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Nichols Financial Part 1: Introduction

September 8th, 2015 | Posted by Torin in NICK

Monte Sol and its affiliates own NICK shares. In the future Monte Sol and its affiliates may reduce or increase their investments in NICK depending on changes in share price or business performance. Monte Sol and its affiliates have no obligation to disclose any future transactions in NICK shares. The analysis presented here is the author’s own. It is believed to be accurate but does not constitute due diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation and as such, should not be used in isolation to make an investment decision. The author undertakes no obligation to update this report based on any future events or information. Estimates are subject to numerous assumptions, risks and uncertainties which change over time.

It is not uncommon in public markets to see a company temporarily trade at a large discount to its intrinsic value. But usually severe mispricings only last a few months. In rare cases they can last a year or even two.

It is uncommon in public markets to see a company trade at a big discount to intrinsic value for years upon years. Usually when a stock receives a persistent low valuation, it isn’t actually mispriced. Rather, the low valuation is the market’s way of telling you there is something wrong with the business. The stock is cheap for a reason.

But occasionally, the market is just flat-out wrong. Once in a while a stock that has been cheap for nearly a decade actually is cheap.

I present to you today a company that I believe has been chronically and grossly undervalued since 2008: Nicholas Financial, or NICK.

And not only has NICK remained undervalued for years, but it is now headed by a new CEO with a smart approach to capital allocation that has already grown NICK’s intrinsic value considerably.

NICK may be familiar to those of you who fish in the same ponds that I do. NICK has been written up nine times on Valueinvestorsclub.com. You can find even more research on the company on Sumzero, Seekingalpha, various value blogs, etc.

I do not view this abundance of public research as a good thing. Usually when a company has been examined by a large number of investors, but remains cheap, something is wrong. The stock is cheap for a reason.

So when a friend suggested I look at NICK, I balked. The entire situation screamed “value trap”. But, these days my cup does not runneth over with opportunity. So I gave in and looked at NICK. I liked what I found. I have searched high and low for the elephant in the room but I cannot find it, and not for lack of trying.

As with every company, there are near-term uncertainties, industry obstacles to contend with, and so on. But I do not believe anything is fundamentally wrong with NICK.

At the current price, I think NICK shares present an excellent investment opportunity.

Nicholas Financial is a subprime auto lender. Subprime auto lending can be a tough business. The industry gets a lot of bad headlines—many well-deserved—and right now competition among lenders is brutal.

But NICK has a proven business model that has generated high returns on equity over multiple economic and credit cycles. The current cycle should be no different. Time and again, NICK has demonstrated lending discipline that has allowed it to emerge from each successive crisis unscathed. As someone from the company said to me, “we have never even come close to losing money”.

Recently NICK promoted its CFO of 17 years to the CEO role, after the company’s founder stepped down. The new CEO’s first order of business? Execute a tender offer to repurchase 40% of the outstanding shares at a 25-30% discount to fair value.

Suboptimal capital allocation has long an Achilles’ heel for NICK.

No longer.

This matters, a lot. You need look no further than NICK’s peer CACC to see the power of consistent, significant repurchases of an undervalued stock:

1.1

The tender offer is complete. NICK is earning around 15% on equity now, and under the post-tender capital structure, I expect it to earn 20% over the cycle. Yet the shares trade at book value. I submit to you that that is stupid.

I believe NICK’s run-rate EPS is $1.80 or so. I also believe, more importantly, that mid-cycle earnings are in the neighborhood of $2.50. Those estimates put NICK at 7x run-rate earnings, and 5x mid-cycle earnings.

At 10-12x mid-cycle earnings, NICK shares are worth $25 or more. There is room for debate about the precise valuation—NICK nearly sold itself for $16 per share a year ago, before backing out of the deal—but every single reasonable framework I can conceive indicates material upside from today’s share price.

In short, NICK shares are extremely cheap. The table below shows NICK’s past earnings, adjusted to account for:

1)    Increased interest expense from debt used to finance the tender offer,

2)    Non-recurring costs related to an aborted sale of the company and a dividend the company doesn’t pay anymore, and

3)    The new share count

1.2

What you see above are not accounting gymnastics. I’m not adding back share-based compensation. I’m not removing “excess” D&A. I’m not giving credit for projected future cost reductions, or anything else aggressive. I am simply looking at the business they way an owner would. What you see above are the past five years’ real underlying economic earnings at today’s share count.

And a 5x P/E.

For a company whose past 20 years of GAAP EPS (not adjusted for the tender offer) look like this:

1.3

Monte Sol and its affiliates own shares of NICK. Nicholas Financial is an excellent business, not a value trap. Eventually the market will wake up and value NICK correctly.

As usual I have too much to say, so I will publish my research in pieces throughout the week to aid digestion.

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