JEF - OneMain Holdings: Cashing In The Chips

2023-12-05 07:00:00 ET

Summary

• Shares of OneMain Holdings, Inc. have returned over 45% since the "strong buy" call.
• While I'm a fan of the company and the business model, I'm not feeling good about the financial health of hard-working Americans.
• I'm taking OneMain Holdings, Inc. chips off the table.

Since writing on OneMain Holdings, Inc. (OMF) around a year ago, shares have returned over 45%, validating the "strong buy" call.

I'm also long shares on OMF, and it's time for an update.

Before digging into the story, I want to warn you that investing in the distressed consumer market is much riskier than investing in real estate investment trusts, or REITs.

When I purchased shares in OMF, I knew exactly what I was investing in:

As you can see, this consumer finance company charges its customers rates from 18% to as high as 35.99%.

That means there will be defaults…

Yet, I was comfortable with that risk, as I explained in my December 2022 article:

"I think OMF's management team has prepared for the overall worst outcome (worse recession) and if my assumptions are correct (mild recession) I believe OMF could hit $40.00 by Q1-24."

The Business Model

OMF has unique competitive advantages that revolve around serving nonprime customers via a nationwide branch network. As seen below, OMF has over 19 million customers with ~1,400 branches and six central operations centers across 44 states.

This branch network is powerful as the company is the 7th largest network of finance companies in the U.S., and that includes banks.

The combination of local relationships with central servicing and underwriting allows OMF to maintain close contact with customers while also being supported by digital capabilities.

Technology is another competitive advantage.

OMF's application process begins online, 80% of new customer applications, and the company has sophisticated analytics to return a credit grade.

The proprietary scoring model is powered by diverse data sources, in which models are enhanced with third-party data. In addition, AI techniques are evaluated (gradient-boosted models) whereby machine learning supports strong loss performance.

Another advantage.

OMF's business is specifically designed to provide responsible lending solutions to a large and often underserved market. The company's vision is to be "the lender of choice for the nonprime consumer, solving their current needs while enabling progress toward a better future."

This means the company offers a diverse product suite of unsecured and secured loans, as well as credit card, and other optional products.

As you can see (above), ~50% of OMF's originations are unsecured loans (that average $8k with an average APR of 28%). The average credit score for this customer is 641 and the normalized net loss (for the unsecured loans) is 8% to 10%.

The other loans are made up of secured loans (4% to 6% normalized net loss) and direct auto loans (2% to 3% normalized net loss).

In addition, OMF rolled out a credit card platform called Brightway® with roughly 340,000 customers and $232 million in receivables.

Risk Management

In the latest quarter , OMF's 30 to 89 delinquency rate was 2.98%, up 22 bps from Q2-23, but in line with previous quarters (+21 bps in 2018 and +15 bps in 2019). Loan net charge-offs were 6.7%, down from 7.6% in Q2-23. On the latest earnings call, OMF's CEO explained,

"…the underwriting standards are tighter. We put a level of stress and assumed extra level of stress in the event that there was a recession.

And the way our customer lifetime value models work as we assume certain interest rate, length of loan, the type of loan, whether it's secured or unsecured and then we also assume a certain amount of losses.

And so when we put extra stress on it, all we mean is even if unemployment rises and losses go up, it would still meet our 20% return on equity hurdle. So that's what extra stress means. So it is tighter than pre-pandemic when we didn't put an extra level of stress on."

Balance Sheet

In August 2023, OMF completed its largest ABS transaction in history, a $1.4 billion 3-year revolving securitization prices at a blended rate of 6.4%. This issuance consisted of 3 large anchor orders and a deep order book that included six new investors.

OMF's liquidity is strong, with $7.4 billion of undrawn and committed bank facilities spread across 15 financial institutions.

A few days ago the company announced that it was buying Foursight Capital's $900 million loan portfolio from Jefferies Financial Group ( JEF ) for $115 million. As OMF's CEO explained,

"Foursight is an attractive tuck-in acquisition giving us a seasoned team, scalable technology, tested credit models, a franchise dealer network and a high-quality loan portfolio to support our disciplined expansion into the auto lending business."

Earnings

In Q3 2023 , OMF's net income was $194 million or $1.61 per diluted share, up 8% from $1.49 per diluted share in Q3 '22. C&I adjusted net income was $189 million or $1.57 per diluted share up 5% from $1.49 per diluted share.

Q3 '23 interest income was $1.2 billion, up 4% year-over-year and the portfolio yield was flat to the prior quarter at 22.2%, reflecting the ongoing impacts of higher delinquency levels, borrower payment assistance, and the strong originations in secured distribution channels that have lower pricing than the core loan business.

As seen below, analysts are forecasting OMF's EPS to decline by 26% in 2023 and increase by 29% in 2024 and 20% in 2025. There are 15 analysts providing 2023 and 2024 estimates, and 8 in 2025.

Valuation

OMF's current $4.00 annual dividend provides an attractive yield of 9.2% (was 11.4% when I recommended it as a "strong buy" last year). Let's compare this yield with these peers:

• Synchrony Financial ( SYF ): 3.0%
• Capital One Financial ( COF ): 2.1%
• Enova International ( ENVA ): 0%
• OneMain Holdings: 9.2%.

OMF is trading at 7.8x P/E, let's compare:

• Synchrony Financial: 6.5x
• Capital One: 8.5x
• Enova International: 6.3x
• OneMain Holdings: 7.8x.

Needless to say, the yield is attractive and so is the growth profile.

But the key question here is "what is that state of the OMF customer," which the company describes as "hardworking Americans."

As seen above, this customer is likely to experience some pressure in a recession which means defaults could become higher.

Since I wrote my last article (around a year ago), a lot has changed, and average "hardworking Americans" are feeling the pressure of higher costs.

Car loan defaults are rising.

Buyers with credit scores of less than 640 are looking at distressing interest rates of about 14.18% and 21.38% for new and used cars, respectively.

The percentage of subprime auto borrowers at least 60 days past due on their loans rose to 6.11% in September - up from a previous high of 5.93% in January, according to Bloomberg , citing Fitch Ratings data. Car loan defaults are at a 29-year-high.

Also, "hardworking Americans" are defaulting on their credit card loans, with delinquencies reaching 3.6% so far this year , according to credit agency Equifax.

While I'm happy with the 45% returns with OMF, I'm going to take these chips off the table to cash in on a few REITs and BDCs.

I find OMF "fairly valued" given the consumer-facing risk profile of the business model. In the words of Kenny Rogers,

You got to know when to hold 'em. Know when to fold 'em. Know when to walk away. And know when to run.

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