NICK Part 7: New Management and the Awesome Power of Share RepurchasesSeptember 9th, 2015 | Posted by in NICK
It is worth repeating that new CEO Ralph Finkenbrink’s first major action after becoming CEO was to tender for 40% of outstanding NICK shares at 6-7x NICK’s post-tender, mid-cycle earnings. That created an awful lot of value for shareholders.
Further, the tender told us some important things about Mr. Finkenbrink. To begin with, it suggested that he is concerned with shareholders’ interests above his own. I imagine that a large package of equity options and/or restricted shares is coming his way as part of his promotion to CEO. He could have waited until he received that package in full before undertaking the tender. But he chose not to. He chose instead to increase per-share value as much as possible, as fast as possible.
In addition, the tender showed that Mr. Finkenbrink has a belief about the intrinsic value of Nicholas that is not wholly reliant on the public markets, which have undervalued NICK for years. If Mr. Finkenbrink took NICK’s historical P/E as gospel, he would not have perceived the stock as undervalued, and presumably he would not have repurchased shares.
Finally, and most importantly, the tender suggested that Mr. Finkenbrink is smart about capital allocation. In particular, based on his choice to repurchase shares rather than pay a dividend, or grow the loan book at any cost, Mr. Finkenbrink appears to A) understand the tax implications to investors of special dividends, B) understand that there is a price at which NICK shares are better investments than are new loans, and C) be willing to act boldly when the circumstances favor doing so.
Neither Mr. Finkenbrink nor the board have made any explicit indication of their plans for future capital allocation, but I think given recent actions it is fair to conclude that the company favors repurchases, especially as retained earnings begin to build up, which will naturally de-leverage the capital structure.
Which brings us to one of the juiciest parts of the investment thesis: the possibility (likelihood?) of large and ongoing share repurchases.
NICK is a profit machine. It generates a lot of after-tax income, far more than it can redeploy into new loans at the desired yields, especially in the current hyper-competitive environment. Luckily for us, the stock market is giving Mr. Finkenbrink and the board an extremely high-IRR alternative for redeploying those profits.
When NICK repurchases its own shares, not only does it receive the earnings yield on those shares (currently a terrific 15-20% based on mid-cycle profitability and repurchase price), it also captures the value created by paying 5-7x earnings for a company that should probably be priced closer to 12x. And since we, the shareholders, are the true owners of NICK, this benefit ultimately accrues to us.
The even greater beauty of repurchasing deeply discounted shares it that it creates a win-win situation for equity owners. As NICK continues to repurchase its shares, either they appreciate significantly in response—in which case investors make healthy gains on their NICK investments—or the shares do not appreciate—in which case NICK can continue shrinking its share count at a high rate indefinitely. In either scenario, investors win. The former is better in the short-term, the latter is better in the long-term.
The only way that we investors lose is if we have erred in our evaluation of the business, and either the fair valuation multiple is lower than what we are currently paying (extremely unlikely), or the ongoing earnings power of the business is much lower than we think (more likely than the former, but still unlikely).
Below you will find my repurchase model. The numbers are eye-opening. My hypothetical scenario assumes that:
- Loan losses spike in year one, representing the trough of the cycle,
- Year two is better but still below-average, and
- Year three is in line with historical profitability levels.
My scenario also assumes that:
- NICK grows its loan portfolio 5% a year,
- NICK continues to finance two thirds of the loan portfolio with debt,
- NICK uses all retained earnings above those needed to finance 5% loan growth to repurchase shares. and
- The price at which NICK is able to repurchase shares starts at $15.00 and increases 25% annually thereafter.
A $41 share price three years from now. And I believe the inputs are reasonable. One could question whether it is reasonable to assume that the company will be able to purchase 5% of its shares’ average daily volume for three straight years. I admit this could be problematic. But I think periodic tender offers can be a solution to this problem, if need be.
Just so that no one looks at the numbers above and concludes I’ve completely lost my mind, here again is the CACC stock chart, starting in 2004 when that company began repurchasing stock in size:
Credit Acceptance is a somewhat different—and superior—business to Nicholas Financial. But the chart nonetheless shows what can happen when you combine business growth, mean-reverting profitability, large discounted share repurchases, and an expanded trading multiple.
But is my 12x multiple reasonable? How should NICK be valued? These questions are the subject of the next post.
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