In our initial analysis of Medallion Financial's (NASDAQ: TAXI) second quarter earnings, we noted the limited press release disclosure was unduly optimistic, and investors would again have to wait for the 10-Q to know critical "numbers behind the numbers." As predicted, the 10-Q shows worsening deterioration in medallion loan quality and offers a curious explanation of a $10.6 million ($0.43 per share) non-cash write-up we previously highlighted.
Medallion Loan Quality Deteriorating Rapidly
Total medallion loan delinquencies (31 days or greater past due) increased 85% in the last three months to $23.4 million (parent-only, excluding nonaccrual status loans of $14.7 million in the quarter - up $4.6 million from Q1 and likely mostly related to medallion loans, but lumped together with Commercial Loans). On a combined basis, the sum of delinquencies, troubled debt restructured (TDRs) just in the quarter, and nonaccruals (Medallion Bank only) as a percentage of managed medallion loans went from 1.3% to 3.9% to 7.6% in the last two quarters (see Chart below), an accelerating trend of deteriorating loan quality while taxi medallion cash flows continue to decline in major markets. The consolidated LTV ratio stands at 75%, up from 40% in September 2014 (see second Chart below).
Medallion Financial Combined Medallion Loan Performance Metrics
Medallion Financial Consolidated Medallion Loan LTV Ratio
Valuations of Medallion Bank and Chicago Medallions Salvage Earnings
During the quarter, TAXI valued Chicago taxi medallions at $248,000 (a $0.19 per share write-down), a price level only observed for medallion sales in which 100% or near-100% financing was offered to fleet-owning buyers. For already heavily leveraged fleet owners, 100% financing, even at those prices, resembles a free call option on the recovery of Chicago medallions. Ignored were clear market signals that fair-market-value remains at $150,000 (an additional $0.64 per share write-down), a price at which medallions continue to be offered but not financed, and the price of the only medallion sold in July.
But TAXI owners should not despair. As taxi medallion skies grow darker, like manna from heaven, according to the 10-Q:
… the Company became aware of external interest in Medallion Bank and its portfolio's assets at values in excess of their carrying amount. The Company incorporated these new factors in the Medallion Bank's fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. The Company also engaged a valuation specialist to assist the Board of Directors in their determination of Medallion Bank's fair value, and this appreciation of $10,600,000.
Wow. After years of unwittingly low-balling themselves on the value of Medallion Bank, "external interest" alerted the Board in time to book a $0.43 per share non-cash gain in the second quarter, more than offsetting the Chicago medallion write-downs and delivering an "upside earnings surprise." (See the income statement at the end of the document.) The "external interest" was purportedly prompted by the July 2013 expiration of the Dodd-Frank moratorium "… on the acquisition of control of an industrial bank by a 'commercial firm'." Apparently, this externally interested party was a very patient tire-kicker as well as a hopeless optimist, as there is zero chance TAXI parts ways with the franchise golden goose short of a silly offer, also unlikely, in our estimation.
Medallion Bank has been the primary source of NII and growth for TAXI as well as the singular reason critical third party capital has been available to sustain the BDC/RIC structure during multiple years of operating cash shortfalls. In 2015 (6 months), 2014, 2013 and 2012, the Medallion Bank cash dividend accounted for the following percentages of NII, respectively: 108%, 99%, 98% and 120%. It has averaged between 71% and 91% of reported net income in that period. TAXI would be a relative shell of itself if Medallion Bank were sold, and hard pressed to redeploy as profitably whatever it fetched.
Medallion Bank is an asset categorically not-for-sale. Moreover, Medallion Bank purchases its deposits through brokers, having no retail presence. There is also that little taxi medallion loan problem. In the last six months, medallion loan (plus minimal contributions from Commercial Loan) delinquencies, troubled debt restructured and nonaccruals held by the Bank have increased from 0.5% to 6.8% of total outstanding loans. Medallion loans represent 37% of total investments and 233% of Bank equity. Multiple banking sources have indicated that Medallion Bank fetching a meaningful premium to book value is unlikely even if TAXI were so inclined.
This is an aggressive pair of calls by a Board exercising the good faith discretion required to value company assets. Together, they represent over a $1.00 per share swing in reported earnings and tangible book value in a single quarter, on the basis of Boardroom valuation decisions.
No Commentary on Debt Covenants
TAXI has a $150 million revolving line of credit with DZ Bank ($120.7 million outstanding at June 30). It would appear that regulatory changes in Illinois and those pending in Massachusetts may place TAXI in breach of Section 6.01 (E) of Omnibus Amendment No. 3 to the Loan and Security Agreement and Amendment No. 1 to Medallion Loan Sale and Contribution Agreement and each Affiliated Loan Sale Agreement, (see Exhibit below).
DZ Bank Omnibus Loan Agreement Articles of Default
From the SEC Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations, Section IV C:
… companies should consider whether discussion and analysis of material covenants related to their outstanding debt (or covenants applicable to the companies or third parties in respect of guarantees or other contingent obligations)55 may be required.56
… companies that are, or are reasonably likely to be, in breach of such covenants57 must disclose material information about that breach and analyze the impact on the company if material. That analysis should include, as applicable and to the extent material:
· the steps that the company is taking to avoid the breach;
· the steps that the company intends to take to cure, obtain a waiver of or otherwise address the breach;
· the impact or reasonably likely impact of the breach (including the effects of any cross-default or cross-acceleration or similar provisions) on financial condition or operating performance; and
· alternate sources of funding to pay off resulting obligations or replace funding.
TAXI made no mention of this subject in the MD&A or anywhere else in the 10-Q, despite SEC guidelines that seem to call for such commentary.
Let's review the highlights for the quarter:
- $2 million accounting shift from "net change in unrealized appreciation in Medallion Bank" to Net Investment Income.
- $0.19 per share write-down of Chicago taxi medallions when market intelligence suggests a write-down in excess of $0.80 per share was probably warranted (a mark to $150,000).
- $0.43 per share write-up of Medallion Bank after a change in the Board's long-held valuation philosophy for the Bank.
- Nearly a doubling of medallion loan delinquencies, TDRs and Bank-level nonaccruals to 7.6% of total outstandings,
- Another increase in LTV ratio to 75% despite the modest Chicago write-down and certainly not using a NYC medallion value anywhere near the $603,000 independent medallion transfer in July.
- Another 10-Q published with no commentary on ride sharing nor covenant questions regarding DZ Bank in the MD&A.
Some might say management "managed earnings" in the second quarter, while others might explain it less euphemistically. One thing is certain, earnings quality was weak and the headlines claiming Medallion Financial beat second quarter earnings expectations were a little premature.
Medallion Financial Quarterly Earnings Trends
Disclosure: I am/we are short TAXI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.