We are writing a brief update note in light of Medallion Financial's (NASDAQ:MFIN) second-quarter release yesterday (earlier than expected). We plan to write a more detailed note after 10Q is published.
MFIN stock is down over 30% for the past two days largely due to the dividend cut. However, we think there is a lot more pain ahead for the MFIN shareholders. Not surprisingly, management refused to admit serious underlying problems with MFIN's loan portfolio and instead tried to spin another nonsensical story at the KBW conference on Aug 2, 2016.
We have argued for several months that underlying cash earnings power of MFIN is substantially less than GAAP earnings. Medallion Bank ("MB") filed 2Q call report a few days prior to MFIN's earnings release, which had couple interesting data points. During 2Q, no dividend was distributed by MB to parent. This was significant because not only it has never happened in the recent past but also MFIN would have negative consolidated distributable cash earnings. Excluding dividend from MB, holdco generates approximately $1.5m of pre-tax loss per quarter, adjusted for the issuance of new 9% bond.
More puzzling was that MFIN parent had to inject $3m of additional capital to MB during 2Q. MB was supposed to have excess capital post the sale of the $100m prime portfolio, right? And if medallion loan portfolio is finally stabilizing, why did holdco have to inject additional capital to MB, especially when liquidity is running dangerously low at holdco as we discussed in the last report? Bulls would probably say there may be so much new consumer loan opportunity at MB that MFIN wanted to accelerate growth by providing additional capital. We don't buy that. Top priority of MFIN management has always been maintaining dividend to shareholders at all costs. Given cash needed for quarterly dividend and ongoing refinancing, it made no sense for holdco to spend extra cash today unless it was necessary to keep MB alive. Despite no distribution to holdco, MB's tier 1 leverage ratio improved to 15.6%, slightly above 15% regulatory minimum.
These two facts led us to believe there would be a strong possibility of a dividend reduction in the near term and we finally got it yesterday. Dividend reduction is obviously negative for a yield-oriented stock like MFIN. Most retail investors have bought MFIN mainly for a high yield. Since MFIN is now evaluating unwinding BDC structure with much lower dividend, we expect to see a complete rotation of investor base in the near term, which will be hugely negative from a technical perspective.
We disagree that MFIN is unwinding BDC and RIC election to create value for shareholders. MFIN was most likely no longer eligible to remain an RIC. Sure, there could be small tax benefit since holdco ex-MB generates pre-tax loss. However, holdco ex-MB has never generated any meaningful positive pre-tax income. It is also important to note MFIN is "evaluating" corporate restructuring. Restructuring is going to be complex with significant financial implication for shareholders. Based on our preliminary analysis and views on the asset value at MFIN, merging the two entities would likely result in capital ratio below the regulatory minimum, which may require MFIN to raise additional equity to effect the combination.
Another motivation behind de-RICing could be related to holdco refinancing. As we discussed in our last report, MFIN needs to refinance $230m of bank debt and revolver by the end of 2016. If banks are unwilling to renew at reasonable terms, MFIN's only remaining option is to issue equity. As a BDC, MFIN is unable to issue equity without shareholders' approval. When a BDC stock trades at well below its stated NAV, shareholders are unlikely to allow the company to issue equity because it is highly dilutive. De-RICing should provide flexibility to issue equity if MFIN can't roll the short-term debt. We have not received any update yet regarding refinancing of the bank debt with Sterling National Bank, which was extended to July 31, 2016, per 8K on June 27th. Since MFIN said "the Company expects to enter into a longer term amendment on or before July 31, 2016," we should be getting update any day now. We also await update on $45m other bank debt, which was scheduled to mature by July this year (in previous note, we estimated total $67.5m of bank debt maturing by July 2016).
Lastly, MFIN's plan to enter into a new line of business with marketplace lending platforms. Here is a slide from KBW conference, which contains limited information about the new business opportunity.
At KBW conference, MFIN described this growth opportunity as: "a fee income business that we are looking to get into. The way it would work is somebody like Kabbage or Lendingclub, which sends loans to our bank, we would fund it, they would buy it back next day and they would pay us a fee of about 25bps. So it ties up very little capital but lets these marketplace lenders enter lending markets in all 50 states." Any finance professional with just reasonable amount of experience would know how absurd this sounds. Just pull up the stock charts of LendingClub and read recent news articles about the industry. This is a highly precarious space that is imploding. These marketplace companies are not lenders but just matching creditors and borrowers. Many of these consumer loans have been funded by third party investment vehicles that are showing little or no return because of high delinquency and loss ratio. Now MFIN is saying it can just warehouse for a day, almost risk-free and get paid 25bps of fee… Something doesn't smell right.
What is the stock worth now? In terms of book value, we think it is worth somewhere between zero and $4 depending on medallion valuation. When a financing company has a potential solvency issue, current earnings and dividend matter less as a valuation metric. When a new investor is studying the MFIN stock, what yield would he/she assign to the new annualized dividend of 20c per share? 5% yield (which we consider too aggressive) would imply $4 stock price. What if MFIN can't roll the revolver or bank debt?? MFIN has no asset that can be easily sold. If MFIN has to issue equity, MFIN no longer has access to the easy retail money. Unfortunately, we see more pain ahead.
Disclosure: I am/we are short MFIN.
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.
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