Gator Financial Partners commentary for the month of September, 2016.
Dear Gator Financial Partner:
We are pleased to provide you with Gator Financial Partners, LLC’s (the “Fund”) September 2016 investor letter. This letter briefly reviews the Fund’s investment performance through August 2016, discusses three consumer finance stocks we own in the portfolio, reviews the low valuations of stocks within the portfolio, and discusses the Fund’s current net exposure and positioning by sub-sector.
Review of YTD 2016 Performance
As you know, 2016 has been a bumpy year so far, and we have managed through the year with more than our fair share of volatility. Through August 2016, the Gator Financial portfolio has returned a positive 12.0%. We’ve continued to benefit from a rebound in a few underperformers from 2015 and a couple of new ideas. Syncora Holdings, Ambac Financial Group, and Bimini Capital Management have helped to increase returns in 2016. On the negative side of the portfolio, our positions in Voya Financial and KKR are still lagging.
Gator Financial Partners – Consumer Finance Stocks
We increased our holdings of consumer finance stocks after the industry drastically underperformed the market in June. We owned a position in Capital One, and we built new positions in two other consumer finance stocks: SLM Corporation and OneMain Holdings. We see a high level of skepticism among investors regarding consumer lending. We believe investors are still fearful of the industry after the problems of 2008. Our view is that the industry is on stronger footing now than any time in the 25 years that we have followed it. Plus, we think it is unlikely consumer lending will be the cause of the next recession or financial crisis like it was in 2008. We see many investors making the argument that subprime auto lending is in a bubble, so consumer lending is about to implode. We think there may well be companies that get into trouble in subprime auto lending, but there is not a widespread problem. We think the current fear of consumer lending has created an environment where investors have overlooked good things happening at each of these companies.
We believe Capital One stock is interesting because it has the best combination of growth and value among the super-regional banks. With its mix of national lending platforms and online deposit gathering franchises, Capital One has the best strategic positioning of super-regional banks. The company is posting the best growth rate among the credit card issuers. The non-promotional management team has been positive about the growth opportunities that they currently see. The company’s stock trades for less than 9.0x 2017 Bloomberg’s consensus estimated earnings per share compared with similarly sized banks trading more than 12.0x. Capital One has been returning excess capital to shareholders by repurchasing 6% of outstanding shares per year for the past few years. We think the downside is limited as Capital One trades at 1.2x tangible book value.
Capital One is the best positioned of the super-regional banks. Capital One is unique among the superregional banks in that it has national lending platforms for credit cards and auto finance. These two
lending segments have consolidated and peers would have difficulty entering these businesses beyond cross-selling to their existing customers. We believe the growth rates and the returns from these two segments are higher than the typical bank loan portfolio of business loans, commercial real estate loans, and mortgage loans. In late 2015, Capital One added another national lending platform by acquiring General Electric’s Healthcare Finance unit. We give credit to Capital One’s management team for realizing years ago that certain lending businesses would consolidate nationally. Then, they positioned the company to ensure they will be one the long-term players in these markets.
Capital One is also better positioned than its peers with both local and online deposit gathering franchises. Over the last ten years, Capital One improved its liability profile by acquiring banks in New York, Washington, DC, and New Orleans. These banks were primarily acquired for their deposits, but they each had reasonable commercial lending businesses. Capital One has continued to operate these commercial lending businesses in the local markets because they earn more than their cost of capital, but they have lower growth and returns than Capital One’s national lending businesses. In 2012, Capital One enhanced its deposit franchise by acquiring ING Direct, one of the pioneers in online banking. This acquisition gave Capital One the leading position in online deposit gathering. Although the banking system has been awash in deposits since this acquisition, this online deposit gathering scale will enable Capital One to maintain its growth rate when industry deposit growth is less robust. With the combination of national lending platforms, local deposit franchises, and the online deposit gathering presence of ING Direct, we believe Capital One will able to grow faster and earn higher returns than the other super-regional banks.
We think investors are overlooking the best-in-class growth rate of Capital One’s credit card business. The table below shows Capital One is growing both credit card receivables and credit spending by its customers faster than the other major credit card issuers. We believe Capital One’s growth is driven by management’s long-term marketing campaigns focused on rewards and building the best card products with 1.5% cash back (Spark) and double miles cards (Venture). We think Capital One differentiates itself from peers because of a willingness to forgo current earnings for business enhancing investments for customer acquisition or advertising that have a long-term positive net present value. Often, these investments detract from earnings in the current period. An example of this business investment is the 15% annual increase in marketing spending over the past two years, which has accelerated receivable growth from 1% to 12%. However, Capital One’s earnings per share over this time period is flat as the additional revenue from the receivable growth has gone to pay for the marketing spend and to add to its loan loss reserves. While companies in other industries are rewarded for deferring earnings in favor of growth investment, bank investors may be hesitant to give Capital One credit for their growing credit card portfolio until they see evidence of earnings growth. We see this as an opportunity to buy Capital One at an attractive valuation with growth on the horizon.
