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NICK > SEC Filings for NICK > Form 10-Q on 10-Feb-2014All Recent SEC Filings

Show all filings for NICHOLAS FINANCIAL INC

Form 10-Q for NICHOLAS FINANCIAL INC


10-Feb-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Information

This report on Form 10-Q contains various statements, other than those concerning historical information, that are based on management's beliefs and assumptions, as well as information currently available to management, and should be considered forward-looking statements. This notice is intended to take advantage of the safe harbor provided by the Private Securities Litigation Reform Act of 1995 with respect to such forward-looking statements. When used in this document, the words "anticipate", "estimate", "expect", and similar expressions are intended to identify forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. Such statements are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or expected. Among the key factors that may have a direct bearing on the Company's operating results are fluctuations in the economy, the ability to access bank financing, the degree and nature of competition, demand for consumer financing in the markets served by the Company, the Company's products and services, increases in the default rates experienced on Contracts, adverse regulatory changes in the Company's existing and future markets, the Company's ability to expand its business, including its ability to complete acquisitions and integrate the operations of acquired businesses, to recruit and retain qualified employees, to expand into new markets and to maintain profit margins in the face of increased pricing competition. All forward looking statements included in this report are based on information available to the Company on the date hereof, and the Company assumes no obligations to update any such forward looking statement. You should also consult factors described from time to time in the Company's filings made with the Securities and Exchange Commission, including its reports on Forms 10-K, 10-Q, 8-K and annual reports to shareholders.

Arrangement Agreement

On December 17, 2013, the Company entered into an Arrangement Agreement (the "Arrangement Agreement") whereby the Company has agreed to sell all of its issued and outstanding Common Shares to an indirect wholly-owned subsidiary of Prospect Capital Corporation ("Prospect") pursuant to a plan of arrangement (the "Arrangement") under the Business Corporations Act (British Columbia).

Prospect (NASDAQ: PSEC) (www.prospectstreet.com) is a closed-end investment company that lends to and invests in private and public middle market businesses. Prospect's investment objective is to generate both current income and long-term capital appreciation through debt and equity investments.

Prospect has elected to be treated as a business development company under the Investment Company Act of 1940 ("1940 Act"). Prospect is required to comply with a series of regulatory requirements under the 1940 Act as well as applicable NASDAQ, federal and state rules and regulations. Prospect has elected to be treated as a regulated investment company under the Internal Revenue Code of 1986. Failure to comply with any of the laws and regulations that apply to Prospect could have an adverse effect on Prospect and its shareholders.

Pursuant to the terms of the Arrangement, the Company's shareholders are to receive (subject to applicable dissenters' rights under the Business Corporations Act (British Columbia)), in exchange for each Common Share of the Company held immediately prior to the effective time of the Arrangement, the number of shares of common stock of Prospect (or fraction thereof) determined by dividing US $16.00 by the volume-weighted average price, or VWAP, of Prospect common stock for the twenty (20) trading days prior to and ending on the trading day immediately preceding the effective time of the Arrangement. In addition, each option to acquire Common Shares of the Company outstanding immediately prior to the effective time of the Arrangement will be cancelled or transferred by the holder thereof to the Company (subject to applicable dissenters' rights under the Business Corporations Act (British Columbia)) in exchange for a cash amount equal to the amount by which (i) the product obtained by multiplying
(x) the number of Common Shares of the Company underlying such option by (y) US $16.00 exceeds (ii) the aggregate exercise price payable under such option.

The transactions contemplated by the Arrangement Agreement will not be consummated unless certain conditions typical for this type of transaction are either satisfied or waived prior to closing. These conditions include, among other things, that the Arrangement Agreement and the transactions contemplated thereby are approved by the securityholders of the Company in accordance with the Business Corporations Act (British Columbia) and the Company's Articles. An information circular providing further information regarding the Arrangement Agreement and the parties thereto will be mailed to securityholders of the Company in advance of the special meeting thereof expected to be held for the purpose of approving, among other things, the Arrangement Agreement and the Arrangement contemplated thereby.

Janney Montgomery Scott LLC is acting as the exclusive financial adviser to the Company and rendered a fairness opinion regarding the transaction to our Board of Directors.


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Litigation and Legal Matters

See "Item 1. Legal Proceedings" in Part II of this quarterly report below.

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.

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, Contracts were recorded at the net initial investment, with the gross Contract balances 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 each loan using the interest method.

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 for incurred losses. 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 as of and for the three and nine months ended December 31, 2012 to ensure the errors would not result in a material difference in future periods.

The changes to the Company's consolidated financial statements for the three and nine months ended December 31, 2012 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 1. Financial Statements (Unaudited)" of this Report.

Prior period interim financial information appearing elsewhere in this Report 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.

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 losses based on management's evaluation of the risk inherent in the loan portfolio, the composition of the portfolio, 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.


