my thoughts about excess capital. The then board outlines how they view the company in two separate buckets. The first is the financial division (referred to as NFI) and the second is the parent company (Referred to as NICK)
At NFI, we generate earnings by collecting on finance receivables, and NFI held approximately $168.6mm of these receivables on a net basis on March 31, 2022. Our receivables base is financed by both equity and debt capital via our line of credit with Wells Fargo. Most subprime auto lenders hold $2.50-$3.50 of receivables for every $1 of equity capital. NFI ended the fiscal year with $1.45 of receivables per $1 of equity capital, meaning we use far more equity capital to fund our earning assets than the competition.
Too much equity capital is not a bad thing; your board and management prefer erring on the side of conservativism. However, our present capital structure is extreme in that it prevents competitive rates of return on total equity, even if we earned a competitive return on our assets. We seek a healthier balance of equity and debt usage going forward, which we believe may also incent NFI to operate even more competitively than it has in the past.
A prudent capital structure for NFI is $2-$3 of receivables for every $1 of equity capital invested, fluctuating at times based on the competitive environment for good customers and our scale. Using the mid-point of our preferred leverage levels, NFI would presently require the use of just $67.4mm of NICK’s $116.4mm of total equity on March 31, 2022, leaving $49mm of what could be called excess equity capital (more on how we may allocate this later).
In the twelve months ended March 31, 2022, NFI generated all the $3.0mm in net income reported at NICK. We believe the business could have generated around that level of earnings using approximately $67.4mm in equity, as opposed to using our total equity capital of $116.4mm.
I believe the above passage is a great way to think about capital use and how too much of it can drag on performance. A financial company, to me, is easier to assess in terms of this thought process because capital is the product. When the owners of a bank say, “We have excess much capital in our business” it’s much different than the owner of a farm equipment company saying the same thing.
Understanding this is key to grasping why the board decided to push in a different direction at the end of the most recent fiscal year. NFI, even after a few years of turning around, was not being run as effectively as possible even after the CEO did his best.
Alright, so NFI has too much capital, now what?
NICK/Parent Co Operations
NICK is our second bucket, which is simply the excess equity capital we believe we have of around $30- $50mm. To be clear, we are currently limited in our ability to use this equity capital outside of NFI’s business, due to our credit agreement with our lender.
At present, we have complete autonomy on just under $3mm of our excess equity capital, but to use larger sums, we need to be granted permission from our bank (something they have not been unreasonable about). Nonetheless, the board’s longer-term goal is to formally separate our excess equity capital from NFI and have an agreed upon process with our lending partner to either dividend future excess profits produced at NFI to the Parent Co, where it could be non-recourse to our debt, or reinvest our excess equity right back into NFI when opportunity warrants.
In the event NFI is not using all our equity capital due to a lack of high return opportunities, as is the case today, we have a few other ways to deploy the excess capital productively and tax efficiently that are worth mentioning:
• Share repurchases, and/or
• Acquisitions of businesses or assets related or unrelated to NFI
Sound Familiar? Too much capital in a company, going to try and get it out, and then allocate it to other uses that could be much more attractive using a return on the capital metric.
After this passage, the board describes an example of how they used capital in an unrelated asset investment when they purchased $4.2mm of stocks in late 2020 and then cashed out generating returns of $1.8mm. They also disclose how the speed of this gain was not expected and could have easily been a loss given the volatile nature of short-term price action in the markets.
I would have been much more standoffish about this approach if the people running the show didn’t already have a history of capital allocation and investing. Given Adam’s track record, this shift away doesn’t concern me.
In the end, the board’s hope with any new investment made or new business purchased would be to develop a new stream or streams of earnings power for NICK. A new, durable earnings stream has several potential benefits for shareholders: a source of additional earnings power for NICK, a possibly unrelated source of new capital for NFI to access when competitors and debt capital providers pull back in the subprime lending industry, and a competitive environment for capital within the company, which can instill more discipline in the capital allocation process.
Overall this overview was needed given all of the movement in the company. It meant something to me, as an analyst, that a company goes out of its way to be clear on its intentions and what they plan the future to look like. The level of transparency tells you about the integrity of the people running the place.
