Most people have never heard of Springleaf Holdings (LEAF). And that's a shame, because I believe the nation's newly public second-largest dedicated provider of installment loans is extremely well-positioned for a rising rate cycle in a post-Crisis financial environment. The stock went public at the end of last year, and a lack of analyst coverage and track record (first earnings date as a public company is scheduled for March 10th), have left the stock under-followed thus far.
Springleaf has several major drivers for long-term share price appreciation, in my view. First, while the company has more than 800 offices in 26 states right now, making it the second-largest player in the space behind Citigroup (C)-owned One Main Financial (1,300 offices), I think the firm can add locations for years before saturating the market. This is especially true given most large money center banks seem to be looking to exit this area of finance, as I will discuss later. (Indeed I think it's possible that One Main could be spun off or sold by Citi in the next few years, perhaps even to LEAF, in a move reminiscent of AIG's recent deal to sell ILFC to AER - see my article on AER for more on that deal.)
(All figures taken from company filings available here.)
Second, Springleaf had a pretty weak online presence until recently, but last year the company started a new division which should change that and let the firm grow its customer base substantially. Third, LEAF was in the real estate mortgage business for a long time, but in 2012, the firm stopped originating loans and is slowly getting out from under the burden of bad loans made during the financial crisis. My 2014 estimates reflect these losses, which should be largely written off by the end of the year. (The firm started writing down loans in earnest last year, which is why 2013 GAAP EPS makes it look like the company is losing money - it's not, or at least it's not on an adjusted or on-going basis.) The conclusion of real estate losses will lead to an explosion in earnings power from LEAF, with my 2015 EPS estimate of $2.55, with double-digit EPS CAGR thereafter.
Finally, LEAF has ancillary insurance operations that it operates out of its branch offices, mainly selling insurance to people who come in for a loan. From what I can tell about these operations based on the firm's public filings, I am not impressed with their efficiency. I think LEAF has neglected this division in favor of focusing on its core business. This is reflected in my earnings expectations and the market's current price. Yet, if there is one redeeming virtue of the publicly traded equity markets, it is discipline. Equity markets do an outstanding job of forcing discipline, efficiency, and a single-minded drive toward profit maximization onto firms. (If you don't believe me, just look how far Facebook (FB) has come in the last year. Valuation aside, it is a much better business than it was a couple of years ago.) So rather than look at the insurance operations as a liability or a weakness, I view them as an opportunity to improve shareholder value in the future. The insurance segment and its customer book could be spun off, sold to another insurance company, or even just given a little more beneficial attention by management under the watchful gaze of public shareholders.
Overview & Operations:
Institutional investors continue to hold a major portion of LEAF's stock, with private equity group Fortress (FIG) owning 65% of the company and AIG (AIG) holding another 12%. While it is possible that either party could opt to sell some or all of its shares in the future, I think that's unlikely anytime soon. I believe both AIG and Fortress recognize that Springleaf is in a great position by making loans to underserved consumers, yet providing the type of services that warrant little in the way of regulatory harassment. (LEAF's primary regulator will be the CFPB, who have yet to issue guidelines regarding the firm's core business. This will undoubtedly happen eventually, but for the foreseeable future, LEAF is just too small to worry about compared with everything else the CFPB has going on. This benign neglect will benefit Springleaf and its shareholders greatly and help to limit the investment risk in the stock.)
Let's talk about Springleaf's history for a minute, as I think this speaks to the stability of the business model. The company was incorporated in 1920 and spent the next 80 years growing slowly and patiently before being bought by AIG in 2001. Then of course when the financial crisis came along, the world learned that AIG had really gotten too far beyond its insurance roots (remember the ILFC transaction I alluded to earlier?), and AIG sold an 80% stake in LEAF to Fortress. For years before this, LEAF had been heavily involved with originating real estate loans both in the United Kingdom and the US. Almost as soon as the FIG sale was complete, it looks like management started looking for a way out of that business. In early 2010, LEAF stopped making real estate loans, shuttered 231 branches, and started focusing on personal loans, an area largely abandoned by traditional banks (especially for consumers with credit scores below 700) in the wake of the Dodd-Frank and the Basel sea-changes in the industry.
