February 25, 2013
MicroFinancial, Inc. (MFI)
Current Price: $7.42
Target Price: $9.50
Why MFI?
- Runway for new business remains long and robust
- Best in-class collections agency within MFI remains hidden gem
- Conservative management team (leverage only 1:1.1 times)
- Margins are impressive and sustainable
- Reasonable competitive moat
- Proprietary credit software and database gold standard in industry
- Large insider ownership
- 3%+ dividend yield , and growing
Why Now?
- MFI’s major risk of funding resolved
- COGS reduced by $500K+/yr. (refinanced RLOC 25bps cheaper)
- Economic backdrop, improving charge-offs
- Dividend increase shows management’s confidence
- Shares inexpensive on cash basis, as well as, GAAP basis
- Stock down on investment in California office … will pay-off
Business Description & Company History
MFI operates primarily through TimePayment Corp. TimePayment is a specialized commercial finance company that leases and rents “microticket” equipment and provides other financing services. The average amount financed by TimePayment is $5,500, MFI uses proprietary software to develop a sophisticated, multi-level pricing model and in automating credit approval and collection systems, including a fully-automated Internet-based application, credit scoring and approval process.
MFI provides financing alternatives to a wide range of lessees ranging from start-up businesses to established enterprises. MFI primarily leases and rents low-priced commercial equipment, which is used by these lessees in their daily operations. MFI does not market services directly to lessees. MFI primarily sources originations through a nationwide network of independent equipment vendors, sales organizations, brokers and other dealer-based origination networks. MFI funds operations through cash provided by operating activities and borrowings under the company’s revolving line of credit.
MFI originate leases for products that typically have limited distribution channels and high selling costs. MFI facilitates sales of such products by allowing dealers to make them available to their customers for a small monthly lease payment rather than a higher initial purchase price. MFI primarily leases and rents low-priced commercial equipment to small merchants. MFI currently leases a wide variety of equipment including, but not limited to, water filtration systems, food service equipment, security equipment, and point of sale (POS) cash registers, salon equipment, health care and fitness equipment and automotive equipment.
The company borrows long-term funds at a fixed rate and lends at a higher rate to small businesses, capturing spread income. MFI borrows at around 4% and earns around 34% average lease return. That spread, less charge-offs, get you to their margins.
MFI’s clients are generally small owner-operated businesses (often with limited business credit history), engaged in manufacturing, distributor or selling micro-ticket equipment. These clients borrow small sums (generally $500 – $25,000 per lease with a $5-6,000 average ticket) for ~4 years (average contract term 44 months).
MFI has identified 33 market segments and totaling an estimated $30B of equipment sales of which currently $6B is either leased or financed. MFI has relationships with 9,000 vendors. About 62% of these vendors are active and MFI has received leases from 3,144 or 35% of these vendors.
The microticket leasing and financing industry is highly competitive. MFI competes for customers with a number of national, regional and local banks and finance companies. MFI’s competitors also include equipment manufacturers that lease or finance the sale of their own products. While the market for microticket financing has traditionally been fragmented, MFI could also be faced with competition from small or large-ticket leasing companies that could use their expertise in those markets to enter and compete in the microticket financing market.
MFI’s competitors include larger, more established companies, some of which may possess substantially greater financial, marketing and operational resources, including a lower cost of funds and access to capital markets and other funding sources which may be unavailable to MFI.
MFI’s competitors are often subsidiaries of larger corporations and banks, as well as, the risk of client’s taking the business in-house. MFI has found that companies that take the business in-house typically experience more credit defaults and lower collections received. Many eventually see MFI’s value-add trough their superior software systems and customer support and return to use their services.
MFI always has some outstanding bad receivables on their books. They have experimented with farming out this business to collections “experts”, but with little success. As it turns-out MFI’s collections department with their proprietary system and software is able to get higher repayment at a much lower cost. We foresee some opportunity down the road to expand their collections business to third party clients, but not in the near-term.
MFI has recently addressed the looming question of refinancing its revolving line-of-credit. It had been for $100m at Libor + 275 with Soverign Bank. There had been some question of MFI’s ability to refinance since Sovergin had been acquired. This turned out not to be an issue as their LOC has been increase to $150mm at Libor + 250, saving the company more than $500K in interest charges per year.
Management
Richard Latour serves as MFI’s President and CEO. He earned a B.S. in accounting from Bentley College in Waltham, Massachusetts. When Mr. Latour became President and CEO back in 2002 he inherited a dying business in the credit card swipe machines. Mr. Latour’s foresight and leadership reinvented the company to what it is today.
James Jackson Jr. serves as MFI’s Vice President and Chief Financial Officer since April 2002. Mr. Jackson is a passionate individual who enjoys what he does, and for all intents and purposes seems more than capable at it.
Valuation
MFI is rated a buy at current levels, based on several trends. First, credit metrics are improving, while MFI recorded a higher provision for credit losses, this is natural due to expanding business. Actual credit losses have been improving as the economy has improved. Second, macro trends are in MFI’s favor. Given the forecast for economic growth in the United shows how MFI could be positively impacted in this environment (the company could see higher growth in originations and/or lower credit losses).
Should MFI trade up to a higher valuation of ~12x depressed 2013 estimates of $0.70 (or a price of $9.50). Calendar year 2014 should be stronger as the expense of the new California office start to improve operations on a client services and new business standpoint. We believe MFI could earn closer to $0.85 in 2014, putting valuation north of $10 per share.
At 1.3x book value and ~11x 2013 earnings, MFI is reasonably valued given the current macro backdrop in the United States. In the event of a stronger macroeconomic environment, MFI is poised to benefit as small businesses typically lead an economic recovery.
On a cash receipt perspective shares are much cheaper. Due to GAAP accounting standards earnings are depressed do to timing of payment recognition and amortization. MFI generates a substantial amount of cash from clients. Cash earnings and revenue run more than double GAAP numbers. An analyst can choose how they want to look at valuation (GAAP vs. Cash), but on a cash basis the shares of MFI are very cheap.
Risks
Funding risk
MFI’s ability to draw down amounts under the credit facility is potentially restricted by a borrowing base calculated with respect to the company’s eligible receivables, and the revolving line of credit has financial covenants that MFI must comply with to obtain funding and avoid an event of default.
Economic Risk
Similar to other leveraged financial lenders, MFI is vulnerable to a protracted economic downturn. A downturn or slowdown in economic growth may cause an increase in defaults of leases and lower demand for the commercial equipment MFI leases. A protracted economic downturn similar to the one the United States and other nations have experienced in recent years could result in a decline in the demand for some of the types of equipment or services MFI finances, which could lead to a decline in originations. In addition, a protracted downturn could result in an increase in delinquencies and defaults by MFI’s lessees and other obligors, which could have an adverse effect on the company’s financial results and ability to securitize leases.
Credit Risk
Even in times of general economic growth, the credit characteristics of MFI’s lessee base correspond to a high incidence of delinquencies, which in turn may lead to significant levels of defaults. The credit profile of MFI’s lessees heightens the importance of both pricing our leases and contracts for the risk assumed, as well as maintaining an adequate allowance for losses.
In addition to MFI’s origination practices, the company also purchases lease portfolios from dealers. These purchases include leases that were initially below MFI’s underwriting standards but have subsequently performed. These lower quality loans have a higher risk of default should economics conditions deteriorate.
Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.