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NICK > SEC Filings for NICK > Form 10-K on 14-Jun-2013All Recent SEC Filings

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Form 10-K for NICHOLAS FINANCIAL INC


14-Jun-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Nicholas Financial-Canada is a Canadian holding company incorporated under the laws of British Columbia in 1986. Nicholas Financial-Canada conducts its business activities through two wholly-owned Florida corporations: Nicholas Financial, which purchases and services Contracts, makes direct loans and sells consumer-finance related products; and NDS, which supports and updates certain computer application software. Nicholas Financial accounted for more than 99% of the Company's consolidated revenue for each of the fiscal years ended March 31, 2013, 2012, and 2011. Nicholas Financial-Canada, Nicholas Financial and Nicholas Data Services are collectively referred to herein as the "Company".

Strategic Alternatives

On March 20, 2013, the Company announced that its Board of Directors has retained Janney Montgomery Scott LLC as its independent financial advisor to assist the Board of Directors in evaluating possible strategic alternatives for the Company, including, but not limited to, the possible sale of the Company or certain of its assets, potential acquisition and expansion opportunities, and/or a possible debt or equity financing. The Company also announced that it has received an unsolicited, non-binding indication of interest from a potential third-party acquirer. As of the date of this Report, the Board of Directors is continuing to evaluate possible strategic alternatives and their implications. No assurances can be given as to whether any particular strategic alternative for the Company will be recommended or undertaken or, if so, upon what terms and conditions.

Corrections to Consolidated Financial Statements

In connection with the audit of our consolidated financial statements for the fiscal year ended March 31, 2013, the Company determined that it was necessary to correct its consolidated financial statements for the fiscal years ended March 31, 2012 and 2011, respectively, as discussed below.

One of the corrections is related to the accounting treatment for dealer discounts. A dealer discount represents the difference between the amount of a finance receivable, net of unearned interest, based on the terms of a Contract with the borrower, and the amount of money the Company actually pays the dealer for the Contract. Prior to the correction, based on past industry practices, Contracts were recorded at the net initial investment with the gross Contract balance recorded offset by the dealer discounts which were recorded as an allowance for credit losses for the acquired Contracts. The Company determined that this accounting treatment was incorrect as U.S. GAAP prohibits carrying over valuation allowances in the initial accounting for acquired loans. Accordingly, the Company has now applied an acceptable method under U.S. GAAP, deferring and netting dealer discounts against finance receivables as unearned discounts, and recognizing dealer discounts into income as an adjustment to yield over the life of the loan using the interest method.

As a result, the allowance for loan losses is now established solely through charges to earnings through the provision for credit losses. The Company has evaluated the significance of the departure from U.S. GAAP to the consolidated financial statements. Under both the former accounting policy and U.S. GAAP, the dealer discount remains a reduction of gross finance receivables in arriving at the carrying amount of finance receivables, net. Accordingly, finance receivables continue to be initially recorded at the net initial investment at the time of purchase. Subsequently, the allowance for credit losses is maintained at an amount that reduces the net carrying amount of finance receivables. The change in this accounting presentation does not result in a change to the net carrying amount of finance receivables or to net income as historical losses incurred, and estimated incurred losses as of the balance sheet date, are generally in excess of the original dealer discount. The removal of the dealer discount from the allowance requires an equal replacement of provision expense as that portion of the allowance is necessary to absorb probable incurred losses. This correction also did not have an impact on previously reported assets, liabilities, working capital, equity, earnings, or cash flows.

The second correction related to the accounting treatment and presentation of certain fees charged to dealers and costs incurred in purchasing loans from dealers. Such costs related principally to evaluating borrowers subject to Contracts in relation to the Company's underwriting guidelines in making a determination to acquire Contracts. Prior to the correction, fees charged to dealers were reduced by certain costs incurred to purchase Contracts, deferred on a net basis and then amortized into income over the lives of the loans using the interest method. Under U.S. GAAP, the fees charged to dealers are considered to be a part of the unearned dealer discount as they are a determinant of the net amount of cash paid to the dealer. Further, U.S. GAAP specifies that costs incurred in connection with acquiring purchased loans or committing to purchase loans shall be charged to expense as incurred. Such costs do not qualify as origination costs to be deferred as the Contracts have already been originated by the dealers. The Company evaluated the significance of the departure from U.S. GAAP to the consolidated financial statements. After an adjustment to beginning equity and the opening balance of unearned dealer discounts, net of tax, for the initial period presented, there is a limited effect on earnings and no impact on cash flows.