Springleaf's niche is supplying personal loans to US consumers with a credit score between 550 and 650 (~20% of the US population over 18 years of age). This is an area that US banks can't serve realistically in a post-Crisis world. These borrowers are riskier than the upper 2/3 of the credit spectrum, and so their credit needs to be correspondingly more expensive. Yet, because banks serve the higher end of the spectrum, in the post-Crisis world, the CFPB, politicians, and consumer advocacy organizations just complain that banks aren't being fair to these consumers and are steering them to high-cost loans. Banks are perhaps the most heavily regulated industry in the country, and this type of issue is one they simply don't want to have to deal with. LEAF is not a bank, and it doesn't really make loans to people with high credit scores (for the most part anyway). This leaves it free to price its loans accordingly, and escape the majority of regulatory scrutiny. In that sense then, LEAF's real competition is not banks, but payday lenders and pawnshops. Financing from these firms, though, is far more expensive than financing from LEAF, which makes it a comparatively good bargain for the consumer.
As I mentioned earlier, LEAF is one of the two dominant players in the installment loans space, the other being Citigroup subsidiary One Main Financial. Between the two competitors, they operate roughly 2,100 branches across the country. At the same time though, there are an additional 3,000-4,000 branches operated by independent owners and small firms. Thus, LEAF has considerable opportunity to roll up some of these small competitors through acquisitions or compete hard against them using superior scale and access to capital. I also believe that LEAF has the opportunity to make its branches more efficient and profitable in the future based on the example set by One Main. Citigroup filings suggest that One Main makes about $7.2 million in loans per branch ($9.3B total) versus only $3.8 million ($3.1B) for LEAF. With access to public equity markets and new initiatives that LEAF is rolling out, some of this gap should disappear over the next 12-24 months, further boosting LEAF"s profits. Indeed management has already suggested they should be able to get to $5 million in loans per branch relatively quickly. Strategies for doing this include partnering with hard goods retailers to make loans directly to its customers and partnering with peer-to-peer lenders like Prosper and Lending Club, who will refer customers for a fee.
The immediate concern that many investors will likely have with LEAF is driven by memories of the Credit Crisis and subprime borrowing there. I would argue, though, that Springleaf's business is safer. For one thing, its customers have among the best credit scores in the traditional subprime market (commonly defined as credit scores below 640). For another, LEAF generally has hard collateral (i.e. a car or boat) just under half of its loans, and soft collateral (i.e. furniture, computers, electronics, etc.) on another 40% of loans. These two factors are likely what lead to LEAF's relatively low net historical charge-off rate of 3-4%. (Well-run banks frequently see net charge-offs of 2%, the auto-industry has a charge-off rate of ~3.5%, and credit card companies see charge-offs of more than 5%, so Springleaf is doing quite well given it deals with a higher-risk cutomer base.) Given that LEAF makes an average loan of ~$4,300 with an interest rate of ~26% (about the same as a revolving credit card balance) with a loan life of about 3 years, I think the company is well compensated for this extra risk.
Last year, Springleaf set up a new online lending platform iLoan. The platform enables customers to apply for loans online as well as pay existing loans online. Management believes that the new iLoan platform will enable Springleaf to reach customers in 46 states versus current operations in 26 states. Thus, the new platform significantly increases iLoan's market opportunity set. Initial indications for iLoan are promising, according to management, with online loan originations doubling over the last year. Of course, the new platform will have to be monitored carefully and keeping tight credit standards online is very important since online loans tend to have higher net charge-offs, but it's clear this is an opportunity for LEAF.
