JGWPT Holdings Has Massive Potential

| About: The J.G. (JGWEQ)
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JGWPT Holdings (JGW) is a pretty unique financial company with a novel niche area that it dominates; the structured settlement and defined cash flows business. The firm owns the two largest brands in structured settlements (JG Wentworth and Peachtree) as well as an enormously valuable database of customers that it uses to drive transactions. As the premier player in the business, JGW is uniquely positioned to capture large amounts of loan business (especially from nonprime customers) without significant regulatory or credit risk.

My Thesis

JGW also has the opportunity to move into the factoring space (particularly receivables) without incurring significant additional costs, thus increasing its efficiency and earnings dramatically. Further JGW trades at a dirt-cheap multiple (roughly 10X trailing adjusted EPS, and ~7X forward EPS), which I believe is partially driven by Wall Street's confusion about the company. There are no direct peers or competitors to JGW trading publicly today, and thus the Street seems unsure how to value the firm. Further, with the company itself being a November IPO, the market lacks the assurance that a long publicly traded history would provide. Given all this, it is not surprising that Wall Street has not figured out how to value the firm yet, but after a few earnings reports, I think the company's multiple could at least double giving the stock more than a 100% upside going forward.

Firm Overview:

Basically, JGW's business is finding individuals who are owed defined periodic cash flows like structured settlements or annuities (think long-term payouts from a lawsuit or lottery), and then "buying" that future stream of cash flows from the individual in exchange for an upfront lump sum. The firm's most iconic brand, JG Wentworth has been on television for twenty years offering consumers cash now for their annuities or structured settlements. By purchasing a stream of future cash flows as a discount today where the cash flows come from a reliable third party, JGW has minimal credit risk (90% of their counter parties have Moody's investment grades of A3 or better). Further, because the company isn't a bank nor are they really making a loan to consumers, they face minimal regulatory scrutiny. This is especially true since the majority of the firm's business must be court approved (for structured settlement payments). Finally, JGW's strong history of success in the securitized credit markets means that the firm has a low funding cost, which should enable to continue acquiring more cash flows going forward.

Based on these factors, in my view, JGW faces minimal risk of serious losses on its operations. After having spent hundreds of millions of dollars establishing two well-recognized brands, and built an enviable marketing machine, the firm should be poised to be a consistent double-digit EPS growth machine for a long time to come. Indeed the only major risk for JGW (and the one that drove the firm into bankruptcy during the Financial Crisis) is liquidity. JGW spends large amounts upfront to acquire the rights to long-term streams of cash flows. Today though, the firm has better access to capital than ever before, a broader brand (JGW acquired Peachtree in 2011 after its one-month bankruptcy was competed in 2009), and a vest set of blockholders in the firm that want to see the company succeed (the public shareholders only hold 33% of the company). While liquidity will always be a minor risk for JGW and many other firms, short of another financial crisis, the company should not face any issues.

The Industry and JGW's Place In It

JGW's business focuses on buying certain types of "stream of cash flow" products. The most important of these is structured settlements. Generally, these come about as a result of a tort claim for a physical injury or illness with payments that are either guaranteed or life contingent. JGW buys these claims from the recipient and then receives the payments from the liable defendant (which is almost always an insurance company virtually all of which have excellent credit ratings). Since 1995, these structured settlement purchases have added up to more than $9 billion and comprise nearly 80% of JGW's revenues. JGW has a set of sophisticated models that govern how much it will pay for a structured settlement. As a result, by sticking with these models the firm has been able to avoid virtually all losses on these settlements with cumulative total losses of less than 0.1% since 1995. Annuities, lotteries, earned income from residuals and other similar periodic payment streams make up the remainder of JGW's revenues, but these are very small amounts compared with structured settlements (annuities for example are roughly 4% of revenues).