Table of Contents

Because of the nature of the customers under the Company's Contracts and its Direct Loans, 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, 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 the 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 state maximum interest rates or the maximum interest rate 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.

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.

The allowance for loan losses is established through charges to earnings through the provision for credit losses. The allowance for credit losses is maintained at an amount that reduces the net carrying amount of finance receivables for incurred losses. If a static pool is fully liquidated and has any remaining reserves, the excess provision is immediately reversed during the period. For static pools that are not fully liquidated that are deemed to have excess reserves, such 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.

Introduction

Consolidated net income decreased 17% to approximately $3.8 million for the three-month period ended December 31, 2013 as compared to $4.6 million for the corresponding period ended December 31, 2012. Diluted earnings per share decreased 18% to $0.31 as compared to $0.38 for the three months ended December 31, 2013 and December 31, 2012. Consolidated net income decreased 9% to approximately $13.8 million for the nine-month period ended December 31, 2013 as compared to $15.2 million for the corresponding period ended December 31, 2012. Diluted earnings per share decreased 9% to $1.13 for the nine months ended December 31, 2013 as compared to $1.24 for the nine months ended December 31, 2012.

The results for the three- and nine-month periods ended December 31, 2013 were adversely affected by a reduction in the gross portfolio yield and significant professional fees associated with the previously announced sale of the Company. Also, after-tax earnings were increasingly impacted as a significant portion of the professional fees were not deductible for income tax purposes resulting in a higher effective tax rate and after-tax impact of $0.07 per share. Our results for the the three- and nine-month periods ended December 31, 2012 were affected by an after-tax charge of $747,000 or $0.06 per share related to a 5% withholding tax associated with the one-time special cash dividend of $2.00 per share paid in December 2012.


Table of Contents

The Company's software subsidiary, Nicholas Data Services, did not contribute significantly to consolidated operations in the three or nine months ended December 31, 2013 or 2012.

                                                   Three months ended                    Nine months ended
                                                      December 31,                          December 31,
Portfolio Summary                               2013               2012               2013               2012
Average finance receivables, net of
unearned interest (1)                       $ 291,620,270      $ 281,553,866      $ 289,110,042      $ 281,242,951

Average indebtedness (2)                    $ 128,500,000      $ 114,131,239      $ 127,545,256      $ 111,293,746

Interest and fee income on finance
receivables (3)*                            $  20,756,034      $  20,594,614      $  62,168,566      $  61,708,812
Interest expense                                1,441,175          1,275,015          4,288,979          3,717,386

Net interest and fee income on finance
receivables*                                $  19,314,859      $  19,319,599      $  57,879,587      $  57,991,426

Weighted average contractual rate (4)               23.33 %            23.34 %            23.20 %            23.55 %

Average cost of borrowed funds (2)                   4.49 %             4.47 %             4.48 %             4.45 %

Gross portfolio yield (5)*                          28.47 %            29.26 %            28.67 %            29.26 %

Interest expense as a percentage of
average finance receivables, net of
unearned interest                                    1.98 %             1.81 %             1.98 %             1.76 %

Provision for credit losses as a
percentage of average finance
receivables, net of unearned interest*               5.74 %             4.95 %             4.98 %             4.67 %

Net portfolio yield (5)*                            20.75 %            22.50 %            21.71 %            22.83 %

Marketing, salaries, employee benefits,
depreciation, administrative,
professional fee expenses and dividend
taxes as a percentage of average finance
receivables, net of unearned interest (6)           11.68 %            11.86 %            11.29 %            10.76 %


Pre-tax yield as a percentage of average
finance receivables, net of unearned
interest (7)*                                        9.07 %            10.64 %            10.42 %            12.07 %


Write-off to liquidation (8)                         7.62 %             7.94 %             7.24 %             6.82 %
Net charge-off percentage (9)                        6.34 %             6.75 %             6.20 %             5.74 %

Note: All three and nine month key performance indicators expressed as percentages have been annualized.

(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 Line. 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 Nicholas Data Services, Inc., ("NDS") the wholly-owned software subsidiary of Nicholas Financial, Inc.

(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 finance revenues as a percentage of average finance receivables, net of unearned interest. Net portfolio yield represents finance revenue 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 $58,000 and $54,000 during the three-month periods ended December 31, 2013 and 2012 and $161,000 and $172,000 during the nine-month periods ended December 31, 2013 and 2012, respectively. For the three and nine months ended December 31, 2013, the numerators include expenses associated with the potential sale of the Company. Absent these expenses, the percentages would have been 10.55% and 10.75%, respectively. For the three and nine months ended December 31, 2012, the numerators include a tax associated with cash dividends. Absent the dividend tax, the percentages would have been 10.03% and 10.08%, respectively.

(7) Pre-tax yield represents net portfolio yield minus administrative 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 gross receivable balance plus current period purchases minus voids and refinances minus ending gross receivable balance.

