I've been lucky. I've found my share of ten-baggers in my eighteen years of investing. My mistake has been not sticking with great stories like Jos. A Bank Clothiers (NASDAQ:JOSB) or Apple (NASDAQ:AAPL), selling much too early in their stratospheric rises. This time, however, I'm in for the long haul because MicroFinancial Inc. (NASDAQ:MFI) fits so many Peter Lynch criteria and is doing so well in its niche industry, that I am confident this stock has fantastic days ahead of it.
What The Company Is About
MicroFinancial is in the equipment leasing business. So as Peter Lynch would say, "boring is good". They don't just lease any equipment, though. They focus on sectors where the equipment is expensive and lacks efficient distribution channels: water filtration, food service, security, cash registers, salon, copiers, health care and fitness, and auto repair. These are all businesses that Americans use every day, in many different locations, and on a regular basis. They are all items that are virtual staples of everyday consumption, which is why the company has done just fine during the recession and weak recovery.
However, MicroFinancial is called "micro" because they deal in "microtickets". In other words, they lease and finance equipment to small businesses. That even includes start-ups. So these leases are for five to ten thousand dollars and for an average of 42 months. These small businesses have been struggling to find debt capital, because traditional financiers like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and J.P. Morgan Chase (NYSE:JPM) haven't been terribly excited about making loans. Companies like CIT Group (NYSE:CIT) and General Electric (NYSE:GE) subsidiary GE Capital prefer to make much larger loans. Then you have private equity shops that want to do deals in the millions. So MicroFinancial is filling this niche with its services. It has a further advantage in that it doesn't even have to advertise, because the leasing companies themselves make certain that those companies in need of equipment are provided with financing options. It is, at its core, a B2B version of Rent-A-Center (NASDAQ:RCII), in which equipment is leased with the option to own.
A transaction is generated when a lease application is approved. MicroFinancial steps in, and offers a non-cancellable lease. It handles everything from that point on, in terms of processing, collecting payments, or chasing down defaults. With its highly efficient technology, it streamlines the process so as to avoid unnecessary overhead. In most cases, that lease generates even more money because it is financed.
There's also another segment to MicroFinancial, one which they abandoned in 2002, but have since revitalized. It doesn't sound like it makes sense initially, but once you understand that MicroFinancial is a cash flow business, you'll see why they've chosen this other segment.
Perhaps you have a security system installed by Tyco (TYC) subsidiary Brink's, or from ADT Corporation (NYSE:ADT). You pay a monthly fee to have that system monitored. The monitoring company sometimes wants to accelerate its cash flow, so it will sell off that recurring revenue stream to MicroFinancial, based on some multiple of the monthly payment. It's still a leasing transaction, in that the homeowner is leasing the monitoring. MicroFinancial is simply purchasing the leasing contract. Now this obviously only makes sense if people stick with their alarm company - which is exactly what most people do. It's very much akin to having a satellite TV provider like DIRECTV (NYSE:DTV) or Dish Network (NASDAQ:DISH) - there's very little churn in these businesses. Once you get that alarm system installed, switching to another company may entail an expensive re-installation.
So whether it is a piece of equipment that's leased, or a contract that's purchased, once MicroFinancial has collected more in lease payments than they paid for the item, they are literally collecting free money. That's exactly what has made the rent-to-own industry so profitable. It's exactly the reason that timeshare companies were bought up by hotel companies like Starwood (HOT). It's why automakers like Ford (NYSE:F) or General Motors (NYSE:GM) love to lease cars - they make a massive profit on their investment after the lease term is up…and the car can be leased or sold used.
It's boring. It's simple. It just happens to be an industry I have experience in for more than ten years. It's Peter Lynch to this investor.
The Financial Model
MicroFinancial will purchase the equipment to lease it, and often does so directly from the dealer. The company does this from both its cash flow, and from its $150 million credit facility. In fact, over the past several years, every last dime of operational cash goes into these investments. It leases equipment nationwide, with Florida (13%) and California (11%) contributing the largest shares.
So just how much money does MicroFinancial make on these deals? The best metric is to use average yield, and that number comes in at an astonishing 27.6%, based on both its MRQ and its historical track record. Think about any asset you invest in, outside of equities. Where else can you find an investment yielding anything even close to this? This translates to operating margins of about 30%, almost double that of Rent-A-Center's or competitor Aaron's Inc. (NYSE:AAN).