Management corrected the errors and retroactively adjusted amounts in all periods presented to ensure the errors would not result in a material difference in future periods.

The changes to the Company's consolidated financial statements for Fiscal 2012 and Fiscal 2011 resulting from such corrections are set forth in "Note 2. Summary of Significant Accounting Policies - Corrections" to the consolidated financial statements of the Company included in "Item 8. Financial Statements and Supplementary Data" of this Report.


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The selected financial data and other financial information appearing elsewhere in this Report (including such financial data for periods prior to Fiscal 2011) has also been revised in light of the foregoing corrections. The changes resulting from such corrections are immaterial and, accordingly, we are not amending or restating any previously filed SEC reports or the consolidated financials included therein.

Portfolio Summary

The Company's consolidated revenues increased for the fiscal year ended March 31, 2013 to $82.1 million as compared to $80.5 million and $73.7 million for the fiscal years ended March 31, 2012 and 2011, respectively. The Company's consolidated net income decreased for the fiscal year ended March 31, 2013 to $19.9 million as compared to $22.2 million and $16.8 million for the fiscal years ended March 31, 2012 and 2011, respectively. The Company's earnings were negatively impacted by an increase in the net charge-off percentage to 5.88% for the fiscal year ended March 31, 2013 as compared to 4.59% for the fiscal year ended March 31, 2012. The Company believes the increase in the charge-off percentage was primarily attributable to an increase in competition. Historically, when competition has increased, the Company has experienced higher losses, decreased contract origination and as a result reduced profits. While it is difficult to predict the level of competition long-term, the Company believes the current competitive environment will be prevalent throughout fiscal 2014. The average dealer discount associated with new volume for the fiscal years ended March 31, 2013, 2012, and 2011 was 8.54%, 9.23%, 9.55%, respectively.

Portfolio Summary                                          Fiscal Year ended March 31,
                                                  2013                2012                2011
Average finance receivables, net of
unearned interest (1)                         $ 280,916,731       $ 272,979,496       $ 250,962,519

Average indebtedness (2)                      $ 115,157,810       $ 115,688,980       $ 113,833,641

Interest and fee income on finance
receivables (3)*                              $  82,072,643       $  80,470,980       $  73,661,457
Interest expense                              $   5,120,827       $   4,891,854       $   5,599,951

Net interest and fee income on finance
receivables*                                  $  76,951,816       $  75,579,126       $  68,061,506

Weighted average contractual rate (4)                 23.43 %             23.93 %             23.66 %

Average cost of borrowed funds (2)                     4.45 %              4.23 %              4.92 %

Gross portfolio yield (5)*                            29.22 %             29.48 %             29.35 %
Interest expense as a percentage of
average finance receivables, net of
unearned interest                                      1.82 %              1.79 %              2.23 %
Provision for credit losses as a
percentage of average finance receivables,
net of unearned interest*                              4.77 %              4.53 %              6.22 %

Net portfolio yield (5)*                              22.63 %             23.16 %             20.90 %
Marketing, salaries, employee benefits,
depreciation and administrative expenses
as a percentage of average finance
receivables, net of unearned interest (6)             10.81 %              9.85 %             10.15 %

Pre-tax yield as a percentage of average
finance receivables, net of unearned
interest (7)*                                         11.82 %             13.31 %             10.75 %

Write-off to liquidation (8)                           6.81 %              5.66 %              6.18 %

Net charge-off percentage (9)                          5.88 %              4.59 %              4.65 %

(1) Average finance receivables, net of unearned interest, represents the average of gross finance receivables, less unearned interest throughout the period.

(2) Average indebtedness represents the average outstanding borrowings under the Company's line of credit facility. Average cost of borrowed funds represents interest expense as a percentage of average indebtedness.

(3) Interest and fee income on finance receivables does not include revenue generated by NDS.

(4) Weighted average contractual rate represents the weighted average annual percentage rate ("APR") of all Contracts purchased and direct loans originated during the period.

(5) Gross portfolio yield represents interest and fee income on finance receivables as a percentage of average finance receivables, net of unearned interest. Net portfolio yield represents interest and fee income on finance receivables minus (a) interest expense and (b) the provision for credit losses as a percentage of average finance receivables, net of unearned interest.

