But First, Some Background
Nicholas Financial, of $200mm market cap, is a British Columbia holding company with its main operating subsidiary in Florida. The founder owns but 13.6%. No controller exists.
A well disciplined purchaser of subprime auto loans, Nicholas spectacularly compounded book-value-per-share from $0.33 in 1995 to $11.46 today, while returning a $2 special dividend to shareholders in late 2012 and maintaining a 33% payout ratio.
Unlike credit-spread-driven participants in the industry, Nicholas' team prices the risk of capital loss, obtains adequate discounts to face value and segregates the loans into underwriting pools. Employee incentives are tied to loss development in the pools and risk appetite changes quickly with changes in the credit cycle.
Remarkably, debt-to-equity ratios have been maintained below 1.5x since 2005 and are under 1x today. This is even more remarkable when considering peer group capital structures.
I cannot emphasize the point enough: Nicholas is a story of smart credit underwriting, not leverage. In both capitalization and underwriting protocol, Company best resembles an insurance company, not a subprime lender.
On December 17th, 2013, Company announced a collared stock-for-stock transaction, with one share equal to $16 in shares of Prospect Capital.
Nominal deal terms are below 1.4x book and around 10x trailing earnings.
Such terms meaningfully undervalue Nicholas and its future prospects. ROE is 15%+ on a minimally-levered loan portfolio and reached 18% in 2012. Long term growth, as discussed above, has been wonderful.
Well-underwritten, high-yielding, and well-secured loan assets tend to sell much for higher multiples to book.
For example, in 2013, competitor White River Capital (NYSE: RVR) transacted at 1.8x book (excluding the large NOLs in that deal). White River had a very similar ROE and balance sheet.
Shareholders who liked owning Nicholas are unlikely to want shares of Prospect, a highly leveraged Business Development Corporation.
Prospect's debt and loan-related assets have grown exponentially before any of its commitments-of-capital have reached maturity.
It is a discomforting exhibit and seems like a transaction engineered to create long-term shareholder turnover prior to a vote.
And the hurdle for approval is high: 75% of votes cast.
What Should Be Done?
There are two ways to do so much better financially.
A robust auction would certainly fetch a higher price. Nicholas has received and rejected unsolicited merger proposals in the past. I believe there are better bidders out there.
But I think the much better course of action is to implement the following Four Point Plan.
(1) Block Deal and get Board Representation. Nicholas appears to have failed to hold an annual meeting in 2013. That means 3 out of 5 directors need to stand for election at the next AGM. Shareholders should show the current slate the door and put in a team with a tad more interest in fiduciary care.
(2) Increase Payout Ratio from 35% to 100%. The credit-underwriting cycle is soft and company doesn't need the capital. A 100% payout would generate a near 10% dividend at current share prices.
Shares would certainly trade much closer to $30 than deal terms of $16.
PSEC has represented it intends to do precisely that with Nicholas' earnings, and nothing else. If it is good enough for PSEC, it is good enough for me. We can reevaluate the wisdom of a high payout when the subprime credit cycle tightens and NICK needs capital to grow the loan portfolio.
(3) Another Special Dividend. In light of management representations of higher competition, lets shrink the book with another special dividend and wait for the credit underwriting cycle to harden.
(4) Re-domicile Nicholas to a locale with more robust shareholder protections. Delaware would be an excellent start.
Nicholas shareholders would do well to vote the deal down and rapidly implement the Four Point Plan, above.
I think the vulnerability of the board and the stupidity of the proposed deal is also a magnificent opportunity for an activist fund to step in and do well while doing good.
(After writing this article, I contacted Nicholas management to discuss my conclusions. They were supportive of the deal with Prospect and expressed no opinion on my alternatives for Company's future earning stream. After speaking with them, my views remain unchanged; shareholders will do better opposing management's proposed transaction.)