ATLC - Atlanticus Holdings: Contrarian Opportunity

Summary

• Fears of recession, inflation, rising rates, and consumer defaults appear to have weighed heavily on Atlanticus’ share price.
• With the share price in the mid-$20s, down from above $90, we believe that this is a compelling risk vs. reward contrarian opportunity.
• Atlanticus is sitting on $20 per share of pro forma cash compared to a stock price of around $26 per share.
• In addition, Atlanticus is producing approximately $6 per share of earnings with imbedded peak default rates already factored in.
• All told, we see little downside below $20 per share and multiple of money upside.

We have published extensively on Atlanticus (ATLC) starting a little over two years ago. These reports can be found here . Since the time of our introductory report on October 1, 2020, the stock is up 106% through today (October 10, 2022) compared to an 8% increase in the S&P 500. Of course, this does not tell the full story of this stock as, between these two dates, the stock reached an intraday high of over $90 per share before retreating to its current levels in the mid-$20s.

During this time, Atlanticus’ share price and financial results were buoyed by both the rapid growth of its loan portfolio, as its direct and second look retail credit product offerings found acceptance in the marketplace, and defaults ran at historically low levels in part due to the large government stimulus programs that saw consumers flush with cash. During this period, the company also completed numerous other initiatives that created value for shareholders. More recently, as the market has become more risk-averse and macro headwinds have increased, the stock has languished.

Background

We encourage readers to read our introductory report mentioned above for more about Atlanticus’ business lines, but, essentially, Atlanticus is a technology-oriented subprime lender. It is the reincarnation of CompuCredit Corporation, Inc., founded in 1996, that ran into trouble in the 2008 financial crisis and had to dramatically restructure their business to avoid collapse. We believe that Atlanticus management, which owns over 50% of the company’s beneficial interests, has learned valuable lessons from this time and has positioned the company well to endure through challenging environments. We like to quote Mark Twain on this point in that “good judgment is the result of experience and experience the result of bad judgment”. We certainly believe that this is the case here.

We believe that these learnings can be seen in Atlanticus’ significant cash position, its long-dated fixed rate financing facilities, and its approach to underwriting, servicing, and management of customer credit availability. Given the level of insider ownership, we also believe that management is highly aligned with the outside shareholders.

The only area of concern for us in this area is that, given the current attractive share price, management may seek to enter into a transaction whereby they take Atlanticus private, or similar, at prices that may not reflect the full value of the company. We believe that this is mitigated, in part, by the company’s oft-stated optimism around the share price, which only a few months ago they claimed could be worth as much as $396 per share. For more information on Atlanticus, the company also publishes a helpful investor presentation on its website’s investor portal .

Thesis

We published our detailed internal projections for Atlanticus in a report dated January 4, 2021. We continue to believe that these projections, particularly from a cash perspective, reflect the earnings power of Atlanticus’ businesses of currently around $10 per share. On that note, Atlanticus’ cash generation has been consistently strong and generally in line with our projections. As a result, Atlanticus sits today with a pro forma cash position of over $400 million dollars.

We look at this cash position on a pro forma basis as the company’s financing facilities provide them with revolving credit flexibility and, as of June 30, 2022, Atlanticus had $100 million undrawn on their most recently completed financing facility alone (which, reassuringly, was completed during a time of market dislocation). This translates to cash per fully diluted share of over $20.

On the other hand, reported earnings have been more volatile as the company has been effectively “provisioning” their balance sheet for higher delinquencies than it has been experiencing. Management has repeatedly said in the MD&A sections of their public filings that they were using loss rate assumptions in the models they employ for their financial statement accounting that were higher than the levels actually being experienced due to macroeconomic uncertainty.

We have discussed this repeatedly in our prior reports. For example, in the second quarter of 2022, we read that Atlanticus employed an “expected principal credit loss rate" of 31.2%. This compares to a realized “net charge-off ratio” of 19.0% for the same period. To put this in context, we calculate that the realized “net interest margin ratio” for this period was 21.7%, of which 12.2% (or more than half) effectively went to building reserves. Or, said differently, the realized margin appears to be twice that which was reported.

We further note that, upon review of Atlanticus’ historical financials, we see that the company only briefly exceeded the 30% loss levels during the 2008-era financial collapse. In fact, the average credit losses for the 5 and 10 year periods prior to the pandemic were 18.9% and 19.3%, respectively, which is fairly consistent with the currently observed realized numbers. All of that said, in these unpredictable times, we cannot fault management for being conservative. However, we are encouraged that Atlanticus is able to generate $6 per share of run-rate earnings (based on the results from the second quarter of 2022) using historical peak default assumptions.

