Blue Tower Asset Management annual letter for 2014 discussing the fund’s positions in Nicholas Financial.

See Part I and Part II here.

Blue Tower Asset Management – Nicholas Financial

The biggest position in the strategy at the close of 2014 was Nicholas Financial, making up a 13.6% position. Nicholas Financial is a specialized subprime automobile loan company which purchases and services consumer loans for automobiles and light trucks. While other subprime car loan companies use statistical models in order to decide to whom to give their loans and rely on a large pool of borrowers to balance out defaults, Nicholas focuses on truly understanding their potential borrowers. They have a distributed system of underwriting where the local branch manager determines which buyers will receive loans. This differs from the statistical and centralized model of other subprime automobile lenders. Nicholas Financial endeavors to provide loans to good customers who have had poor luck in their recent life leading to poor credit such as medical issues and avoid “credit criminals” who have poor credit due to habitually living beyond their means. They incentivize good underwriting by tying the compensation of their branch staff to the performance and recovery of the loans they approve. This has led to their employees getting a reputation for extreme vigilance in repossessing vehicles from delinquent borrowers.

Furthermore, Nicholas builds in two layers of protection for their loans. First, they make the loan for a principal amount that is cheaper than the collateral of the vehicle. Secondly, they purchase the loan at a discount to its principal when buying from the dealer. This emphasis on good underwriting has allowed them to create a pool of borrowers with far lower non-performing loans than their peers.

With such an excellent business model it may lead some people to question why it would trade at a cheap valuation. The current catalyst for this opportunity is due to a failed acquisition of the firm by Prospect Financial. The reasons for the failure were an SEC investigation of Prospect as well as push back from Nicholas board members and shareholders against the acquisition who felt that the $16/share price was far too low. Once the acquisition fell through, there was a forced liquidation of the stock from merger arbitrage funds who had built up large positions of the stock in anticipation of the acquisition.

There was also a possible catalyst which was realized in December of 2014 from the low degree of leverage employed by Nicholas relative to many of its peers. Nicholas had an assets to equity ratio of 2 in an industry where many companies are employing leverage ratios of 10 or higher. This conservative accounting gave an opportunity for the business to boost its return on equity through the use of a special dividend or share buyback. On December 22, 2014, the company announced an intention to do a modified dutch auction tender offer to buyback over a third of their outstanding shares. This acted as a catalyst to greatly boost the share price and will generate a great deal of value for shareholders through increased earnings per share.

Nicholas alone boosted the composite returns of the strategy by 3.26% in the fourth quarter. I continue to have a great degree of confidence in the position and intend to maintain it as a longterm holding for Blue Tower’s investors.