Medallion Financial: Structure Explained, As Footnote Opens Our Eyes To Hidden Value
Summary
- Hidden value and earnings of $16 million revealed in footnote of recent 10-Q.
- NAV after write-downs still over 200% of today's trading price with EPV (Earnings power value) suggesting mid teens.
- Earnings Power Value at the bank's consumer lending and mezzanine businesses point to $2.00 net per share in 2019.
- A once valid short thesis, now outdated, ignores Medallion's primary business but creates a value entry opportunity.
Medallion Financial (NASDAQ:MFIN) can't seem to do anything right... in the eyes of the short sellers. This bodes well for us value investors, as the price, despite rising over 100% in the last 10 months, remains far below its NAV (Net Asset Value) and its EPV (earnings power value). Below, please find the following:
1) A $16 million footnote explained.
2) Short-sellers tired, and now flawed, arguments exposed.
3) EPV at the bank and mezzanine business point to earnings of $2 per share.
Losses overstated (per GAAP) by $16,188,000 or $0.66 per share
"During the 2018 first quarter, Trust III had a deficit of $22,312,000, as a result of the unrealized depreciation and losses taken on the medallion loans in Trust III. This amount exceeded our maximum exposure to Trust III, which is solely due to a limited guarantee by MFC of $6,124,000, by $16,188,000. Due to technical consolidation accounting rules, we are required to record these losses, even though we are under no obligation to cover them financially. As a result, we are exploring alternative approaches to this investment to allow for a full or partial recovery of these amounts as well as to not incur additional losses in this entity going forward." source MFIN 10Q filed May 15,2018 MFIN 10-Q.
This Trust also houses the DZ loan (the nearly $100 million of MFIN's consolidation debt). As stated above, MFIN has a maximum exposure of $6.124 million. This "exposure" has already been written off along with an additional $16.188 million. So if Medallion does sell off this entity, or as the shorts previously claimed, DZ forecloses, or medallion prices go to ZERO and borrowers default and the Trust is shut down (files bk), MFIN GAINS back the $16.188 million AND the $100 million debt is off of Medallion's books. To be CLEAR, in any of the three scenarios, DZ is the one who suffers from any further losses or possible defaults in this Trust.
Misunderstood structure creates the opportunity for value investors to buy MFIN.
Medallion lending business
Fact: Medallion Financial and its subsidiaries lend money owners and operators of taxis that are secured by the medallions, the businesses, and personal guarantees.
The market's treatment of MFIN's medallion loans as worse than that of unsecured credit card debt may have been warranted up until a point given the poor lending practices of some banks and credit unions. However, we see this now as an overdone narrative and see the medallion lending business as stabilizing and being either neutral or even positive in 2019 after the significant write-downs this quarter.
Fact: Prices today in NYC range from $150k (cash and or related party) to over $400k if financed with April's average price being $220K. Medallion Financial wrote down NYC medallion loans in default down to $183,500.
Some analysts were not satisfied. Their claim? Medallion should change their accounting to include more write-downs to mark all the loans at "fair value," which in their mind was the liquidation value or all loans to $183.5K (lower than the $220k) as opposed to their belief that MFIN's average loan is closer to $437k per medallion. However, this thesis ignores today's current market and the structure of MFIN (as we detail below). Just like there was too much money lending to the medallion business at its peak of $1.4mm per medallion, today, financing is much more difficult.
Operators are willing to pay $400k and higher, if the medallion comes with financing (and yes, we have done our homework and spoken to many of NYC's top operators). The cash prices are being paid mostly by institutional investors who are now entering the market to take advantage of the troubled credit unions who got overly concentrated in the medallion space at its peak (including Melrose Credit Union).
Some suggest that another $50 million in write-downs would be in order. However, while there may indeed be more write-offs in 2018, we believe that many owners and operators have the wherewithal to pay the debt and will indeed honor the loan payments. Should all of the banks have written all of their mortgages to zero? Or the unsecured credit card debt to zero?
The biggest opportunity is in the market's failure to understand the corporate structure of Medallion. MFIN's structure isolates their exposure to medallion more than the markets appreciate, thus the opportunity.
Structure of Medallion
"MFC established a wholly-owned subsidiary, Taxi Medallion Loan Trust III (Trust III), for the purpose of owning medallion loans originated by MFC or others. Trust III is a separate legal and corporate entity with its own creditors who, in any liquidation of Trust III, will be entitled to be satisfied out of Trust III’s assets prior to any value in Trust III becoming available to Trust III’s equity holders. The assets of Trust III, aggregating $77,649,000 at March 31, 2018, are not available to pay obligations of its affiliates or any other party, and the assets of affiliates or any other party are not available to pay obligations of Trust III...
and...
The Company established a wholly-owned subsidiary, Medallion Financing Trust I (Fin Trust) for the purpose of issuing unsecured preferred securities to investors. Fin Trust is a separate legal and corporate entity with its own creditors who, in any liquidation of Fin Trust, will be entitled to be satisfied out of Fin Trust’s assets prior to any value in Fin Trust becoming available to Fin Trust’s equity holders. The assets of Fin Trust, aggregating $36,144,000 at March 31, 2018, are not available to pay obligations of its affiliates or any other party, and the assets of affiliates or any other party are not available to pay obligations of Fin Trust." source: MFIN 10q filed on May 15, 2018.
