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NICK Part 6: Earnings Power, Present and Future

September 9th, 2015 | Posted by Torin in NICK

How much is NICK on pace to earn this year?

In the most recent quarter, NICK reported a 7.38% pre-tax profit yield. After a 38.5% income tax, this equals a 4.54% net margin. Apply this to $331 million, which was the balance of loans receivable (gross of loss provisions and dealer discounts) ending the quarter, and you get annual net income of $15 million. Divide that by 7.74 million shares, and you get about $1.95 of EPS.

That’s a good start. But we must make a few adjustments. On the one hand, NICK has been growing its portfolio at an accelerated rate (±7%) recently. If this continues—and based on recent accelerating growth at CACC and others, I think it will—then looking forward NICK is set to earn $2.10 or so in the coming months.

But, unfortunately, loan yields continue to decline (in part because many lenders, including CACC and NICK, are currently willing to accept minor yield degradation as a trade-off for incremental growth). This is not fully reflected in NICK’s financials yet because the old, higher-yielding loans still in the portfolio will eventually mature, and be replaced by new, lower-yielding loans. This means the average yield across the portfolio has further to fall.

Moreover, this trend of falling yields hasn’t shown much sign yet of slowing. So maybe lower yields erase some of the gains from portfolio growth.

In addition, I think compliance costs will continue increasing for a while as NICK deals with the new raft of industry regulations put in place by the CFPB (the CFPB will get its own post later on).

Finally, NICK’s business is somewhat seasonal. Losses tend to be lowest in the March and June quarters, driven by tax refunds, which improve borrowers’ cash flows. Since the most recent quarter—the one we are annualizing—was the June quarter, the full year loss rate will probably be higher than the June rate we’ve used.

So in the end, I think NICK’s forward earnings power is probably a bit below the $1.95 I initially posited. Maybe $1.80 or $1.90. That would put the P/E at 6.7x or 6.8x.

But this exercise only attempts to pinpoint the company’s profitability at a single point in time. What we really want to know is, what will the company earn over time? What are the cyclically-adjusted profits?

This table, borrowed from earlier, helps give some idea:

6.1

This is an interesting table. One of the things I take from it is that the post-GFC years were a really great time to be a subprime lender. So many lenders blew themselves up (or saw their funding sources blow up) that the ones who were still standing after the crisis were making every loan at the state-max APR, getting big discounts from dealers, and still getting their pick of the best credits in the applicant pool.

Personally, I do not think the next cycle will be as profitable as the last one. Capital access in the U.S. may tighten marginally in the future, but it will probably still remain generally loose for many years. As a result, even when the lending cycle does turn, I do not think we will see the barren competitive landscape that we saw from 2009 to 2012.

So the base business might be marginally worse going forward. There are other detrimental factors to consider as well. The primary one is increased regulation and the costs that it imposes on the regulated—a group which includes NICK. Nobody knows the exact cost, but for NICK an expense of $1M a year, which is 30bps of the loan portfolio, does not seem crazy. NICK is already starting to incur some of these expenses.

In some situations, new regulatory costs can be passed on to the customer. But I don’t think that will be the case here. Right now competition is too fierce. But when competition is relaxed, NICK generally makes loans at state-maximum APRs. In those cases, the rates NICK charges can’t go any higher, which constrains the company’s ability to pass on the costs. NICK could demand larger discounts from the dealers, but then the dealers would need to find a way to pass the costs on to the customers, who are already operating under tight financial constraints. So I expect NICK is simply going to eat some or all of these costs, probably through increased overhead.

Regulation could also hurt the gross yield. The CFPB has not turned its attention to ancillary products such as gap insurance, but it might at some point. In particular it may look to force dealers to more clearly disclose the details of these add-on products and fees. If and when that happens, NICK’s gross yield will probably take a slight hit, unless—again—it can pass on the burden by getting larger discounts from its dealers.

Okay, so finally, what might future margins be over the cycle? Here is my very rough guess:

6.2

Most of this should be self-explanatory. I am not sure about any of it, but I am least sure about the loss provisions. On the one hand, losses over the past cycle were very high; the past cycle includes some of highest provisions on record thanks to the GFC and subsequent flood of capital (and thus competition) into the industry. On the other hand, as I’ve said I expect capital availability to remain good even if interest rates start to climb a bit.

You can use your own assumptions and see where you come out. The tax rate is 38.5%, the loan book ended the quarter at $331M, and there are 7.7M shares outstanding.

Anyway, using my assumptions, what is NICK’s mid-cycle earnings power?

6.3

I think this is a very good way to make a guess about NICK’s ability to generate profits over the cycle.

However, I do not think it is a good way to formulate earnings estimates for specific periods. It is possible that industry conditions will get worse before they get better, and which case NICK could see margins contract further before they expand back towards cross-cycle norms. We have not yet had painful events clear out the marginal lenders. Until we get them, NICK will continue to earn below-average profits. It is very possible that “t+1” (or even “t+2″) EPS will be much closer to $1.70 than something like $2.40.

But over time, $2.40 is the more correct number. $2.40 is the number that you are most concerned with if you own the business outright.

This analysis leaves one crucial thing out—the use of excess retained earnings. The scenario I present above assumes that NICK grows its portfolio 5% per year. But under the current capital structure NICK could finance that growth with less than half of the earnings it generates in the year. The rest of the earnings would be free for other uses.

What those uses might be (hint: repurchases), and how they might impact the intrinsic value of NICK (hint: positively), will be the subject of the next post.

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