Since the Letter
The letter from the board was distributed on May 25th, 2022 and since then there have been some material events that have taken place.
New CEO: August 15th, 2022- Mike Rost was given a formal employment agreement as CEO of the company and was given a compensation plan of 250K cash and a stock bonus plan that states the company will match 100% of the shares purchased by the CEO during the employment period (which was written for one year) up to a dollar level of $50K. (Press Release)
On November 4th, 2022 the company announces a major change in operating structure and a servicing agreement with Westlake Portfolio Management.
Going forward Westlake Portfolio Management will be responsible for managing, serving, administering, and collecting receivables. In addition, they will also complete other duties that are common among financial companies (aka if the owner doesn’t pay they are going to organize the repossession of the asset). Overall they will act as the custodian of the receivables. Under the Agreement Nicholas will pay Westlake a boarding fee for the initial receivables and then more fees should they add any more receivables to the pool.
This is an entire facelift for the company. They are outsourcing all of the administrative duties and because of this on the same date the company announced it will be closing 34 of the 36 branches and laying off 82% of the workforce. There are now only 18 employees in the company.
Here was the explanation for the change from the most current 10-Q:
Change in Operating Strategy
On November 2, 2022, the Company announced a change in its operating strategy and restructuring plan with the goal of reducing operating expenses and freeing up capital. As part of this plan, the Company is shifting from a decentralized to a regionalized business model, but continues to remain committed to its core product of financing primary transportation to and from work for the subprime borrower through the local independent automobile dealership. The Company intends to scale down Contract originations to focus on certain regional markets and will no longer originate Direct Loans. The Company's servicing, collections and recovery operations will be outsourced. The Company's operating strategy also includes risk-based pricing and a prudent underwriting discipline required for optimal portfolio performance. The Company expects that this plan will reduce overhead, streamline operations and reduce compliance risk, while maintaining the Company’s underwriting standards. The Company further anticipates that execution of this plan will free up capital and permit the Company to allocate excess capital to increase shareholder returns, whether by acquiring loan portfolios or businesses or by investing outside of the Company’s traditional business. The Company’s principal goals are to increase its profitability and its long-term value.
In the outline of the disposal they state that in the first year, they are going to incur costs of around $11-12mm but after the initial restructuring is done the admin costs of years 2-5 are going to be in the range of $3.2 to 4.0 mm. Just to give you a rough idea of the savings, the company reported a cost of Salary and Administrative expenses of $32mm in 2022, taking away 82% and we get total savings of around $26m a year. If this is even close, the costs associated with the disposal will be paid for in the form of savings going forward.
With all of the administrative duties gone from the portfolio, NFI will now only be focusing on the purchase and origination of specific loans. I want to highlight the work done by Doug prior to all of this restructuring. He might not be running the business right now and but I do think he should be thanked for the work he did to turn around the loan book and improve its quality. His effort probably made it easier for the company to then outsource the administrative side of it to a third party without having to worry about whether the book was profitable or not.
The Future of Nicholas Financial
During the most recent quarterly report, they still stated over $100mm in book value. This was even after taking $9mm in loss reserves for the impending “recession”. When it comes to the future of operations the lower cost structure is going to offer benefits to owners that wouldn’t have occurred if they continued down the path they were already headed. These savings will free up more capital to either be invested in the loan book or allocated elsewhere.
If the point hasn’t been made clear enough yet I’ll make it simple.
There is too much capital in the business and it needs to either be distributed to shareholders or invested in assets that might be unrelated to the business of NFI. These investments could prove to be beneficial to shareholders in the form of new earnings streams for NICK.
Putting the pieces together makes me reminisce about other investors who have done the dirty work to go into a business, free top the excess capital, and allocate it elsewhere. It’s a study of capital allocation and the results going forward are going to be tied directly to how well the extra capital is invested. Given that the board is stacked with BOC people, Adam Peterson, Brendan Keating, and Jeffery Royal, I believe all capital allocation decisions will be coming through these guys and they occupy half of the board seats. They have the experience, they have the capital, and they have the voting power to make things happen.