(6) Administrative expenses included in the calculation above are net of administrative expenses associated with NDS which approximated $220,000 for each of the fiscal years ended March 31, 2013 and 2012, respectively. The numerators for the fiscal years ended March 31, 2013 and 2012 include a tax associated with cash dividends. In December 2012, this amount was substantial due to a $2.00 special cash dividend. Absent the dividend tax, the percentages would have 10.28% and 9.78% for the fiscal years ended March 31, 2013 and 2012, respectively.


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(7) Pre-tax yield represents net portfolio yield minus operating expenses as a percentage of average finance receivables, net of unearned interest.

(8) Write-off to liquidation percentage is defined as net charge-offs divided by liquidation. Liquidation is defined as beginning receivable balance plus current period purchases minus voids and refinances minus ending receivable balance.

(9) Net charge-off percentage represents net charge-offs divided by average finance receivables, net of unearned interest, outstanding during the period.

* These amounts for 2009 through 2012 have been revised as discussed in Note 2 to the consolidated financial statements.

Critical Accounting Policy

The Company's critical accounting policy relates to the allowance for credit losses. It is based on management's opinion of an amount that is adequate to absorb losses in the existing portfolio. The allowance for credit losses is established through a provision for credit losses based on management's evaluation of the risk inherent in the loan portfolio, the composition of the portfolio, specific impaired loans and current economic conditions. Such evaluation considers, among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience, management's estimate of probable credit losses and other factors that warrant recognition in providing for an adequate credit loss allowance.

Because of the nature of the customers under the Company's Contracts and its direct loan program, the Company considers the establishment of adequate reserves for credit losses to be imperative. The Company segregates its Contracts into static pools for purposes of establishing reserves for losses. All Contracts purchased by a branch during a fiscal quarter comprise a static pool. The Company pools Contracts according to branch location because the branches purchase Contracts in different geographic markets. This method of pooling by branch and quarter allows the Company to evaluate the different markets where the branches operate. The pools also allow the Company to evaluate the different levels of customer income, stability and credit history, and the types of vehicles purchased in each market. Each such static pool consists of the Contracts purchased by a branch office during a fiscal quarter.

Contracts are purchased from many different dealers and are all purchased on an individual Contract by Contract basis. Individual Contract pricing is determined by the automobile dealerships and is generally the lesser of the applicable state maximum interest rate, if any, or the maximum interest rate which the customer will accept. In certain markets, competitive forces will drive down Contract rates from the maximum rate to a level where an individual competitor is willing to buy an individual Contract. The Company only buys Contracts on an individual basis and never purchases Contracts in batches, although the Company may consider portfolio acquisitions as part of its growth strategy. See "Item 1. Business - Growth Strategy."

The Company has detailed underwriting guidelines it utilizes to determine which Contracts to purchase. These guidelines are specific and are designed to cause all of the Contracts that the Company purchases to have common risk characteristics. The Company utilizes its District Managers to evaluate their respective branch locations for adherence to these underwriting guidelines. The Company also utilizes an internal audit department to assure adherence to its underwriting guidelines. The Company utilizes the branch model, which allows for Contract purchasing to be done on the branch level. Each Branch Manager may interpret the guidelines differently, and as a result, the common risk characteristics tend to be the same on an individual branch level but not necessarily compared to another branch.

A dealer discount represents the difference between the finance receivable, net of unearned interest, of a Contract, and the amount of money the Company actually pays for the Contract. The discount negotiated by the Company is a function of the credit quality of the customer, the wholesale value of the vehicle, and competition in any given market. The automotive dealer accepts these terms by executing a dealer agreement with the Company. The entire amount of discount is related to credit quality and is amortized as an adjustment to yield using the interest method over the life of the loan.

If the reserve for credit losses is determined to be inadequate for a static pool which is not fully liquidated, then an additional charge to income through the provision is used to reestablish adequate reserves. If a static pool is fully liquidated and has any remaining reserves, the excess discounts are immediately recognized into income and the excess provision is immediately reversed during the period. For static pools not fully liquidated that are determined to have excess discounts, such excess amounts are accreted into income over the remaining life of the static pool. For static pools not fully liquidated that are deemed to have excess reserves, such excess amounts are reversed against provision for credit losses during the period.

