“Charlie and I have been surprised at how much profitability banks have, given that it seems like a commodity business.”
– Warren Buffett, Meeting with students from Vanderbilt University, January 28, 2005
In contrast to consumer brands where the moat is readily apparent, I have never understood how financial services companies drive such high returns on equity when their services seem like a commodity. After all, what is more commodity-like than a loan? Yet, some companies show persistent moat-like qualities. Could financial services companies have a moat?
To start my investigation, I chose the sub-prime auto lending industry and one company in particular, Nicholas Financial Corp. (NICK).
Automobile financing is the second largest consumer finance market in the United States. The automobile finance industry can be divided into two principal segments: a prime credit market and a sub-prime credit market. Traditional automobile finance companies, such as commercial banks, savings institutions, credit unions and captive finance companies of automobile manufacturers, generally lend to the most creditworthy, or so-called prime, borrowers. The sub-prime automobile credit market provides financing to less creditworthy borrowers at higher interest rates.
As December 31, 2012, there were over $700 billion in auto loans outstanding. Approximately 20% of this amount is subprime defined as a credit score less than 620.
Automobile finance is a fragmented industry with low barriers to entry. There are few dominant players. According to Experian, the top 20 used car lenders combine for just a 38% market share. National players in the subprime segment include GM Financial (including the former AmeriCredit) (GM), Santander Consumer (SAN.MC), CapitalOne, Chase Finance (a division of JPMorganChase (JPM)), Wells Fargo (WFC), Westlake Financial, Credit Acceptance Corp. (CACC).
Securitizations, wherein various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations, are pooled and sold as pass-through to various investors, are common in the industry.
The industry is highly cyclical. When economic and capital market conditions are good, more companies will serve the market and do so on a more aggressive basis. Conversely, when economic and capital market conditions are challenging, many companies exit the market or curtail their lending activities substantially. (More on this below.)
NICK is a Florida-based consumer finance company focused primarily on the purchase of retail installment contracts from auto dealers. NICK has 64 branches in 14 states. As of March 31, 2013 the Company had a total of 321 employees and managed a portfolio of approximately $250MM finance receivables.
NICK’s typical customer has a poor credit history that prevents him/her from borrowing from most banks and credit unions. NICK tries to find customers who have a poor credit history due to a one-time problem rather than a habitual abuser of credit. Among the one-time problems experienced by the Company’s customers that resulted in a poor credit history are: divorce, medical problems or job loss.
The typical contract purchased in fiscal 2013 had the following profile:
Weighted APR 23.38%
Weighted average term (months) 50
Average loan $ 10,260
NICK maintain relationships with approximately 4,000 dealers of which approximately 1,600 are active.
How Does The Business Work?
A customer selects a used car and makes a down payment ranging from 5% to 35% of the purchase price. The balance is then financed over 12-72 months. The dealer than offers to the loan to NICK. If the loan is deemed to meet NICK’s strict under-writing criteria, it purchases the loan at a discount from the face value of the loan. The average dealer discount in FY2013 was 8.54%.
NICK describes its review process as follows:
- The customer provides NICK with a standardized credit application completed by the consumer which contains information relating to the consumer’s background, employment, and credit history.
- NICK obtains credit reports from Equifax, Experian and/or TransUnion, which are independent credit reporting services.
- NICK verifies the consumer’s employment history, income and residence.
- In most cases, consumers are interviewed via telephone by an application processor.
- NICK reviews the customer’s prior payment history with the Company, if any, as well as the collateral value of the vehicle being financed.
Each branch enjoys a considerable amount of autonomy in the assessment, approval, and pricing of loans but has to justify any deviation from company-wide practices on the basis of predeﬁned subjective criteria, such as impression of management quality, personal assessments of collateral value, own view of the consumer’s prospects, etc. Hence, credit decisions ultimately reside with branches but managers’ career prospects and remuneration depend on their overall lending success, and local overrides are closely monitored by the company’s risk management.
NICK vigorously monitors the performance of the loan following acquisition. Oral requests for payment are made beginning when an account becomes 11 days delinquent. Once an account becomes 30 days past due, repossession proceedings are implemented unless the customer provides the Company with an acceptable explanation for the delinquency and displays a willingness and the ability to make the payment, and commits to a plan to return the account to current status. When an account is 60 days past due, the Company ceases recognition of income on the Contract and repossession proceedings are initiated. At 120 days delinquent, if the vehicle has not yet been repossessed, the account is written off. Once a vehicle has been repossessed, it is sold, either at auction or to an automobile dealer.