In addition to its loan business, Springleaf also has an insurance business selling life, accident, casualty, and health insurance through its branches. The insurance operations represent about 20% of revenues for the firm, so they are non-trivial to the company as a whole. At the same time, though, I believe the firm can do better both on an individual level and a macro level. At the macro level, insurance rates are getting stronger and insurance demand is up across the property & casualty space. This is slowly leading to stronger pricing for insurance sellers like LEAF. At the same time, this insurance improvement is in the context of a very competitive environment. Travelers (TRV) has been particularly vocal about this on its recent calls. Yet, LEAF has an advantage here. As much as people like shopping online, customers also like being able to go talk to someone when they are confused or have a problem. That fact, and the advertising value of having a sign people see are why companies like Allstate (ALL) continue to have thousands of physical branches across the country. LEAF starts with an installed base of 800 branches. To date though, the company has mainly been selling insurance to customers who got loans rather than the other way around. If Springleaf were to get a little more aggressive and start actively marketing its insurance (and then potentially offer loans to people who came in and got insurance), then I bet it would dramatically increase its insurance revenues. There is no indication the company is pursuing this aggressively just yet, but I think time and shareholder pressure will fix that oversight.
The legacy real estate business of LEAF is (along with a lack of investor familiarity and awareness), one of the factors that has held the stock back from a higher valuation. When Springleaf was acquired by Fortress, the company had more than $13B in real estate loans. Since then, though, the value of these loans has been written off/run-down to around $9B. More than 30% of the portfolio has been modified and net charge-offs are running at about 1.6% annually. Going forward, with the company not originating any new loans and any existing loans that were going to go bad having done so already during the course of the financial crisis, I think charge-offs and the net interest spread on the portfolio will balance each other out. These loans are running-off at a rate of about $1B a year, and with an improving macroeconomic outlook, I don't foresee this legacy portfolio being an issue for LEAF going forward.
As I have mentioned several times already, one of the things I like about LEAF's business is that it is not a bank. The company does not take deposits, and hence is not under the same degree of regulatory scrutiny as the banking sector is. At the same time, though, this does create a funding need for LEAF. The company has done a great job covering this issue, though, in my view. Springleaf has issued debt on a rolling basis going forward with annual maturities of between $300-800 million each year. In addition, Springleaf has been highly successful in securitizing its loan portfolio. During 2013, the company took in $1.4B from three securitizations, suggesting that an origination-to-securitization model could be an effective alternative funding source for the company. Between these two factors and the company's strong banking relationships (as evidenced by its recent $750M term loan, which matures in 2019), I don't believe funding will be an issue for LEAF going forward. The firm's average cost of funds is around 5.5%, well below its return on loans, making for very profitable gross margins.
On the regulation front, things for Springleaf have changed a bit in the last few years. Historically, the company was regulated by authorities in each state it operated in. This will continue and given the company has been dealing with this type of regulation for decades, it should not be a major issue. What is new, though, is the Consumer Financial Protection Bureau (or CFPB). They are now LEAF's primary Federal regulator. So far, the CFPB has not adopted rules governing making installment loans, and frankly, given the agency's workload and the amount of fighting they are doing with Congress, I think it will be at least a few years before they do. Further though, compared with payday lending, credit cards, other short-term loans that involve a balloon payment, LEAF should be far more palatable to the CFPB. The company's loans are amortized over a 2-to-4 year period, which makes paying them off in full far easier for consumers, and seems more consistent with the CFPB's preferred lending style. Given this, I think LEAF is at less risk of severe regulatory harassment than many other financial firms.
On the whole then, with LEAF trading around $24 after a recent 10% pullback, a bit more than 12X my estimate of CY 2014 EPS of $1.96, this is a great time for investors to look at taking a position. Growing firms in the specialty loans financial space like First Cash Financial (FCFS) and Green Dot (GDOT) sport normalized multiples between 16-22X CY 2014 EPS. Insurance companies like Brown & Brown (BRO) and Selective Insurance (SIGI) (peers for LEAF's insurance operations) both sport similar multiples. Based on these peers, I think Springleaf should have at least 33% upside (16X CY 2014 EPS or ~$31) once it establishes a track record with investors, and given that it looks likely to grow faster than any of the other firms I mentioned with a less competitive market environment, even greater upside is certainly possible.