In analyzing a static pool, the Company considers the performance of prior static pools originated by the branch office, the performance of prior Contracts purchased from the dealers whose Contracts are included in the current static pool, the credit rating of the customers under the Contracts in the static pool, and current market and economic conditions. Each static pool is analyzed monthly to determine if the loss reserves are adequate, and adjustments are made if they are determined to be necessary.


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Fiscal 2013 Compared to Fiscal 2012

Interest and Fee Income on Finance Receivables

Interest income on finance receivables, predominantly finance charge income, increased 2% to $82.1 million in fiscal 2013 from $80.5 million in fiscal 2012. The average finance receivables, net of unearned interest, totaled $280.9 million for the fiscal year ended March 31, 2013, an increase of 3% from $273.0 million for the fiscal year ended March 31, 2012. The primary reason average finance receivables, net of unearned interest, increased was the opening of four branch offices during fiscal 2013. The gross finance receivable balance increased 2% to $395.7 million at March 31, 2013 from $389.0 million at March 31, 2012. The primary reason interest income increased was the increase in the outstanding loan portfolio. The gross portfolio yield decreased to 29.22% for the fiscal year ended March 31, 2013 from 29.48% for the fiscal year ended March 31, 2012. The net portfolio yield decreased to 22.63% for the fiscal year ended March 31, 2013 from 23.16% for the fiscal year ended March 31, 2012. The gross portfolio yield decreased primarily as the result of a lower weighted APR and a reduction of the average dealer discount on acquired loans. The net portfolio yield decreased primarily due to the increase in provisions for credit losses.

Marketing, Salaries, Employee Benefits, Depreciation, and Administrative Expenses

Marketing, salaries, employee benefits, depreciation, and administrative expenses increased to $30.6 million for the fiscal year ended March 31, 2013 from $27.1 million for the fiscal year ended March 31, 2012. The increase of 13% was primarily attributable the dividend tax related to the $2.00 per share cash dividend. The remaining increase was primarily attributable to the opening of four new branch locations. The Company increased the average headcount to 309 for the fiscal year ended March 31, 2013 from 293 for the fiscal year ended March 31, 2012. Marketing, salaries, employee benefits, depreciation, and administrative expenses as a percentage of average finance receivables, net of unearned interest, increased to 10.81% for the fiscal year ended March 31, 2013 from 9.85% for the fiscal year ended March 31, 2012.

Interest Expense

Interest expense increased to $5.1 million for the fiscal year ended March 31,
2013 as compared to $4.9 million for the fiscal year ended March 31, 2012. The
following table summarizes the Company's average cost of borrowed funds for the
fiscal years ended March 31:



                                                             2013        2012
      Variable interest under the line of credit facility     0.47 %      0.48 %
      Settlements under interest rate swap agreements         0.24 %      0.00 %
      Credit spread under the line of credit facility         3.74 %      3.75 %

      Average cost of borrowed funds                          4.45 %      4.23 %

The primary reason that the Company's average cost of funds increased for the fiscal year ended March 31, 2013 as compared to the preceding fiscal year was the presence of costs associated with settlements under interest rate swap agreements during fiscal 2013.

For a further discussion regarding the Company's line of credit, see "- Liquidity and Capital Resources" below and note 5 ("Line of Credit") to our audited consolidated financial statements included elsewhere in this Report.

The weighted average notional amount of interest rate swaps was $35.8 million at a weighted average fixed rate of 0.94% during the fiscal year ended March 31, 2013. For a further discussion regarding the effect of our interest rate swap agreements, see note 6 ("Interest Rate Swap Agreements") to our audited consolidated financial statements included elsewhere in this Report.

Analysis of Credit Losses

As of March 31, 2013, the Company had 1,347 active static pools. The average pool upon inception consisted of 58 Contracts with aggregate finance receivables, net of unearned interest, of approximately $590,000.

The following table sets forth a reconciliation of the changes in the allowance for credit losses on Contracts for the fiscal years ended March 31. See Note 2 regarding corrections to the 2012 amounts.

                                              2013               2012
           Balance at beginning of year   $  19,499,208      $  19,952,595
           Current year provision            13,252,382         12,185,529
           Losses absorbed                  (19,851,080 )      (14,971,422 )
           Recoveries                         3,190,142          2,405,750
           Discounts accreted                        -             (73,244 )

           Balance at end of year         $  16,090,652      $  19,499,208


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The following table sets forth a reconciliation of the changes in the allowance for credit losses on direct loans for the fiscal years ended March 31:

                                                2013           2012
              Balance at beginning of year   $  492,184      $ 378,418
              Current year provision            139,493        182,062
              Losses absorbed                  (190,871 )      (93,041 )
              Recoveries                         27,111         24,745

              Balance at end of year         $  467,917      $ 492,184

The average dealer discount associated with new volume for the fiscal years ended March 31, 2013 and 2012 was 8.54% and 9.23%, respectively.