When an account becomes delinquent, the Company immediately contacts the customer to determine the reason for the delinquency and to determine if appropriate arrangements for payment can be made. If payment arrangements acceptable to the Company can be made, the information is entered in its database and is used to generate a “Promises Report,” which is utilized by the Company’s collection staff for account follow up.
NICK is no stranger to the value investing community. It has been written up on the Value Investors’ Club an astounding 8 times since 2003. None of these 8 write-ups, in my view at least, made a very compelling case for investment. The thought I keep coming back to again and again as I read these write-ups is, how do they compete with the big boys? What would happen if Citicorp, Bank of America or JP Morgan made a big move into subprime auto lending? At first glance, a local or regional lender would seem to be at a marked disadvantage to the large, global banks. The too big to fail (“TBTF”) banks can borrow at lower rates than small lenders. The TBTF banks have economies of scale in marketing, information technology, credit risk analysis, etc. They have millions to pour into creating credit risk algorithms and, at most points in time, loads of investors eager to purchase their securitizations. How can small players compete? In other words, where is the moat?
Does NICK Have A Moat?
Quantitative Evidence of a Moat
Despite the low barriers to entry, NICK shows clear signs of a moat:
- Diluted earnings per share have grown at 40% 5 year CAGR and an 11% 10 year CAGR. Here is NICK’s EPS growth compared to their public competitors (ACF stops in 2011 because it was acquired by GM Financial):
Click to Enlarge
- Book value has grown at an 11% 5 year CAGR and 19% 10 year CAGR
- The average Return on Equity over the past 10 years was 14%. Here is NICK’s 10-year average ROE compared to their public competitors:
Click to enlarge
- The average Return on Assets over the past 5 years was 6%.
Qualitative Evidence of a Moat
1. A Conservative And Disciplined Approach To Credit Risk
After looking at NICK and some other small banks and financial services companies, the surprising conclusion I have reached is that a conservative and disciplined approach to credit risk is, in and of itself, a durable competitive advantage.
This conclusion was hard to accept because this approach seems so easily copied. Can temperament really be the basis for a moat? But, like value investing, it takes a certain emotional make-up that few people possess. Warren Buffett had a similar take on the insurance business in his 2011 letter to shareholders:
At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.
Comparisons between the lending business and the insurance business are not perfect but they are illustrative. When asked why his company survived when so many others struggled during the 2008-2010 period, Dick Marohn, then a Senior VP of NICK, sounds similar to Buffett: “We did not aggressively over buy like some others in the marketplace. We have a model and we’ve stuck with it. We’ve seen so many competitors over the years come and go because they stretched terms, and tried to buy dealers. You can’t do this and be there for your customers in the long run.” The 2012 10-K stated: “”The Company will not sacrifice credit quality, its purchasing criteria or prudent business practices in order to meet the competition.”
Buttressing this conservative approach to loan underwriting is the simple fact that NICK does not securitize its loans. All of the loans they purchase remain on their books and the credit risk remains with them as well. Securitization creates a moral hazard — the bank/institution making the loan no longer has to worry if the mortgage was paid off — giving them incentive to originate loans but not to ensure their credit quality.
Historically, NICK has displayed the ability to walk away when pricing become irrational – Buffett’s fourth test above. This happened in 1996-98 and again in 2008-2010. The experience of the 1990s is particularly instructive in this regard. Attracted by the high yields and fast growth rates, between 1994 and 1996, Wall Street underwrote $1 billion to help 25 small subprime auto finance companies go public. Overheated competition amount lenders led to poor underwriting that drove up losses. The predictable result: the lowered credit standards, cheap loans and loose accounting combined to drive companies into bankruptcy. Perhaps the most spectacular of these flame-outs was Mercury Finance. At its peak, Mercury Finance had a market capitalization of $2.6 billion and 290 loan offices across the country. Just one year later, it entered bankruptcy. The CEO, who had compensation of $12.9 million in 1995, ended up going to jail for 10 years for an accounting fraud scheme used to cover up unprofitable loans.
NICK avoided these problems by resisting getting pulled into destructive battles for market shares. In 1996, NICK purchased just $6 million of contracts. In 1997, when a number of its competitors were imploding, it purchased $18 million – an increase of 33%. During the period 1995 to 1999, net income jumped from $623,595 to $1,602,356.