The company is thus able to leverage its super-cheap debt capital, which costs 3-4% annually. It also underwrites with an eye towards quality, as net charge offs as a percentage of average gross investment is down to 8.08% from 11.7% in 2010. The company also has been dead on target with its loss provisions, with actual losses always coming well within expectations.
The company's P&L is very simple. Revenue consists of income on financing leases (66% of revenue), rental income (17%), income on service contracts (1%), loss and damage waiver fees (9%), and other service fees (7%). On the expense side, there's SG&A, a credit loss provision, depreciation, interest, and taxes. That's it. The balance sheet is equally simple, as is the cash flow statement, which is what I want to focus on because this business is more about cash flow than growth to me.
In lean times, if a company can maintain solid cash flow, it's going to survive recessions. In boom times, that cash flow should theoretically increase substantially. Since the financial crisis, free cash flow at MicroFinancial has been growing. In 2009, despite the financial crisis, it generated $57 million of FCF, followed by $73 million in 2010, $83 million in 2011, and $90.5 million in 2012. As I said, it takes that money and buys more equipment to lease…and does this while paying a nice 2.8% dividend to investors. That cash flow comes on a four-year 125% increase in net income and a 33% revenue increase, while expenses have only increased 10% and provision for credit losses has declined. Meanwhile, the dividend has increased from $0.15 per share annually in 2009 to $0.24 today.
Read that again. Revenue and income are increasing in leaps and bounds over expenses. There's no real overhead at the company. The expenses come from the equipment purchases.
The quarterly growth numbers are not stellar, but as I said, I'm not focused on that right now. They are seeing modest growth in a weak recovery. Things will boom when the economy recovers, and that's when I expect the stock to really take off. So while net income was flat YOY, cash received from customers was $32.8 million, up 9.0%. Revenue increased by 6.7% to $15.7 million. The company also repurchased 82,169 shares.
Other Important Numbers
There is nothing that gives this investor more confidence in a company than large degrees of insider ownership. I feel lucky if I find a company like Ashford Hospitality Trust (NYSE:AHT) with well more than 10% of shares owned by management.
MicroFinancial insiders? They own some 40% of shares. You can bet that management will do everything it can to keep the company humming along because their own necks are on the line. I also like to see a multitasking CEO. Richard Latour is CEO, President, Treasurer, Secretary, Clerk and Director. The company's performance obviously rests on his shoulders, yet he's paid a relatively modest $706,000 in annual salary.
The company has several private equity funds with ownership. I like to see this with a microcap because private equity firms seek out significant returns on investment for their clients. Four PE firms own a combined 11% of shares, along with another 10.3% held by investors Austin Marxe and David Greehouse, who also hold significant positions in over two dozen other microcap plays.
And by the way, exactly one analyst sees fit to follow the company.
All this would make Peter Lynch smile.
As I've said, the company is growing modestly during the weak recovery, while pumping out the free cash flow, which is then plows back into the business. The company has more than $80 million remaining on its credit facility, and I imagine banks would extend it even more credit. Even if not, there are PE firms that would.
The stock trades at 10x next year's earnings, although there's only that one analyst who even has an estimate. The trick with microcaps is that pegging exact growth rates isn't always that important, particularly when you have a company with such robust cash flow.
What I see is a company that tends to its knitting, servicing a niche it knows very well, and is well-positioned to strap a rocket on its back when the economy picks up even more. I always hesitate to invoke the "ten bagger" phrase on any stock. That's quite a prediction to live up to. However, in this case, I think I just may be on to something, which I why I am long the stock.
Author's Update, August 27, 2015: MFI was bought out by Fortress Investment Group for $10.20 per share in December of 2014.
As with any articles regarding investments, you should never rely on information you read without doing your own due diligence. My articles contain my honest, forthright and carefully considered personal opinion, and conclusions, containing information derived from my own research. This may include discussions with management. I do not repeat "talking points" but may quote management from an interview. I am never influenced by third parties in arriving at my conclusions. Do not solely rely on my articles or anyone else's when making an investment decision. Always contact your financial advisor before investing in any security.
Disclosure: I am/we are long MFI, BAC, GE, AHT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.