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

* The amounts for the three and nine months periods ended December 31, 2012 have been revised as discussed in Note 2 to the consolidated financial statements.


Table of Contents

Three months ended December 31, 2013 compared to three months December 31, 2012

Interest Income and Loan Portfolio

Interest and fee income on finance receivables, predominately finance charge income, increased 1% to approximately $20.8 million for the three-month period ended December 31, 2013 from $20.6 million for the corresponding period ended December 31, 2012. Average finance receivables, net of unearned interest equaled approximately $291.6 million for the three-month period ended December 31, 2013, an increase of 3.6% from $281.6 million for the corresponding period ended December 31, 2012. The primary reason average finance receivables, net of unearned interest, increased was the increase in the receivable base of several existing branches in younger markets and also the opening of one new branch location (see "Contract Procurement" and "Loan Origination" below). The gross finance receivable balance increased 6% to approximately $411.1 million as of December 31, 2013, from $389.4 million as of December 31, 2012. The primary reason interest income increased was the increase in the outstanding loan portfolio. The gross portfolio yield decreased to 28.47% for the three-month period ended December 31, 2013 compared to 29.26% for the three-month period ended December 31, 2012. The net portfolio yield decreased to 20.75% for the corresponding period ended December 31, 2013 from 22.50% for the three-month period ended December 31, 2012. The gross and net portfolio yields decreased due to a decrease in the weighted APR earned on finance receivables.

Marketing, Salaries, Employee Benefits, Depreciation, Administrative, Professional Fee Expenses and Dividend Taxes

Marketing, salaries, employee benefits, depreciation, administrative, professional fee expenses and dividend taxes increased to approximately $8.6 million for the three-month period ended December 31, 2013 from approximately $8.4 million for the corresponding period ended December 31, 2012. There were no dividends or related taxes for the three-month period ended December 31, 2013. Dividend taxes approximated $1,287,000 for the three months ended December 31, 2012. The absence of the dividend tax was offset by an increase in professional fees of $874,000 associated with the potential sale of the Company and a $586,000 increase in salaries, employee benefits and administrative expenses. The increase in salaries, employee benefits and administrative expenses was primarily attributable to one new branch location and an increase in costs associated with maintaining the finance receivable portfolio. The Company operated 65 and 64 branch locations as of December 31, 2013 and 2012, respectively. The Company opened one additional branch and increased average headcount to 329 for the three-month period ended December 31, 2013 from 314 for the three-month period ended December 31, 2012. Marketing, salaries, employee benefits, depreciation, administrative, professional fee expenses and dividend taxes as a percentage of finance receivables, net of unearned interest, decreased to 11.68% for the three-month period ended December 31, 2013 from 11.86% for the three-month period ended December 31, 2012. For the three months ended December 31, 2013, the numerator includes the expenses associated with the potential sale of the Company. Absent these expenses, the percentage would have been 10.55%. For the three months ended December 31, 2012, the numerator includes the taxes associated with a one-time special cash dividend. Absent the dividend taxes, the percentage would have been 10.03%.

Interest Expense

Interest expense increased to approximately $1.4 million for the three-month
period ended December 31, 2013 from $1.3 million for the three-month period
ended December 31, 2012. The following table summarizes the Company's average
cost of borrowed funds:



                                                        Three months ended December 31,
                                                       2013                         2012
Variable interest under the line of
credit facility                                             0.36 %                       0.45 %
Settlements under interest rate swap
agreements                                                  0.30 %                       0.32 %
Credit spread under the line of credit
facility                                                    3.83 %                       3.70 %

Average cost of borrowed funds                              4.49 %                       4.47 %

The Company's average cost of funds remained relatively flat. The credit spread increased and the variable interest decreased due to a decrease in LIBOR rates in the three months ended December 31, 2013.

The weighted average notional amount of interest rate swap agreements was $50.0 million at a weighted average fixed rate of 0.94% for the three months ended December 31, 2013. For further discussions regarding the effect of interest rate swap agreements see Note 6 - "Interest Rate Swap Agreements".


Table of Contents

Nine months ended September 30, 2013 compared to nine months ended December 31, 2012

Interest Income and Loan Portfolio

Interest and fee income on finance receivables, predominately finance charge income, increased 1% to approximately $62.2 million for the nine-month period ended December 31, 2013 from $61.7 million for the corresponding period ended December 31, 2012. Average finance receivables, net of unearned interest equaled approximately $289.1 million for the nine-month period ended December 31, 2013, an increase of 3% from $281.2 million for the corresponding period ended December 31, 2012. The primary reason average finance receivables, net of unearned interest, increased was the increase in the receivable base of several existing branches in younger markets and also the opening of one new branch location (see "Contract Procurement" and "Loan Origination" below). The gross finance receivable balance increased 6% to approximately $411.1 million as of . . .

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