2023-11-14 03:15:16 ET
Summary
- OneMain Financial, a company that provides personal loans to subprime borrowers, has reformed its practices over the past decade, with observable results.
- OMF has remained profitable over the last three years, in spite of several macro-challenges.
- With these profits come dividends and, crucially, buybacks at prices that offer attractive returns on capital to long-term owners.
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OneMain Holdings (OMF) is a nervous purchase to the untrained eye. Dealing in personal loans to subprime borrowers-which they have understandably rebranded as "nonprime" - one has to wonder if this is a company that will go belly-up in a macro-environment marked by high inflation and high interest rates. Yet, I will make the case that OMF is a buy and offers attractive returns to investors through business growth, dividends, and buybacks.
OneMain has a history of issuing consumer loans for almost a century. They were eventually acquired by Citigroup (C) but spun off in the aftermath of the 2008 Financial Crisis. By 2015, they had emerged as the current company and began the work of reforming their practices to originate better loans to this under-served base of nonprime borrowers. So what's the appeal of a company that primarily serves the class whose collapse brought on the Great Recession? Well, let's differentiate a few things from the subprime mortgage crisis of 2008 and the loanbook of OneMain.
Principal
First, a mortgage crisis necessarily involves homes. These require much larger amounts of principal behind the loan. As we know, even cheap homes can cost at least six figures. What are the sizes of OneMain's loans?
OneMain's 10/2023 ABS Investor Slideshow
That's right, we're talking about loans that, at the high end, are about $17K in principal, making monthly repayment much easier than a home mortgage as a function of either smaller payments or shorter maturity.
Interest
Moreover, the APRs range from 22% to 28%. What were the adjustable rates on the loans that led to the 2008 Financial Crisis?
Adjustable rates in lead-up to 2008 Financial Crisis (St. Louis Fed)
Yes, these subprime loans were not only larger amounts of principal but offered lower returns on capital, with even the adjustable rates never going over 7%. Even if all of OneMain's loans were issued at its lower 22%, that's a world of difference.
Unsecured Loans
Some might have noticed that the unsecured loans make up a larger portion of the loanbook than their secured loans or direct auto loans, at about 50%. Yet, the extra risk here is smartly balanced by a higher APR and significantly lower principal. Let's also look at how these loans evolved from the era of the financial crisis, with slides from OneMain's ABS October 2023 Investor Presentation :
OneMain's 10/2023 ABS Investor Slideshow
Here, we see the performance of all of OneMain's loanbook versus just the unsecured loans. We also see that there are several key differences with the old vintage of loans that we don't see with the current:
- Much larger percentage of total loanbook
- Higher net charge-offs (losses) at similar rates of delinquency
- Lower APRs
Today's loanbook enjoys more collateral, higher yields, and less losses.
Due Diligence
This reflects the improvements OneMain adopted in the decade that followed in 2008. The company claims that a key part of its process is its propriety of customer data from years in the business that, combined with improvements in software and technology, allow it to identify risks and strengths of its customer's ability to repay. Through their online platform, they can originate high-quality loans relatively quickly with this data. We should recall that there was almost no due diligence for the subprime mortgages pre-2008. OneMain uses its proprietary data as a filter for due diligence. The excerpted slide below shows the average OneMain customer:
OneMain's ABS Oct. 2023 Slideshow
I believe that this profile of stable, gainfully employed borrowers proves that OneMain is successfully acquiring the best of the nonprime clientele.
Return on Equity
While there is room for growth of the business, management wants a loanbook that, even under a more distressed macro-environment, will yield at least 20%.
Doug Shulman, the CEO, even stated in the Q2 2023 earnings call :
Similar to loans, we're not managing to any sort of growth targets. We're managing to profitability and return on equity products.
OneMain's Q323 Earnings Slideshow
As we can see currently, the loan portfolio currently yields over 22%. Most of the recent delinquencies have been from loans originating prior to their tightening that started in 2022, with higher-quality, better-performing loans continuing to fill their portfolio .
The historical numbers also reflect this commitment to ROE. I've aggregated the company's financial data, starting from 2016 and up to 2022, to show this. You can check their consolidated results in the annual reports if you want. Let's start with interest income.