Capital One’s management has a history of discussing their business in a non-promotional manner, so we take note when we hear them talk enthusiastically about their current prospects. Capital One does not manage earnings or give earnings guidance. Instead, the management team talks in terms of business drivers on earnings conference calls or at investment conferences. When management sees an opportunity to grow the business through additional investment, they will spend the money even if it means they will “miss” the quarter due to the extra expense. On recent conference calls, Capital One’s management has talked favorably about the long-term benefits of the recent growth even though current earnings are not reflecting the recent balance growth of the company’s credit card business.
Capital One’s growth is not only compelling versus other credit card lenders, but its valuation is compelling versus other super-regional banks. As you can see from the table, Capital One has the lowest valuation of the super-regional banks on a Price-to-Earnings basis. Four banks (FITB, KEY, CFG & RF) have lower Price to Tangible Book Ratios, but each of these banks have lower returns on equity than Capital One.
While we believe Capital One is compelling, we need to acknowledge the bearish arguments against our position:
- Company may not meet estimates as it continues to post increasing loan loss provisions due to “growth math.” Capital One has not been explicit about the exact seasoning of their new credit card loans. However, they have said that their loan loss reserve is built to approximate the next 12 months of net charge offs. They have also said that net charge-offs in 2017 will be in the “low 4% range” up from 4% in 2016. Based on our modeling, we think loan loss provisioning will decelerate on a quarterly basis starting in Q3, so we think this will be a tailwind for Capital One earnings over the next 6 quarters.
- Company has a couple pockets of credit weakness: taxi medallion loans and oil & gas loans. We think Capital One is close to putting these two issues behind them. Although, their taxi medallion portfolio may need some modest additional loan loss provisioning over the next couple of quarters. We believe they are adequately reserved for their oil & gas lending exposure.
- Capital One is one of the largest lenders in the sub-prime segments of the credit card and auto loan markets. Subprime lending can be the most volatile when entering a recession, but the returns are higher to compensate for the additional risk. We believe Capital One can manage through the risks of sub-prime lending.
We think Capital One’s stock is interesting at this time because it has asymmetrical returns. With the stock at $71, we see upside to $126 and downside to $58 by the end 2018. With these targets and dividends, the upside case is +32% annualized return and in the downside scenario the annualized return is -7%.
We purchased SLM Corporation (“SLM”) this summer because it was trading at 10x 2017 estimated EPS and is growing its loan portfolio more than 20% annually. SLM is the renamed student loan company formerly known as Sallie Mae. The student loan industry has gone through significant changes over the last 10 years. The industry used to originate a mix of government guaranteed loans and private loans. In 2010, the government ended the program of third-party lenders making government guaranteed loans. Now, the government makes direct student loans for up to $31,000 per student for the four years of college. Student lenders, like SLM, provide private student loans for costs above $31,000.
In 2014, SLM split into two companies: SLM and Navient. SLM retained the student loan origination platform and the newly created banking operation. Navient took most of the existing portfolio of student loans and the student loan servicing and debt collection platforms. At the time of the spin-off, we thought SLM was interesting because it would grow very quickly and we thought the student loan origination platform was a valuable asset, but we didn’t buy the stock because it traded at 25x earnings and a portion of the earnings were gains from selling new loan originations.
After the 2014 separation between SLM and Navient, SLM owned a new banking subsidiary and retained the large, dominant student loan origination franchise. SLM’s economic model was earning revenues from two sources: the net interest spread on loans it retained and gain on sale income on excess loan originations it sold. The reason SLM sold any loans was due to restrictions regulators placed on the growth of SLM’s banking subsidiary. Regulators typically place additional growth and capital limits on new banks because these growth restrictions reduce risk. This is a reasonable regulatory practice because history has shown that new banks are more likely to have problems and/or fail. SLM originates $5 billion of new student loans per year, but their banking subsidiary was not allowed to grow at a rate that would absorb all of these originations, so it sold the loan originations that it could not retain into the capital markets. SLM’s student loans are very attractive to buyers because they have high credit quality, they are variable rate, and they have spreads between 4% and 8% above Libor. In 2014 and early 2015, buyers paid a 10% premium for SLM’s excess loan originations.