Despite the large amount of periodic cash flow assets that JGW already holds, there is a whole lot more room for growth in the market. Legal industry estimates suggest that there have been roughly $400 billion in structured settlement payment streams awarded in the US over the last 40 years of which JGW management believes $130 billion are available for purchase. Thus, the addressable market for JGW is huge, especially when one considers that fact that with ~$9 in structured settlement assets, JGW is by far the largest player in the space (most of the players in the space including the #2 and #3 firms are privately held). Bear in mind also that with increased litigation across the US, and no sign that people are becoming less likely to sue at the drop of a hat, the structured settlement market is continuing to expand. Further, this only includes the structured settlement market, which is only one of the types of periodic cash flow assets that JGW buys. Literally, this is a company that has a large enough addressable market to grow for decades at double-digit rates.

Industry Barriers:

As I mentioned, one of the reasons I am so enthused about this company is the lack of competition in the space. There are literally no large competitors to JGW with a significant share in this market. JGE is far and away the best-of-breed company in this niche area of finance with more than 70% market share. Further, even if another established player in the financial field wanted to get into this niche, there are two obstacles they face.

First, as I mentioned, the vast majority of JGW's revenues come from structured settlement payments that it holds claim to. However, structured settlements are awarded in court, and as such they cannot be sold without the approval of a judge. If an individual is awarded $5,000 a year for life from an insurance company by a court, that payment can only be legally transferred from the consumer to JGW or any other purchasing entity by a judge. Failure to get this court approval triggers a 40% tax penalty on the settlement payments (under the Terrorism Tax Relief Act of 2002). Thus the recipient consumer must go before a judge and show good cause for why they need to sell their settlement, otherwise the settlement becomes much less valuable. Approval for a sale is not guaranteed by any means. JGW has been in this business for a long time and as such the firm has a team of legal experts that advise consumers selling their settlements on what they need to do to maximize their chance of getting a judge to approve the sale. Now of course, other firms can hire lawyers as well, and those lawyers can eventually develop expertise in this market, but my point here is that buying a structured settlement is about more than just having the cash.

Secondly, even if a firm were interested in buying structured settlements and had the legal expertise to get them transferred, finding consumers looking to sell such settlements is quite difficult. Direct marketing is ineffective because only a very small percentage of the overall population has such settlements in their name. JGW pioneered this industry which gives them two advantages here; number one, they have a recognized brand name in the space and so many consumers come to the firm to sell their settlements, and number two, the firm has spent the last 20 years creating a database of more than 120,000 consumers who do hold such settlements and are interested in selling them. This gives JGW perhaps the only large-scale list of these prospective sellers, which is a very valuable advantage. To replicate this list would be difficult, costly, and very time consuming even for a large financial firm interested in the market. In many respects, it would simply be easier for a big bank to acquire JGW than to start their own competing division.

Funding and Growth:

Like most financial firms, JGW's business revolves around a spread. Unlike banks though, JGW borrows funds through the securitized market, and then uses those funds to buy future cash flows discounted to present value at a rate higher than the interest rate they pay on the securitized debt. JGW matches the term and structure of the securitization and the settlements they buy to minimize liquidity risk. While the firm once paid relatively high rates, these terms have gotten better and better over time as JGW has become larger, better known in the market, and more creditworthy. Prior to the financial crisis, the much smaller and financially weaker JGW had to have their issuances wrapped by a bond insurer. Today, the firm enjoys a stand-alone AAA rating. Additionally today JGW has short-term credit available in the amount of $600 million in capacity spread across four different warehouse lenders. The firm's secure funding platform makes me confident that the major risk so many niche financial firms face, liquidity, is not a major concern for JGW. This is a key plank in my view of the firm as a long-term growth opportunity.

On the topic of growth, I view JGW as having three main drivers for additional growth going forward. Thus far the market does not understand JGW's business well enough to realize how powerful these growth drivers are.