We see here that both interest income and net interest income have grown since the company took its current shape in 2015. 2020 is the point where the trends observably diverge. Some of this is due to troubles in the economy (COVID, supply chain disruption, inflation). Some of it is also due to OneMain's decision to slow down growth and instead return capital to shareholders, as the graph below indicates.
Any cash they return to shareholders is cash that doesn't become a new loan, after all. OneMain saw apparent risks and adjusted its capital allocation accordingly.
Now, the biggest divergence is the level of growth between their net finance receivables on book and the actual number of accounts behind them. I see this as OneMain cautiously acquiring customers and leaning toward larger originations with customers who meet their risk criteria.
Again, we have to remember that the subprime mortgages pre-2008 did not originate like this. It was growth, no matter the danger to the principal, where the originators intended to sell the loans at a markup for securitization. OneMain is originating loans from which it must receive the cash flow to realize a profit. The incentives here are very different.
I believe that this is the key feature that distinguishes the loans of OneMain from the infamous mortgages of the 2008 financial crisis.
Valuation
When valuing a financial entity (like banks, insurance, or lenders), folks usually like to look at the assets of the balance sheet, valued mark-to-market, in order to determine its intrinsic value from its tangible book value.
I am going to break that rule because I believe OneMain's loans are very straightforward, and there isn't an abundance of weird assets as we see with larger companies. Moreover, OneMain doesn't sell its loans for securitization. It collects the cash flow.
When looking at the last three years, I think we see what kind of earnings OneMain is capable of generating yearly, between $1.3 billion on the high end and about $800 million on the low, with the trend generally upward. I'll excerpt the 2022 annual report :
Being conservative, I think annual earnings of at least $750 million are possible. With 120 million shares currently, that gives us a baseline EPS of $6.25. From there, I can run a Discounted Cash Flow model and plug in certain assumptions:
- 3% growth of EPS based on:
- Steady rise in receivables as had consistently occurred
- Steady buybacks as the company recently adopted
- Consistent profits make both of these possible
- P/E no more than 5 to allow for some market pessimism in the future
That gets me an intrinsic value of at least $60 for OMF. It's worth keeping in mind that, with a $4 annual dividend as I write this, much of that return will be realized through the dividend, and share appreciation will only come from the internal compounding of growth and buybacks with the undistributed earnings.
For example, per 2022's annual report , the company repurchased 5.6% of its shares with depressed prices of that year. This valuation merely assumes the company will continue to do what works well.
While I am sure many don't agree with this method of valuation for a financial, the simple fact of the matter is that it trades at a high dividend yield, so many who choose to buy OMF are going to realize a return that is practically a matter of cash flow, the same as collecting interest on a Treasury Note, whatever its mark-to-market value might be.
A Look to the Future
What forces might allow for this growth of EPS? Well, there are opportunities for OneMain to grow its business whether or not we enter a recession. A recession can kick currently-prime borrowers into the nonprime category, many of whom would likely have the financial discipline of a prime borrower. I suspect OneMain's strong balance sheet would allow it to acquire these customers, while other lenders are managing losses.
Similarly, if a recession triggers a selloff, OneMain's flexibility with its capital means that it could repurchase shares at a very attractive return for the long-term holder.
As the economy improves in the coming years with declining inflation and declining interest rates, the average nonprime borrower becomes less risky and an opportunity for faster growth of receivables.
Risks
Buybacks are a two-edged sword. If the market were to feel better about OMF, which it did in 2021 when it was priced around $60, the effect of buybacks here on EPS growth would be much smaller. It's not completely clear what level of cash that management would commit to buybacks at that price, and long-term holders should watch carefully and prepare an exit if the buybacks become value-deletive.
Delinquency is still a risk, given that we are talking about loans here. While management has originated loans with the assumption of additional stress than the current macro-environment, a major event that triggers a higher rate of default than the current loanbook can handle could wipe a company out. Long-term holders should be mindful even conservative loans can be victims of bad luck.
Conclusion
While potential always exists for greater stress to hit their loanbook than they have anticipated, OneMain Financial stands out as a deft reformer among subprime lenders in the years that followed the associated financial crisis. Today's buyers should be conservative and not expect quick returns. OMF will provide long-term value primarily through its dividend and modest capital appreciation.
This is a purchase for those who want to own a good business with strong fundamentals, which its consistent profitability and commitment to shareholders have demonstrated.
For further details see:
OneMain Holdings: Long-Term Value Through Dividend And Capital Appreciation