Nicholas Financial: Facing Increased Competition From Subprime Auto Loan Originators

| About: Nicholas Financial, (NICK)
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Nicholas Financial (NASDAQ:NICK) is a subprime used auto lender. The underlying business and customer base of Nicholas Financial is similar to Consumer Portfolio Services (NASDAQ:CPSS) -- whom I've covered here -- except that it retains the loans it issues whereas CPSS securitizes them.

This strategy appears to have resulted in less earnings volatility. The low interest rate environment, combined with numerous corporate polices, have helped net income increase handily in recent years -- peaking in early 2012 at over $22 million. Earnings have since abated and stand at $19.4 million on a TTM basis.

With the common stock selling in the market at about $194 million, the corporation currently has an earnings yield of around 10%. Given the industry the business is in -- not to mention the general discount given to consumer finance companies -- the current price is likely to persist but not increase. Further, recent increases in subprime auto loan securitizations is probably increasing competition. Let us take a look at the important economics of Nicholas Financial.

Operations

The company has branches in 16 states. Each branch markets to local used automobile dealers. The company purchases auto loans on an individual basis -- i.e., not in batch. From a risk perspective, the company will generally pool contracts according to the branch since the important dynamics of each branch location will result in slight variations of standard underwriting practice.

The company purchases the auto contracts from dealers at a discount from the loan's stated value, with the discount amortized over the life of the loan. For example, in fiscal 2013 the corporation purchased automobile contracts at about 93% of their stated principle value. In addition the corporation charges a fee to the dealer. It is possible these fees and discounts have helped Nicholas Financial maintain better profitability over the entire credit cycle.

Take a look at NICK's net income history:

It was able to scrap by during the financial crisis. Take a look at its growth over the years in terms of tangible book value:

The most recent decline is from a $2.00 dividend paid in late 2012. The above growth, when measured by earnings over equity, looks pretty good:

Competition

According to Consumer Portfolio Services, competition in the auto loan market is still far weaker than it was before the financial crisis. However this may appear to CPSS, Nicholas Financial is in a different position as it is forced to compete with securitizers -- i.e., with groups whom sell fixed-rate securities backed by pools of auto loans. This has resulted in the securitizers achieving lower costs of financing when compared with Nicholas Financial.

One could also argue that the securitizers have a larger influence on the market than Nicholas Financial could have. For instance, Nicholas Financial manages a financing portfolio of $260 million against equity of $134 million while Consumer Portfolio Services manages a financing portfolio of $1,046 million on $81 million of equity. While this disparity is due to the fact that CPSS sells ABSs against its loan portfolio, it still signifies that the securitizers are able to influence the market to a much greater degree -- with a far smaller capital base -- than Nicholas Financial.

Nicholas Financial has the classic business model and thus has produced less volatile earnings when compared with CPSS. How far the securitizers takes business away from the likes of Nicholas Financial is difficult to tell. However it is possible that we have received some warning in the most recent quarterly results. According to the most recent 10-Q (p. 20):

"…Due to increased competition in more recent periods, the percentage of loans acquired that are categorized in the lower tiers of the Company's [credit] guidelines has increased… [auto loans] originated during fiscal 2014 and 2013, while still performing at acceptable net charge-off levels, have experienced losses higher than static pools originated in previous years."

Accordingly, net charge offs, as a percentage of the financing portfolio, have been ticking up:

This means lower profitability in the near term. Continuing to quote from the 10-Q (p. 20):

"The delinquency percentage for Contracts more than thirty days past due as of September 30, 2013 was 5.69% as compared to 5.38% as of September 30, 2012. This increase is primarily as a result of increased competition in all markets that the Company presently operates in. Increased competition typically reduces discounts on contracts purchased and also results in a greater percentage of contracts, while still within guidelines, that result in lower credit quality." (Emphasis added.)

So on a whole the business is unlikely to be as profitable in the near future as it was in the recent past. First, the securitization market is back in action and is probably increasing the competitive pressure felt by Nicholas Financials. Indeed, rumor has it that the banks and other financial institutions are getting back into the subprime auto loan securitization market (for example, see here).

Further, it is worth pointing out that, unlike the securitizers, NICK has additional interest rate risk and liquidity risk. Are these the prices one pays to be an old school lender in the new world of mass ABS origination? To some degree it seems that way.

Since NICK needs to finance its own activities -- that is, since it is not selling the contracts off via trust securitization -- it will need to finance its receivables with its credit facility. This credit facility has a current interest rate of LIBOR plus 3% with a 1% floor. This means the lowest possible interest rate Nicholas will pay will be 4%.

Compare this with Consumer Portfolio Services' most recent securitization which had various tranches with a weighted average interest rate of only 3.08%. Obviously there is a difference in interest rates but the broader point is that there is a strong appetite for securitizations -- as exemplified by the 3.08% interest rate -- and the increased appetite will hurt NICK.

From the standpoint of changes in interest rates, CPSS will not care as much as NICK since the debt is largely off its books. But NICK's financing costs, of course, will directly increase.

Lastly, considering that these auto contracts are priced at the highest interest rate acceptable according to state usury laws there is basically no room to offset a rising financing cost by raising interest rates. In a higher interest rate environment, the only thing to offset the higher costs is stricter underwriting. NICK, perhaps, can increase the discount it purchases loans from dealers but this will be a limited tool.

Prospects & Conclusion

It is possible that we are experiencing near peak earnings at Nicholas Financial due to the confluence of bottoming interest rates and a reinvigorated subprime auto loan securitization market. To really compete in the current market, it has to compete with financing groups whom are performing securitizations. Or it has to follow a strategy similar to Credit Acceptance Corp, whom basically, through various fees and prepayments, smoothes out earnings and shares risks with the dealer -- a valuable competitive advantage by which it differentiates itself.

As is well known, the securitization market has greatly increased the available credit to both prime and subprime borrowers. It seems that NICK's business model is at a slight disadvantage now that the securitization market has regained its appetite.

In the long run, if I had to pick and choose, I would choose NICK's business model over, say, Consumer Portfolio Services due to the much longer history of the business model. But as a matter of competitive forces, Nicholas seems currently disadvantaged and this could continue for an extended period in the future.

The stock is likely fairly-valued in the market place and it is unlikely that there would be a dramatic increase in net income in the near term. One can probably accumulate value by holding the stock but they stand the chance of owning the security as competition increases, perhaps dramatically. Its competitor Consumer Portfolio Services, after all, plans on growing its portfolio by over 35% throughout the next year. That is, it will grow over 150% NICK's total net financing receivables in one year. The securitization market can, I would argue, magnify the competition against Nicholas Financial.

Disclaimer: The opinions expressed in this article are those of the author as of the date the article was published. These opinions have not been updated or supplemented and may not reflect the author's views today. The information provided in the article does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular stock or other investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.