First, as I have already mentioned, JGW has a clear advantage in its marketing and customer database. The firm owns the two best-known brands in the space, it has the largest and most comprehensive database of customers, and it spends far more on advertising to customers through TV and similar media than any of its smaller competitors. This will be a long-term driver for the firm especially given that the market is still very under-penetrated. JGW's entire business currently is in the still nascent US market. In other markets around the world, the need to sell defined cash flows still exists, but the industry isn't even in existence yet. Thus over time, JGW can expand internationally as well. Historically, JGW has grown their overall portfolio by around 6% per year.

Second, while JGW is the only big fish in the defined cash flows pond, there are numerous small fish out there. The firm has the opportunity then to acquire the most successful of these small peers, often at prices far below what is paid for assets in the equity markets. Management has said that they are in communication with many small firms regarding acquisitions in the range of $5-75 million. Prospective acquisitions would likely cost JGW around 2X revenues based on management commentary, and one or two small bolt-on acquisitions a year could easily add 7-10% to revenue growth on an annual basis for the foreseeable future. Added to the 6% portfolio growth rate above, this gives a total portfolio growth rate of 13-16% annually long term.

Finally, while JGW's primary business is and will remain purchasing various types of defined cash flows, the firm also has the opportunity to generate revenues from ancillary sources. In particular, the company spends an enormous amount on marketing which generates huge amounts of consumer data. This consumer data can be marketed and sold to other firms as a source of qualified leads. Alternatively, JGW could partner with other firms (i.e. banks) to offer ancillary services like loans to consumers looking to sell their defined cash flows. These are avenues that management still appears to be in the early stages of exploring, but within a couple of years, they could be major contributors to JGW's bottom line.

Risks

I don't see JGW as having much in the way of serious risks. The typical risk for niche finance companies is either credit risk (which JGW has virtually none of since it receives the cash flows directly from highly reputable third-parties like insurers), and liquidity risk (which is present, but limited for JGW given the firm's use of maturity matching with structured asset purchases).

JGW has only minimal interest rate risk since its borrowing rates are fixed for a given period and it determines the price it will pay for a settlement based on these borrowing rates. There is a limited degree of interest rate risk between the time when JGW borrows the money and when it deploys that cash, but this period is only a few months so the risk is minimal.

Finally, niche financial firms like Western Union (NYSE:WU), Green Dot (NYSE:GDOT), First Cash Financial (NASDAQ:FCFS), and others sometimes face regulatory or political risk due to the possibility of a public backlash over their business practices. This risk is much more limited for JGW since the vast majority of its revenues come from structured settlements, which are approved by a court. It is very hard after all for a politician to claim that JGW is cheating the consumer when the transaction is overseen by a court. There is some chance that comprehensive national tort reform legislation will be enacted. It is possible that such legislation will then cause people to stop suing one another and companies at every turn, but as a skeptical American who works for an insurance company and has dealt with a lot of litigious attorneys, I think this risk is the most minimal of all. The odds of people suing less are up there with the odds of pigs flying in my view.

Valuation and Catalysts:

Valuing JGW is difficult to be honest because the firm has no real peers, and certainly no publicly traded peers in the same business. I think this is part of what creates the opportunity in this stock. Without comparable peers, and with JGW having such a limited history as a public firm so far, the Street simply does not have a strong degree of confidence in what the company is worth.

For my purposes though, I see JGW as having a long-term growth rate in the low double digits (see growth section above), and so I think it is more than fair to assume that the company will trade in-line with the broader small-cap financial sector. Thus using a multiple of 17X trailing twelve-month earnings, and using JGW's adjusted EPS for 2013 of ~$2.40 gives a price of $41. Recently, JGW traded for around $17.50 a share, giving the firm more than 100% medium term upside. This upside won't be instantaneous, but over the next few months as sell-side and buyside analysts familiarize themselves with the stock and get comfortable with it after a few earnings announcements, I fully expect the stock to revalue. If it doesn't, given how much cash the company throws off, I would expect a PE firm or bigger financial firm to snap it up in an acquisition. Consistently profitable companies with non-market correlated businesses and decent growth just don't trade at 7-10X trailing EPS long term.

Disclosure: I am long JGW. 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.