To really tie together the mosaic that is Nicholas Financial I would like firmer answers to these questions
1) How real is book value? When we see $100mm of shareholder equity capital on the balance sheet and a current market cap of $40mm it’s natural to believe that some of the loans in the receivables portfolio are not going to materialize into earnings for the company. Is it less than half? I don’t know but it seems like a stretch to believe, if the underwriting standards are held, half of the loan book is a dud.
The outlook isn’t rosy and I am sure we will see some write-downs in loans over the next few quarters. In regards to how much, you’re guess is as good as mine but I do think it will be less than the current gap between book value and market price. If the recent insider buys are a signal of anything, I think they also believe it’s not as bad as the market is currently pricing.
2) How much excess capital will be available for investment outside of NFI? In their letter to shareholders, the board stated that there was between $30-50mm of excess capital. Is all of that going to be freed up to use? I’d say the odds are better than 50%. Back in May, there was only about $3mm available for full use. But this was when the company looked vastly different. Now that the receivables are outsourced and recently refinanced the company with more favorable terms (see below) how much capital does that mean? If there was that much before this change, does that mean there is the potential for more?
On January 25th, they released an 8K disclosing the new lending agreement with another segment of Westlake, Westlake Capital Finance. The new line of credit was $50mm and was used immediately to pay off the Wells Fargo line of credit ($43mm). This new lending agreement takes away some of the limitations on the excess capital that were imposed when Wells was the lender. For example:
The Loan Agreement also requires the Borrowers to maintain (i) a minimum tangible net worth equal to the lower of $40 million and an amount equal to 60% of the outstanding balance of the Credit Facility and (ii) an excess spread ratio of less than 8.0%.
I don't read lending agreements often but if I were to decipher this it would mean (using the latest Qs #s) there would be ~ $40mm in capital freed up from this refinancing. (109mm book value - (40mm required + 60% of $50mm)= ~$39mm). This is right in the middle of their estimates, plus I think the lender wouldn't be so different with the terms if they thought the receivables they just took responsibility for servicing were awful assets.
Here is another passage from the same 8K above (I added the bold):
As previously disclosed, most recently in its quarterly report on Form 10-Q for the quarter ended September 30, 2022, as part of its restructuring plan, the Company is scaling down origination of automobile finance installment contracts and is no longer originating direct consumer loans. Consistent with this significant reduction in footprint, the Company has reduced its workforce to 18 employees as of January 18, 2023.
As previously disclosed, the Company anticipates that execution of its evolving restructuring plan will free up capital and permit the Company to allocate excess capital to increase shareholder returns, whether by acquiring loan portfolios or businesses or by investing outside of the Company’s traditional business. The Company expects that the refinancing reported above reduces the limitations on use of its capital. However, the overall timeframe and structure of the Company’s restructuring remains uncertain.
When I came across the name I wasn’t expecting much, but I should have known better. Smart investors have a reason for everything especially when they are in control. Adam saw the opportunity to close in on a company that had plenty of extra capital sitting around that could be used effectively elsewhere. I don’t know what the plans are for the extra capital are, but you don’t need to know for this situation to be interesting. You have to be bullish on the people running it and based on their track record it’s hard to bet against it.
If there is a lesson I have learned while studying how conglomerates are built the beginning usually begins with a business that is way too overcapitalized and it becomes the job of the board to shrink the current operations to optimal size. The extra capital is then invested into other assets usually not related to the first business. Given the experience of the Board, I wouldn’t be surprised to see some investments into the areas in which they are already involved with their other businesses. (Billboards, Dundee Bank, Real Estate, Fiber Internet, or Stocks)
To me, this is an interesting situation that is still evolving before our eyes. I believe when we have firmer answers to the questions above there will be better clarity as to how the business will look into the future reducing the uncertainty that is currently being reflected in the market.
After doing the digging I decided to take a position in the company. A separate article will be written about the thesis and what can go wrong. What pushed me over the edge is the level of insider ownership by the directors, the massive discount to book value, and the high probability the entire market cap will be freed up in cash over the coming months. I am confident the allocators will invest it effectively for shareholders.
Peace and Love,
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Please be advised, Wall St Gunslinger is not an investment advisor and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you