In 2015 and early 2016, SLM’s stock price declined due to a decline in earnings from selling new student loan originations. This stock decline was interesting to us because we had placed a low value on the income from selling loans. Midway through 2015, the buyers stopped paying 10% premiums for SLM’s loans and only offered 6% premiums. This lower price led to lower revenue and earnings for SLM.
SLM’s management team didn’t like selling the loans in the first place, but they had to because of the growth limits. When the market lowered the premium they were willing to pay SLM, SLM management went to their banking regulator to ask for a growth waiver, so they could retain the loans. SLM’s regulator granted the growth waiver, so SLM’s management could stop selling loans entirely and retain the loans on SLM’s balance sheet. We think it is better for SLM to retain the loans, have higher-quality recurring earnings and a faster growth rate. SLM’s stock declined during this time because near-term earnings estimates declined as gain on sale revenue and income went away completely.
The two main risks to the SLM investment thesis are a potential change to how student loans are handled in bankruptcy cases and some unforeseen problem with SLM’s credit underwriting. Borrowers still have to pay their student debt even if they declare bankruptcy. Congress would have to pass a law to give borrowers relief in bankruptcy. We don’t think a change will happen in the medium-term, but we constantly worry about a possible change. We believe SLM’s underwriting is strong and has improved by using higher credit scores, having more loan co-signers, and focusing on schools with higher
graduation rates. But, we can always get a credit surprise, so we monitor SLM’s credit metrics to see if we can detect any bad trends.
At recent prices, SLM trades at 10.9x 2017 estimated EPS and is growing >20%. We think other investors will recognize this as the company reports earnings over the next year. In addition, we believe SLM’s dominant 50% market share of private student loan originations is attractive to a major bank looking to grow their balance sheet.
We purchased OneMain Holdings because it was trading 5x 2017 estimated EPS, and we believe it is a beneficiary of consolidation in the consumer unsecured lending business. We believe as the company realizes the cost savings from a recent major acquisition and deleverages through retaining earnings that the stock valuation will improve.
OneMain Holdings is relatively new to the public markets, but the core operations of the company have a long history. The private equity firm Fortress Investments purchased AIG’s consumer lending business, American General Finance, in 2010 and renamed it Springleaf Finance. Fortress brought Springleaf public in a 2013 initial public offering at $17. The Springleaf stock performed well in 2014 and traded around $35 by early 2015. In March 2015, Springleaf announced an agreement to acquire OneMain Financial from Citigroup. The market reacted favorably to the proposed acquisition due to the potential earnings accretion and bid Springleaf’s stock above $50. The deal closed in November 2015 and Springleaf changed its name to OneMain.
A key component of the OneMain investment thesis is deleveraging its balance sheet. OneMain paid Citigroup $4.5 billion in cash. Because OneMain borrowed this money, OneMain was leveraged over 18x at the close of the acquisition. But, earnings and a sale of a non-core portfolio has already brought the leverage down to 11.4x. The table below shows our estimate of OneMain’s future deleveraging through retained earnings and having a loan growth rate below the rate of their capital generation. In our experience, stocks of deleveraging companies with low valuations benefit from the value creation of the debt pay down.
OneMain earnings growth profile is attractive due to cost savings and loan growth. OneMain has significant cost saving opportunities while consolidating the purchase from Citigroup. The benefit of these cost savings are phased in over the 2016-18 timeframe. Essentially, OneMain is able to eliminate duplicative costs and there are substantial overlaps. The table below shows the earnings growth progression. Once OneMain accomplishes the cost savings, we believe the earnings growth beyond 2018 will be attractive because we think the basic economic model of OneMain’s business generates a return on equity greater than 25%. We also think OneMain will be able to grow its loan portfolio with quality loans through its core business.
In the sell-off the first six weeks of 2016, OneMain’s stock materially underperformed the Financials sector and the broader market, but we don’t think there was any new reason that justified this level of underperformance. By Feb. 11th, OneMain was down 54% year-to-date compared to a 17% decline in the Financials sector and a 10% decline in the S&P 500. During this time period, there was no news flow on OneMain to justify the underperformance. Clearly, investors decided to de-risk their portfolios by selling their OneMain shares in Q1. Even though the market has recovered to positive territory for the year, OneMain is still down 27% year-to-date and trades at 5x 2017 estimated EPS. OneMain recently traded for $30.