An example of the mispricing that helps the value investor
In one report, an author suggests that in their "best-case" scenario for the NAV, and not including any further write-downs at the bank, they are subtracting $192 million mark-up in value on Medallion Bank which equates to a value of $128 million. This markdown is lower than the bank's stated net equity of $154 million and Medallion's fair value estimate of $320 million. The $128 million valuation is on a bank whose consumer loans are generating $60-70 million of earnings before taxes.
At even 1.5 times book ($154MM), the value would be $231 million. Now if we take a multiple of after tax earnings of 10 times, which is fairly standard, the value would equate to $500 million or an additional $15 per share... and this doesn't include the mezzanine lending business that is worth at least another $4 per share.
$2.00 per share simplified
Medallion Bank consumer lending generates $60-70 million in pre-tax earnings and Medallion's mezzanine business generates approximately $10 million pre-tax earnings. Therefore, if (per below) we are correct that the medallion loan portfolio has stabilized or has been written down by year-end, in 2019, these two businesses should generate $70 million pre-tax or $50 million after taxes or $2.00 per share.
Earnings Power Valuation at Medallion Bank - consumer lending and the mezzanine lending division
First, let's look at the earnings of these two divisions and ask ourselves if these earnings are a) sustainable, and b) if these earnings can grow by making additional investments in these businesses.
Medallion Bank's consumer earnings are indeed sustainable. We believe that the industrial bank license creates a valid moat as does their dealer network. We also see their average interest rate on the portfolio consistently between 14-15% which indicates to us that they have not seen pricing pressure from competitors in their categories.
Can the consumer business grow? We can learn a lot by reading an excerpt from the company's press release dated May 14, 2018. MFIN press release:
"Medallion Bank’s net consumer loan portfolio was $716.8 million as of March 31, 2018, a 12% increase compared to $642.1 million at the end of the prior-year period, primarily as a result of increased originations, and partially offset by the sale of approximately $127 million in performing consumer loans in the 2017 fourth quarter. Including the loans sold, the consumer division grew by approximately 31%. The average interest rate on the portfolio was 14.86%, an increase from 14.79% one year ago. Consumer loan delinquencies over 90 days as of March 31, 2018 were 0.40% versus 0.57% in the prior quarter."
The consumer lending business is growing at 12% even after selling a sizable loan portfolio of $127 million. The growth and sale of the performing portfolio did not have a negative effect on the quality of the portfolio, as measured in delinquency rates (0.40% vs. 0.57%). Medallion Bank has a low WACC (weighted Average Cost of Capital is under 2%). As we can see, these factors are all positive for both sustainability and growth at the bank.
Conclusion
Medallion Financial has been punished for its medallion exposure. The stock was indeed overpriced as the value of the collateral backing the loans suffered. Because medallions are a commodity, predicting the bottom of their value remains difficult. While we see hedge funds stepping in and buying bulk packages of medallions and medallion loans, and we have positive feedback from operators, we are not bullish on Medallion Financial because of the bottoming of the medallion market.
We do not assume any recapture of write-off of medallion loans by Medallion in our valuation model of MFIN. However, we believe that medallions will maintain some value over the next 5 years or more, and more importantly, the borrowers that have signed personal guarantees (all MFIN medallion loans have personal guarantees by borrowers) see value in both operating the medallions, and maintaining their credit.
Therefore, we have a 6-month price target of $11 per share and a 12-month target of $20.
Note on EPV of Medallion Bank
Medallion Bank still has medallion loans outstanding. Although Medallion loans at the bank represent just 17% as of 3/31/18 (per recent 10-Q), the medallion loans outstanding still is a significant number at $157.7 million. We expect the write-downs to be less significant than the quarter ended on 3/31/18. For the EPV above, and based upon our forecast (which are based on feedback from independent industry veterans), we see 2019 having no write-downs and in fact, there may be a recapture of prior markdowns by both the Medallion Bank and Medallion Financial.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
This article was written by
Analyst’s Disclosure: I am/we are long 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.
KORR and its affiliates are long MFIN and may add or reduce its position without notice. The author, KORR's CIO, Kenny Orr, holds a bachelor of science degree from Tufts University, completed case studies on valuation analysis from Harvard Business School, and studied value investing at Columbia Business School. Mr. Orr holds a series 65 license. KORR currently advises institutional and UHNW investors. Each investor should seek their own professional investment advice.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (10)
-It is not so small, it's market cap is small because an institution targeted it for a short attack. Now the shares have been beaten down from 2X TNAV to 0.4 TNAV (it was 0.2 TNAV while the short was still manipulating it down). -MFIN was the preferred target because it had low volume, high dividend (income investors), and BDC status which meant complex accounting and no index fund access.-As anyone knows, making a thinly traded stock decline is as easy as selling gobs of stock short. Making money is much harder because covering causes the price to rise. That is the situation now with MFIN. The short hedge fund tried to cover but the price went from under $2 to over $5. They have limited ability to fake panic selling, so they double their noise level. They used to target long holders but the weak hands are gone. Now they target uninformed new short investors.BTW -the company gave up their BDC status -so the next earnings report will be simple. The next step will be inclusion in small cap indexes -so volume will increase, but it will start with a tsunami of buying by index ETFs. The shorts may be screaming for their lives.