2. The Informational Advantage of Being Local
We have previously spoken about the power of a niche. A niche provides benefits in financial services as well. A niche in this context can mean either a small geographic area or a particular segment of the financial services area. NICK has both types of niches. NICK generates 98% of its revenue from sub-prime auto loans, a sub-sub-genre of financial services. Also, NICK operates in just 15 mainly Southeastern states and 45% of its outstanding loans as of March 2013 were in just 2 states. NICK has 64 branch offices in the 15 states in which it operates. Further, NICK expands slowly allowing it to have a better knowledge of potential borrowers, dealers and the used car market. The majority of lending decisions are decentralized to the local branch office.
Why is a niche important? Lenders with a local presence have an advantage in assessing the creditworthiness of individuals – particularly those with troubled credit histories. Small players are more closely tied to and dependent upon the local economy. Informal information about potential borrower is more plentiful and easier to access. Closer ties to dealers and borrowers gives local lenders a costless endowment of soft information which may serve to offset the production inefficiencies and risk diversification problems associate with small scale and the costly, labor-intensive nature of relationship lending and soft information collection. The closer a borrower is located to a lender in informational distance the more informative the relationship becomes and the better a lender can assess a borrower’s credit worthiness. Thus, an in depth knowledge of the local market provides an information-induced competitive advantage. This makes intuitive sense but there is also academic research to support it.
By contrast, the TBTF banks have become more distant from their customers in their pursuit of economies of scale or scope. As lenders move away from their core markets, competition erodes their specialized lending expertise. On the one hand, TBTF banks quantify the information underlying their lending decisions through credit assessments in the form of credit scores, which allow them to extract meaningful measures of their private information. On the other hand, credit to higher risk individuals crucially relies on ﬁrm-speciﬁc subjective intelligence collected by loan ofﬁcers during the origination process and, especially, long-term lending relationships.
Subjective intelligence is at the root of a local information advantage. Subprime auto loans offer sufficient information opacity for private-information production to be a genuine competitive advantage. Technological progress can only partially substitute for the natural limits to local-information gathering over greater distances.
How does NICK maintain its informational advantage? There are two-prongs to the NICK model. The first prong is NICK’s high touch approach to credit risk assessment. The company’s branch system is key. Branches require overhead, but they put employees in touch with customers. “Customers like to come into the office,” Finkenbrink said. “We create relationships, and employees often will counsel customers.” This approach is expensive and time-consuming but it pays off in lower delinquency rates.
The second prong is a deep relationship with the dealers within their markets, NICK has cultivated a network of dealer-originators with whom it is in almost daily contact. The dealers serve as the primary intermediary between the customer and NICK. This is important because the dealers have a large incentive to close the sale and ignore credit risk. They get paid upfront and the loan does not reside on their balance sheet. They simply originate the loan and shift the credit risk over to NICK. If NICK knows it can rely on the information collected by the dealer, it is a huge boon to their business. As NICK stated in the 2012 10-K: “The Company’s ability to compete effectively with other companies offering similar financing arrangements depends upon the Company maintaining close business relationships with dealers of new and used vehicles.” Further, NICK’s growth strategy hinges upon hiring managers who have pre-existing dealer relationships: “Future expansion of our branch office network depends, in part, upon our ability to attract and retain qualified and experienced office managers and the ability of such managers to develop relationships with dealers that serve those markets. We generally do not open a new office until we have located and hired a qualified and experienced individual to manage the office. Typically, this individual will be familiar with local market conditions and have existing relationships with dealers in the area to be served.”
Even among borrowers with flawed credit, there are different degrees of risk, and Nicholas has prospered on its ability to make those distinctions.
Other attractive characteristics of NICK:
- Clean balance sheet and steady financing: Access to significant funding and liquidity sources is key to NICK’s business model. The Company’s primary source of funding is a line of credit facility. NICK does not issue asset-backed securities. The total amount of funding capacity through the line is $150 million. The line of credit is secured by all of the assets of the Company. As of March 31, 2013, the amount outstanding under the line was $125.5 million. As of the most recent 10-Q, NICK’s debt to equity ratio was just .92. This is a much lower debt to equity ratio than its competitors (CPSS was removed from the data set because its debt/equity was so high it distorted the graph):
Click to enlarge
- Conservative Loss Reserves: As discussed above, conservative accounting is key to subprime financing given the high charge off rates. NICK has a consistent record of accreting reserves.