Valuation

We encourage readers to review our detailed report concerning our internal projections. The metric, to which we pay closest attention, is Level Free Cash Flow per Share. This metric attempts to quantify the cash flow being generated by the business before portfolio growth, after preferred dividends, adjusting for convertible instruments, and utilizing the fully diluted share count. We have been focused on this metric since the inception of our position as it helps us to eliminate some of the “noise” resulting from Atlanticus’ fairly complex accounting.

It does not eliminate all of the noise, as we utilize the loan balances from the beginning and end of each period, which now are affected by management’s fair value adjustments (vs. in the past when we could simply exclude the separately presented provision) but have found it to be a more reliable indicator (and we have not sought to adjust the loan balances for the accumulated fair value adjustments, which would present this metric in a more favorable light).

The ”noise” in Atlanticus’ GAAP earnings has stemmed from several sources, particularly, in prior periods before the company adopted fair value accounting, when the company has to post large upfront provision charges that swamped earnings given the rapid growth. In later period, as the company transitioned new originations and then the entire consumer portfolio (excluding its auto dealer lending business) to fair value, noise likewise existed.

As set forth in our detailed projection report, we have been anticipating that the company should produce around $10 per share of level free cash flow per share. We continue to believe that this is a reasonable expectation. As noted above, the company is currently reporting around $6 per fully diluted share of GAAP earnings after incorporating what we view to be peak loss assumptions. In addition, the company has posted consistent year over year growth and, while the current environment is challenging from a delinquency standpoint, it should present the company with favorable opportunities. As such, we believe that an $80 price target (or $60 net of cash) is reasonable. This would require a 10x multiple of the above earnings or 6x multiple against level free cash flow.

Risks

We believe that the most significant risk the company faces are the macroeconomic risks that are in the headlines every day: inflation, rising rates, and the possibility (likelihood?) of recession. These risks would impact the company most severely in terms of credit losses above and beyond our, the market’s, and the company’s expectations. We believe there are several mitigants that should be considered here.

First, are the company’s substantial margins. With a portfolio yield in excess of 40% and funding costs below 5%, there is quite a bit of room to absorb losses. Second, the company’s financial results already incorporate loss assumptions north of 30% (while they are currently actually below 20%), so, again here, there is room to absorb expanding losses. We also note that, upon our review of the company’s historical financials, the company experienced losses above 30% only in the aftermath of the 2008/2009 financial crisis, and these loss levels were short-lived, returning back to the long-term average in the high-teens (around where they are now).

Thirdly, we believe the company has learned valuable lessons from their previous brush with collapse and will not make the same mistakes again (primarily by aggressively reducing their “open to buy” upon any customer weakness, as they have alluded to in their public filings). Lastly, we note that Atlanticus has continued to buy back stock, which we do not believe they would be doing if there were substantial concerns around performance. In addition, we have not observed any of the key management making any material stock sales (in fact, the chief accounting officer recently purchased some of the perpetual preferred stock).

Like any financial company, a risk exists that rates will continue to rise materially, increasing Atlanticus' cost of funding and compressing their net interest margins. While this is certainly a concern, we note that the company’s financing facilities are primarily fixed rate and long-dated (perhaps a lesson learned) and, as discussed above, there is a substantial spread between their portfolio yield and interest cost to absorb widening of capital costs.

An additional concern that we have, is the risk that management may seek to take advantage of the current depressed trading levels and market weakness to conduct some form of management buyout that does not put full value on the shares. Management has continued to buy shares in the open market, and the share count has continued to come down steadily, benefiting the remaining shareholders. But our concern is some sort of “go private” transaction at less than full value. We believe that this risk is somewhat mitigated by management’s recently published optimism around the value of the company’s share, including a price target of $396 per share using fintech comparables published earlier this year.

Of course, each investor should study the risk factors published by the company in its public filings for additional areas of concern for evaluation.

Conclusion

All told, we believe that Atlanticus presents the sort of fat pitch that contrarian value investors like us try to wait for. Given the lower trading volume, this opportunity also appears to favor the individual investor whereas the typical hedge funds and similar that might customarily traffic in opportunities such as these may well shy away for this reason. We see that, at the current share price levels, excluding cash, investors are paying around 1x run-rate GAAP earnings for the business.

We further note that these earnings already reflect a historically peak loss assumption. Lastly, we believe that Atlanticus has a management team that is well aligned with investors, has the necessary experience (and resultant judgment) to avoid the same mistakes of the past, continues to buy back equity instruments, and has positioned the company well for this environment. As a result, we continue to believe that there is limited downside given the $20 per share of cash and, while not without material risks, with the ability to generate $10 per share in cash earnings, the upside could be north of $80 per share.

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