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Nicholas Financial (NASDAQ:NICK) had a good first quarter because of a drop in loan losses. Nicholas is able to make highly profitable loans while a lot of its competition is hurt. The company has only a fraction of the debt to equity ratio of its peers but because of its unique lending strategy and its ability to make an ROE of 20%+ in a normalized environment, I believe the company is worth at least $12 per share.

Nicholas Financial reported net income of $2.3 million for the three months ended June 30, compared to net income of $2.1 million last quarter and $1.6 million in the first quarter of 2008. Revenue for the just-ended quarter was $13.7 million, compared to $13.1 million a year earlier.

Things are beginning to improve for Nicholas as loan losses, operating expenses and the cost of borrowed funds fell in the quarter. Net income rose 34%.

The biggest issue I see is the company needing to increase its credit line and renewing it in November of next year. This shouldn’t be an issue because they extended their credit line last year without a problem. The credit line is for $115 million and they have $104 million drawn down. The line of credit has one key covenant, which is that the pre-interest-expense, pre-tax income must be 1.25x interest expense at the end of each month. They're at 3.8x as of this quarter. The company should have no problem there.

The economic indicator that best correlates to Nicholas’s charge off rate is the unemployment rate. The pre-tax margin for the quarter was 6.34% and the provision for credit losses was 6.16%. Credit losses would have to double from here to bring Nicholas into the red, a very unlikely scenario given that the provision for credit losses fell from 6.26% of average credit receivables to 6.16% in the current quarter.

Net charge offs fell from 8.94% in the fourth quarter to 7.72% in the first quarter. Management anticipates that losses absorbed as a percentage of liquidation will be in the 11%-16% range during the remainder of the current fiscal year. Losses as a percent of liquidation were 11% in the first quarter.

The loans that the company is making are getting more profitable as their competition has diminished during the credit crisis. The average discount of new loans purchased has risen to 9.29% from 8.87% a year ago. At the same time, the new loans are becoming more profitable they are also being made with more stringent credit standards.

From the first quarter 10Q:

The primary changes include; raising the minimum income required by the debtor to qualify for loan approval, reducing the maximum dollar amount that can be advanced for certain loan applications, and the maximum dollar amount that can be approved by a branch manager on certain approvals.

The average pre-tax yield over the course of the company’s history is around 9%. It is likely that it will be at 9% or higher again given that the loans being made now are of higher quality due to lack of competition. With $216 million in net finance receivables at a 9% pre-tax margin, net income would be $12.5 million. At the same time, the company is growing at more than 10% per year. With a multiple of 10x earnings, Nicholas is worth $125 million or $12 per share.

Each of the 50 branches is budgeted (size of branch, number of employees and location) to handle up to 1,000 accounts and up to $7.5 million in outstanding finance receivables, net of unearned interest. To date, ten of the branches have reached this capacity. The goal is to get all the branches to this level. If all the branches were operating at this optimum level the company would have $375 million in net finance receivables verses $216 currently.

One issue for the company has been attracting qualified branch managers who are able to run a small business and at the same time be street smart and tough enough to collect from non paying customers. In the CEO’s 2009 letter to shareholders, he said:

As a result of the spike in the unemployment rate, especially within financial services, we are now attracting a much higher number of quality job candidates than we have in the past. In many instances their company has either gone out of business or made considerable cut backs leaving them out of work or fearful of future layoffs. This recent change in the recruiting environment has allowed us to staff our company with several well-qualified people, making us stronger than ever. We believe this opportunity will help us to expand our Company, while our competitors pull back or in some cases, abandon our markets.

During the recession, management stopped all expansion to keep the balance sheet strong. Management is more confident with their current results so they have two more branches scheduled to open in the near future. This expansion will include new branch locations in Akron, Ohio and in Gastonia, North Carolina, which will bring the number of branch locations to 50 in 12 states.

Also, the company mentioned, for the second time, that it is interested in an acquisition: The company “remains open to acquisitions should an opportunity present itself.” In ten years, net worth has grown from $11 million to $88 million. Clearly the company has room to grow.

Nicholas is currently trading for $70 million with $88 million in shareholder equity. I believe that the company is worth $125 million and I added to my position a few months ago at $5. Company insiders also think that the company was cheap and have been adding to their already large holdings.

For more background information on Nicholas and my original write up click here.

All my posts related to Nicholas click here.

Disclosure: Author holds a long position in NICK

Source: Nicholas Financial: Q1 Earnings Say It All