- Intelligent allocation of excess capital: High returns on capital and excess cash flows are only useful if you have a management that is smart about deploying it. The simple steady-state business model is to generate cash from collections of receivables on the books, spend a bit on SG&A and taxes, and use part or all of the cash flow to acquire new receivables. However, in 2011, NICK instituted a quarterly dividend and have paid one each quarter since. During the fiscal year ended March 31, 2013, four quarterly cash dividends and a one-time special cash dividend of $2.00 per share were paid.
- Management aligned with shareholders: The owner-operator, Peter Vosotas, owns just over 13.6% of the outstanding shares. His pay package is just $930,119 so a very significant portion of his wealth are the shares of NICK.
Peak earnings risk
Pricing is beginning to turn unreasonable once again as memories of 2008-2010 fade and competition picks up. Increased competition for the purchase of contracts will enable dealers to shop for the best price, thereby giving rise to erosion in the dealer discount. Average credit scores for used car borrowers has dropped for each of the last three years. Subprime loans increased 2.55% in Q2 2013 over Q2 2012. In particular, finance companies like NICK are making a big move into the market. Finance companies increased their market share by 7.3% versus Q2 2012. Private equity is pouring capital into these companies giving them increased loan capacity.
The NICK CEO, Peter Vosotas, sounded downright bitter about increased competition in his FY2012 letter to shareholders: “During the past year we have noticed a huge increase in competition. Like most companies that face new and very aggressive competition our sales people have been challenged by this change in the competitive landscape. Some of our most aggressive competitors are divisions of the very same U.S. banks that the American taxpayer had to bail out when they ran out of money back in late 2008. Now these banks are undercutting our tried and true lending guidelines, which in our business vernacular means bidding more aggressively in their underwriting. In our point of view these banks are biting the hand that has fed them.”
A moat to keep competitors out is of no value if you are at the whim of government regulators. The subprime industry is an easy target because it charges very high interest rates and typically serves the most vulnerable segments of society (one wonders how the regulators think this segment of society would get to work without a car). Further, the very word subprime was stigmatized by the 2008-2010 crash.
Lately the newly created Consumer Financial Protection Bureau (CFPB) is making the most noise. Title X of the Dodd-Frank Act established the CFPB, which became operational on July 21, 2011. Under the Dodd-Frank Act, the CFPB has regulatory, supervisory and enforcement powers over providers of consumer financial products, including explicit supervisory authority to examine and require registration of installment lenders like NICK. For the time being, the interest rate issue seems to be off the table as the Dodd-Frank Act expressly provides that the CFPB has no authority to establish usury limits. Nevertheless, there are indications that the CFPB is taking a hard look at other aspects of the auto financing industry.
First on March 21, 2013, the CFPB issued fair lending guidance that seemed to pressure lenders to eliminate or severely limit an auto dealer’s discretion to negotiate the interest rate. Instead, lenders are to offer dealers a flat rate. In the eyes of the CFPB at least, negotiation over a consumer’s interest rate creates a “significant” risk of discriminatory pricing.
The on June 27, 2013, the CFPB ordered US Bank and one of its non-bank partners, Dealers’ Financial Services, to return $6.5 million to service members who had been deceived by a program aimed at offering subprime auto loans to active-duty military.
The CFPB has not yet stated any plans to oversee nonbank lenders. Nevertheless, I believe that threat of increased regulatory oversight is already priced in to the value of the sock.
NICK certainly shows the signs of a moat and temperament and a local focus seem to support it. I will further explore financial services companies in Part II.
 For our purposes, we will refer to “retail installment contracts” as loans.
 Sharp readers will note that in the 2013 10-K this sentence has been modified to read “However, the Company generally will not sacrifice credit quality, its purchasing criteria or prudent business practices in order to meet the competition.” (emphasis added). I’d like to think the word “generally” was added by an overly-cautious lawyer and does not indicate a change in management sentiment.
 By “soft information,” I mean qualitative information, including opinions, ideas, rumors, and statements of future plans. This is in contrast to “hard information” which is more quantitative, including bank statements, payment history and FICO scores.
 But what, you may be asking, is in it for the dealers? Good question. You would think they would be solely focused on getting the best price and dealing with the least stringent lending criteria. I have not been able to speak to a dealer, but I think this is what attracts them to NICK:
- Low discounts (at least until the credit cycle swings, more on this below)
- Quick reliable loan approval
- Enjoy working with their local representative
NICK simply says: “The Company attempts to meet dealers’ needs by offering highly-responsive, cost-competitive and service-oriented financing programs.”