JGWPT Holdings (JGW) is a direct-to-consumer lender to sub-prime borrowers, but does not face material credit or regulatory risk. It has a strong moat and has attractive free cash flow. The reason this stock is cheaply priced is because it is focused on an esoteric segment (purchase of structured settlements), has a troubled history (filed for bankruptcy during the 2008-09 crisis) and is not yet well known (it has a short history as a public company as it only IPOed in November 2013; its market capitalization is $500 million). Approximately 78% of the company's revenue comes from the purchase of structured settlement payment streams, which are paid out as a result of a settlement of a tort claim involving physical injury or illness.
Lending to Sub-Prime Borrowers While Being Exposed to Negligible Credit Risk
JGW pays the consumer a lump sum and receives periodic settlement payments directly from the defendant's insurance company. As a result, unlike most consumer finance companies, JGW does not take consumer credit risk as it receives payments from primarily A3 or better rated insurance companies, resulting in <0.1% cumulative total credit losses since 2002.
Lending to Sub-Prime Borrowers While Being Exposed to Negligible Regulatory Risk
As required by the law relating to structured settlements, JGW obtains approval by a court prior to purchasing all or part of a structured settlement. Given its expertise in this field, JGW has over 95% approval rate for the cases it brings to court.
The company's strong moat is based on its dominant market share and its strong consumer brand awareness, both of which enable it to have a dominant share of structured settlements, which it can then securitize to lower its funding cost to levels competition cannot match. The company's securitizations have over $5.1 billion in total issuance volume, representing $8 billion in payment streams, which equate to over 90% of the total outstanding guaranteed structured settlement and annuity payment stream asset backed securities (ABS) market. The ABS market is very attracted to securitized structured settlements since 1) they have very low credit risk as they are higher in seniority to all debt on the >A3 rated insurance company balance sheet, 2) cash flows are uncorrelated to any other asset class since tort claims have to be paid irrespective of housing prices, equity markets, debt markets, etc., and 3) there is no pre-payment risk.
The company generates most of its leads via customers initiating communication with the company. JGW owns the two largest brands in the structured settlements business and has a 70% market share. Since 2008, JGW has spent approximately 5x the amount of the nearest industry competitor in marketing (including TV advertisements) in an industry where consumer awareness is critical. Consumer awareness is critical in this industry because there is no database of potential customers. Management stated that it receives 67,000 inbound inquiries per month. Over the years, the company has put together a proprietary database of customers who have sold part of their structured settlement to JGW. Repeat transactions account for 45%-51% of JGW's transactions.
Very Attractive Cash Flow and Tax Characteristics
The company purchases structured settlements at an approximately 11% per annum discount rate and securitizes the assets at an approximately 4% per annum discount rate. For tax purposes, JGW's business model generates losses as a result of the material upfront marketing expenses, compared to revenue that is recognized over the lifetime of the purchased cash flow streams. As a result, the company has virtually no cash outflows for federal taxes. Management estimates that this tax benefit will continue over the course of the next seven-plus years.
Management estimates that there are roughly $130 billion of unpurchased structured settlement streams, (78% of revenue). Pre-settlements (6% of revenue) and medical liens are growing and remain largely untapped. Additionally, following the success of the merger between JG Wentworth and Peachtree, management believes that there are significant opportunities for growth through acquisitions.
DCF-based valuation = $26.70 (56% upside)
- DCF assumptions: 1) 2014 EPS estimate of $2.32, based on consensus analyst estimates; range: $2.20 to $2.43; seven estimates, 2) expected earnings growth: 10%-15% per annum based on the growth opportunity and moat detailed earlier, 3) 12% per annum discount rate, and 4) 4% terminal growth rate after 10 years.
P/E-based valuation = $26.68 (56% upside)
- A comparables-based valuation is difficult since other direct to consumer lenders underwrite credit risk and operate in a very competitive market place. These companies trade at a P/E between 10x and 14.5x. It is not unreasonable to say that JGW trades at 12x based on the valuation of these companies.
- If JGW traded in line with banks and other lenders, it would trade at a P/E of 11x.
You should note that GAAP numbers are not meaningful and the balance sheet appears more leveraged than it is in reality. Even though JGW securitizes all of the cash flow streams it purchases and only holds a residual interest in securitizations, the company is required to consolidate all the interests on to its balance sheet and recognize all earnings and expenses related to the securitized assets. In addition, the company is required to mark the value of its securitized receivables to market, reflecting interest rate moves, which are non-cash marks and results in changes in fair value flowing through the income statement, distorting true earnings. Adjusted net income is the measure provided by the company, which is economically relevant.
The rise of structured settlements came about with the passage of the Periodic Payments Settlement Act in 1982, which exempted structural settlements from federal taxation. JGW estimates that $140 billion of structured settlement payment streams are currently outstanding. JGW has a 70% market share, Stone Street Capital (private) is the second largest with a 7% market share and Seneca One (private) has an approximate 4.5% market share. Other players include Blackstone, Novation Capital, Woodbridge, Symetra Financial, and Client First Settlement Funding.
JGW started purchasing structured settlements in 1995. During the 2008-09 financial crisis, the securitization market shut down causing JGW to have liquidity issues and it filed for bankruptcy. The company received fresh capital during bankruptcy and emerged quickly. In 2011, JGW acquired Peachtree and it completed its IPO in November 2013. The J.G. Wentworth brand targets more price-sensitive and younger customers that are more Internet-oriented. Peachtree offers a high-touch customer service with higher pricing.
From the date of pricing the purchase to the securitization of the structured settlement, the company is exposed to fluctuations in interest rates. Should interest rates rise materially during this period, the company's cash flow and margins on these not-yet-securitized settlements will be negatively impacted. If the securitization market shuts down, like it did in 2008-09, the company will not be able to generate additional business unless it can access alternative funding at an attractive rate.
Learning from its experience in 2008-09 the company now has $600 million of financing capacity spread over four warehouse lenders. The advance rates are fixed and the lines are not subject to margin calls. Additionally, each facility has at least a two-year term and an amortization period of at least 12 months. Prior to 2009, the company had only $250 million available from only one lender, which had a 365-day term, a variable advance rate and a mark-to-market feature. Under the current financing structure, the company has adequate liquidity even if the securitization market shut down for 18-plus months, longer than it was shut during the 2008-09 crisis (10 months).
As stated its investor presentation, the company's business model is based on the simple premise that obligations, backed by strong investment-grade insurance companies, can be purchased at a discount to deliver strong economics while also providing compelling benefits to the consumer. As a shareholder, you are an owner of a company that lends to sub-prime borrowers, but does not fact any material credit or regulatory risk. You also own a company with a strong moat, attractive free cash flow, growth prospects and reasonable expectation of a 50%-plus upside in the stock price.