The provision for credit losses increased to $13.4 million for the fiscal year ended March 31, 2013 from $12.4 million for the fiscal year ended March 31, 2012, largely due to the fact that net charge offs increased during fiscal 2013.

The Company's losses as a percentage of liquidation increased to 6.81% for the fiscal year ended March 31, 2013 as compared to 5.66% for the fiscal year ended March 31, 2012. This increase was primarily the result of increased competition in all markets that the Company presently operates in. Increased competition has led to a higher percentage of loans acquired that are categorized in the lower tiers of the Company's guidelines. The Company also experienced a decrease in auction prices from fiscal year 2012 to fiscal year 2013. Decreased auction proceeds from repossessed vehicles increased the amount of write-offs which, in turn, increased the write-off to liquidation percentage. During the fiscal years ended March 31, 2013, 2012, and 2011, auction proceeds from the sale of repossessed vehicles averaged approximately 52%, 57%, and 52%, respectively, of the related principal balance.

Recoveries as a percentage of charge-offs were approximately 17.62% and 16.80% for the fiscal years ended March 31, 2013 and 2012, respectively. Historically, recoveries as a percentage of charge-offs have fluctuated from period to period, and the Company does not attribute this decrease to any particular change in operational strategy or economic event.

The delinquency percentage for Contracts more than thirty days past due as of March 31, 2013 increased to 3.78% from 3.01% as of March 31, 2012. The delinquency percentage for direct loans more than thirty days past due as of March 31, 2013 increased to 1.23% from 1.09% as of March 31, 2012. The delinquency percentage increases reflect portfolio weakness that generally manifests itself in increased future losses. The Company utilizes a static pool approach to analyzing portfolio performance and looks at specific static pool performance and recent trends as leading indicators of the future performance of its portfolio.

The Company considers the following factors to assist in determining the appropriate loss reserve levels: unemployment rates; competition; the number of bankruptcy filings; the results of internal branch audits; consumer sentiment; consumer spending; economic growth (i.e., changes in GDP); the condition of the housing sector; and other leading economic indicators. The Company continues to evaluate reserve levels on a pool-by-pool basis during each reporting period. While unemployment rates have stabilized somewhat, they remain elevated, which will make it difficult for improvement in loss rates. The longer term outlook for portfolio performance will depend on overall economic conditions, the unemployment rate, the rationale or irrational behavior of the Company's competitors, and the Company's ability to monitor, manage and implement its underwriting philosophy in additional geographic areas as it strives to continue its expansion.

Income Taxes

The provision for income taxes decreased to approximately $12.5 million in fiscal 2013 from approximately $13.9 million in fiscal 2012 primarily as a result of lower pretax income. The Company's effective tax rate was consistent, increasing slightly to 38.61% in fiscal 2013 from 38.52% in fiscal 2012.

Fiscal 2012 Compared to Fiscal 2011

Interest and Fee Income on Finance Receivables

Interest income on finance receivables, predominantly finance charge income, increased 9% to $80.5 million in fiscal 2012 from $73.7 million in fiscal 2011. The average finance receivables, net of unearned interest, totaled $273.0 million for the fiscal year ended March 31, 2012, an increase of 9% from $251.0 million for the fiscal year ended March 31, 2011. The primary reason average finance receivables, net of unearned interest, increased was the development of new markets in Missouri, South Carolina, Ohio, and Alabama. The gross finance receivable balance increased 4% to $389.0 million at March 31, 2012 from $373.0 million at March 31, 2011. The primary reason interest income increased was the increase in the outstanding loan portfolio. The gross portfolio yield increased to 29.48% for the fiscal year ended March 31, 2012 from 29.35% for the fiscal year ended March 31, 2011. The net portfolio yield


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increased to 23.16% for the fiscal year ended March 31, 2012 from 20.90% for the fiscal year ended March 31, 2011. The gross portfolio yield increased primarily due to an unchanged weighted APR earned on finance receivables. The net . . .

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