ATLC - Atlanticus Holdings: Deeper Dive On Balance Sheet And Debt Structure

Summary

• Several of our readers have requested that we provide further commentary on Atlanticus' balance sheet and debt levels - we aim to do so here.
• In this report, we share our thoughts on debt structure, asset coverage, the impact of interest rate increases on earnings, and other topics.
• All told, we find that Atlanticus' debt levels are manageable and well structured, reflecting many lessons learned from the prior downturn.
• Our estimates show that Atlanticus' common shares are trading at 4x its run-rate GAAP earnings and lower when considering the actual credit losses and cash on hand.
• We believe that the current trading level of Atlanticus' common shares is presenting investors with a compelling upside opportunity with limited intrinsic value downside.

First of all, a thank you to our readers - particularly @BeaBaggage @filly1776 @papaloapan @Pops007 @rec2 - for stimulating the discussion about Atlanticus' (ATLC) balance sheet and debt structure. We note that, Atlanticus provides substantial disclosure on these issues in its public filings and we encourage investors to pay particular attention to footnote 8 (Variable Interest Entities) and footnote 10 (Notes Payable) in Atlanticus' most recent 10-Q.

Non-Recourse Debt Structure

As is customary for a properly run finance company, a substantial portion of Atlanticus' indebtedness is in the form of ABS and is non-recourse to the public company. We also believe that the capital structure of Atlanticus reflects the "lessons learned" by ownership and management during the company's near-death experience in the 2008-2010 timeframe.

In footnote 10, Atlanticus specifically identifies which notes are recourse to the company and which are non-recourse. When adding up the non-recourse notes, we arrive at a sum of $1.440 billion. This figure is roughly equal to the amount of debt shown in footnote 8 as being "Notes Payable, net held by variable interest entities" of $1.473 billion (we attribute the difference to deferred financing fees, and other similar accounting entries).

Against this $1.473 billion of notes, Atlanticus discloses that the VIEs hold $1.820 billion of assets, with substantially all of that being loans, at fair value (this is important as the fair value already incorporates a default rate assumption 50% greater than Atlanticus is currently experiencing - we will address that further below) and some cash and other assets. This equates to an advance rate of 79%, which we find to be reasonable if not somewhat conservative (perhaps a reason why Atlanticus has been able to continue to access the securitization markets when others have not - more on that later, as well).

We encourage investors to read the detailed footnote 10 on "Notes Payable" that provides a description of each facility including its key terms such as rate, revolving period, maturity, etc. What we find, particularly among the more recent and larger facilities, is that these ABS facilities (1) are non-recourse to Atlanticus, (2) have a revolving period (usually around three years), and (3) then have an amortization period where the remaining receivables serve to paydown the facility (vs. any sort of bullet refinancing need - a particular valuable feature in times such as these and a key "lesson learned" from prior periods, we believe). We also note in these details that Atlanticus has at least $335 million of undrawn capacity on its existing facilities, providing further cushion.

Recourse Debt Structure and Cash

This leaves $118.5 million of credit facilities that are guaranteed by the parent company (which could be refinanced by the availability on its non-recourse facilities) in addition to the $150 million of senior notes (due November 30, 2026), less $14.4 million of unamortized debt issuance costs, which gets us to the $1.7 billion of total indebtedness. (In addition, the company issued $76.5 million of 7 5/8% perpetual preferred stock.)

In addition, and importantly in our view, Atlanticus had $352.9 million of unrestricted cash and $33.8 million of restricted cash (about half of which is associated with the VIEs) as of 9/30/2022. The company also discloses that, as of 9/30/2022, it was in compliance with its covenants (no small feat given the large number of technical matters typically included in such a capital structure such as Atlanticus'.

Access to ABS Markets and Rates

Importantly in our view, Atlanticus has been able to continue to access the securitization markets during the choppy waters of 2022, with issuances completed in May, August, and September of this year. That is no small feat, either, particularly for a lender focused on subprime consumers. As would be expected, however, the interest rates that Atlanticus is paying have crept up. In November 2021, Atlanticus issued ABS at a fixed rate of 3.53%, whereas the subsequent rates for the abovementioned ABS deals in 2022 were 6.33%, SOFR + 1.8%, and 7.3%.

While these increases in rate are significant on a percentage or relative basis, it is not particularly material to Atlanticus' net interest margin. As discussed in prior reports, Atlanticus is currently realizing (using the 3Q22) a total yield of 45.5%, a charge-off ratio of 18.0%, an interest expense of 4.2% and a net interest margin of 23.3%. So, while a 300 basis point increase in interest expense, for example, would be significant on a relative basis, it does not materially impair Atlanticus' earnings potential (and we would expect that the company would increase its rates and fees to offset this) nor our theses, particularly given where Atlanticus' stock currently trades. Much more important to Atlanticus' earnings power are the default rates (both actual and reported).

Default Rates

On this point, as we have discussed in our prior reports, Atlanticus currently is using default assumptions north of 30% for use in its fair value and earnings reporting while it currently is experiencing a default rate of 18%. Atlanticus management has acknowledged in its disclosures that this loss rate assumption is higher than current and historical trends dictate.

What we understand that this means is that, while Atlanticus currently is generating a NIM of 23.3% it is reporting a NIM of less than 10%. So, with the stock at these levels, investors have the opportunity to buy the common stock at 4x earnings (or likely less than 2x based on the actual NIM using current actual charge-off rates), and getting $20 of cash for free on top of that.

That is likely why we haven't seen any insider selling by the key management team and the company and insiders have continued to buy back equity and preferreds.

Auto Business

As to the auto business, it is important to understand that Atlanticus is not financing subprime customers directly but rather providing wholesale financing to the auto dealers with credit enhancements. As such, the losses experienced there have been low, with charge-offs running below 1% and 90-day delinquencies currently at 1.7%. We view this as a small but excellent business.

Outlook

All told, we view the current sell-off, seemingly driven by macro fears and the inevitable forced liquidations in this part of the cycle, as a tremendous opportunity for patient investors. We continue to believe that, with $6/diluted share of GAAP earnings run-rate, likely double that amount in actual current earnings, and $20/diluted share of cash, this is a multiple of money opportunity from the current mid-$20s trading levels, with limited intrinsic value downside given the $20/share (which we believe the insiders, with their majority diluted ownership interest, will protect).

We hope that this report has been helpful in shedding some light on these important topics. To all our readers: Merry Christmas, Happy Holidays, and a prosperous New Year to all.

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