We believe OneMain is well-positioned in the consumer installment loan industry because the competitive intensity has declined compared to other areas of lending. Since OneMain is a combination of two large legacy players it holds a strong competitive position in the consumer installment lending market. Due to the Dodd-Frank banking regulation law and banking regulators desire to reduce risk within the banking system, commercial banks have pulled back from making consumer installment loans. Some prominent bank competitors have reduced their participation in consumer installment lending such as HSBC, which had purchased Household Financial, and Wells Fargo Financial. We also think OneMain has a significant competitive advantage over online lenders due to the intensive local servicing done by its employees in the branches.
The primary risks to our thesis on OneMain are potential problems with credit quality, potential inability to access the capital markets, and a high degree of financial leverage. OneMain and its predecessors have been making loans for 90 years and were able to navigate the recession of 2008. We monitor their credit statistics on a monthly basis and are comfortable with the recent trends. Since OneMain is not a bank, it is dependent on the capital markets for funding its liabilities. If access to the credit markets shutdown for an extended period of time, OneMain may have problems funding its balance sheet. OneMain uses a combination of loan securitizations and unsecured debt to fund its balance sheet. We do not see any issues with continued access to the capital markets for their loan securitizations. In the unsecured debt market, the ability for OneMain to issue new debt may stop from time to time depending on how the overall credit market is performing. As OneMain retains earnings over the next two years and deleverages, we think it will be able to manage through these market hiccups with more ease. During a recent example of a closed debt market in Q1 of 2016, OneMain was able to access this market in early April and was one of the first non-investment grade issuers to complete a new offering. We expect OneMain to achieve its target leverage ratio by the 3rd quarter of 2018.
With the low valuation and underperformance of the stock this year, we think OneMain has attractive upside. Over the next three years, we think it is reasonable that OneMain will trade up to 10x estimated earnings per share. We believe OneMain’s earnings multiple will expand as the company realizes the cost savings from its recent acquisition and its leverage declines through retained earnings. At 10x earnings, OneMain’s stock would be greater than $60 or more than 100% appreciation from the current share price.
Low Multiples within Portfolio
We believe the holdings in our portfolio trade at compellingly low valuations. We hear consternation about the high valuation of the stock market, but we do not see it in our portfolio. We are reminded that it is a market of stocks and not a single homogenous stock market. In our hated corner of the stock market, we find many inexpensive stocks.
Here are the top twenty holdings in our portfolio (ranked alphabetically.) We exclude four special situation holdings that do not have sell-side earnings estimates: Ambac, BFC Financial, Syncora, Fannie Mae Preferreds, and Bimini Capital Management. In the table, we show the companies’ Price to Earnings ratio (“P/E Ratio”) based on the September 16th stock market close and the current consensus
earnings per share estimates for 2017 calculated by Bloomberg.
As you can see, most of these holdings have single digit price-to-earnings ratios and/or low Price to Tangible Book Value Ratios (“P/TB Ratio”). We note The Carlyle Group, OM Asset Management, Ares Management, and Ameriprise are asset management businesses, so their P/TB Ratios are not as important as these businesses do not need to reinvest their capital to grow their businesses.
We look at these low multiples within our portfolio and are excited about the opportunities we see. We believe the businesses we own are solid and continue to grow and gain value. Although they may be out of favor at the moment, we know stock market investors can be temperamental and may come around to our view on these companies. When market pundits talk about the high valuations in the stock market, we believe our portfolio consists of stocks with modest valuations.
Below are the Fund’s largest common equity long and short positions. All data is as of August 31, 2016.
From this list, we exclude ETFs and fixed income instruments such as preferred stock.
Below is a table showing the Fund’s positioning within the Financials sector as of August 31st:
The Fund’s gross exposure is 143% and its net exposure is 32.9%. From this table, we exclude fixed income instruments such as preferred stock. Preferred stock positions account for an additional 4.6% of the portfolio.
We have made two organizational changes since our letter in May. First, we merged our QP fund into our original fund. We did this to cut expenses across both funds and to ease portfolio management. We still have our Offshore Fund as feeder fund into our original fund. Second, our trader, Chris Pilecki has joined Oakpoint Advisors, and we signed a contract with Oakpoint to continue to use his services. Due to our low turnover, we determined Chris had spare capacity that can be made available to other funds.
As we have many stocks in our portfolio with low valuations and potentially significant upside, we are optimistic over the near-to-medium term. Thank you for entrusting us with a portion of your wealth. On a personal level, I continue to have significantly more than 50% of my liquid net worth invested in the Fund.
As always, we are available by phone whenever you want to discuss the Fund or investing in general.
Derek S. Pilecki
Managing Member of Gator Capital Management, LLC, which is the Managing Member of Gator Financial Partners, LLC
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