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We recommend Chesswood Group (OTCPK:CHWWF) as a Strong Buy and expect the stock to reach $17 ($22 in CAD) by the end of 2022. This upside of > 50% is driven by a turnaround in core business profitability, accretion from a recent acquisition, and valuation expansion.
Chesswood Group is a TSX-listed, specialty finance company. At a high level, the company is fairly simple to understand. Its businesses lend money on a secured basis to individuals/SMEs to purchase equipment across a wide range of industries. What differentiates Chesswood from, for example, a bank is that the company does not fund its lending with customer deposits. Funding comes in the form of established lending facilities from different banks and insurance companies, as well as securitization markets. Chesswood raises money to then lend it out, capturing a spread. Revenue predominantly comes from interest on its loans, while expenses are incurred through interest expense on debt, loan losses when borrowers cannot repay, and other typical business expenses (such as personnel expenses, real estate, computer & systems, etc.).
Key KPIs that we like to use to assess businesses like this are as follows:
- Asset yield (interest income / average receivables balances): Increases and/decreases can indicate exposure to interest rates or changes in target market
- Debt yield (interest expense / average debt)
- Net interest margin (interest income – interest expense / average receivables balance): Effectively the spread between asset and debt yield.
- Loan loss ratio (provision for credit loss / average receivables)
- Net charge-off ratio (charge-offs – recoveries / average receivables)
- Receivables growth
- Operating leverage (revenue growth minus expense growth)
What makes Chesswood not so simple is the fact that business mix has changed a lot over time and it has multiple segments: United States, Canada, and Corporate.
The United States segment has historically been comprised of the Pawnee Leasing business. In 2019, Chesswood founded Tandem Finance and results for the business are also listed within the US segment. Prior to the pandemic, this segment provided ~85% of total revenues. The primary difference between Pawnee and Tandem is distribution. Pawnee’s originations are via the third-party broker channel while Tandem works directly through vendors at the point of sale.
From 2015 to 2019, the segment reported strong receivables growth, but revenue growth was much slower than receivable growth due to Pawnee’s decision to originate more prime-rated receivables. This led to asset yield compression. The founding of Tandem Finance also increased expenses in F2019, which we can see through the increase in expense growth in the image below.
The Canadian segment has historically been comprised of Blue Chip Leasing. While Blue Chip’s asset yields have been much steadier over time, it experienced a management change in 2018 that, in addition to competitive pressures, led to receivable growth stalling in F2018. Balances then began to decline in F2019.
The Corporate segment does not generate revenue but creates costs due to centralized functions. Some of these costs are allocated to the segments and others are not. Two major centralized functions are treasury and accounting, which both were the source of headwinds prior to the pandemic.
The majority of Chesswood’s receivables book is fixed-rate, while its cost of debt has moved with US and Canadian Central Bank policy rates. From F2016 to F2019, the company’s average cost of debt increased by approximately 150 basis points, hurting the net interest margin. Further, the accounting standard for loan losses changed in 2018 and now companies have to book loan losses before they occur. For example, if economic forecasts deteriorate, Chesswood would have to increase loan losses. This happened in F2019, despite the ongoing push to prime-based receivable origination and the fact that the company’s total net charge-off ratio had actually declined from F2016 to F2019.
As we have laid out, this is a complex organization that faced a few headwinds prior to the pandemic that resulted in net income falling by half from F2016 to F2019! These developments were not positive for the stock price.
Major Earnings Tailwinds In Core Business
The pandemic’s onset drove the stock down more than 50% as the market anticipated a rapid increase in loan losses. Six full quarters since and credit, along with a number of other factors, have helped the company. Chesswood experienced a rise in charge-offs in the first quarter under COVID, but they quickly normalized. The company is currently recovering more than it is charging off (Projected Financials – Note a). Requests for loan modifications are at historical lows, as are delinquency rates.
Demand for equipment financing also rebounded quickly. Industry participants continue to see high demand and remain confident in the outlook. In the US, the company’s receivable portfolio has increased 49% since the third quarter of 2020. Tandem Finance (the company started in 2019) has also begun to scale and now comprises 27% of the US portfolio. When Tandem was founded, management noted that the end-market was 5x larger than that of Pawnee Leasing, historically the company’s largest segment. Additionally, the company resolved its issues in Canada by merging with a competitor. This added $200MM in receivables and the Canadian segment has grown Q/Q in each of the last two quarters (since closing the merger).
Chesswood is clearly in growth mode and is currently originating in excess of $100MM in credit per month on its $1.2B receivables base. At a 10% net interest margin, net income grows quickly as the receivables balances grow. The company is also experiencing benefits on funding. As it was hurt when rates rose – it has been helped with the collapse in rates. The cost of debt has fallen to 3.1% – a historic low – as of Q3/F21 (Projected Financials – Note c). We see it falling further. After Q3 quarter-end, Chesswood announced a securitization of $356MM at 1.74%. The securitization refinanced $140MM at 4.4% from the corporate revolving facility and $216MM at 2.1% from the Pawnee warehouse facility. Interest savings are expected to be $4.5MM or 20-25% of pre-COVID earnings.
Lastly, the company has repurchased ~6% of its public float during this period and on January 20th, the share repurchase agreement was renewed at 10% of the public float. The company announced that an automatic share purchase plan had been in place since the beginning of 2022.
As we have laid out here and in the Projected Financials section above, many tailwinds are driving quarterly earnings and free cash flow to record highs. The existing business has the potential to reach $40MM in free cash flow in 2022 on a credit-normalized basis (i.e. assuming worse performance than 2021), which is double the pre-COVID norm ($20-$25MM level). At the current price, the stock is trading at in excess of a 20% free cash flow yield based on our projections!
RIFCO Acquisition Adds An Attractive New Vertical
In late October, Chesswood announced the acquisition of RIFCO, a publicly-traded non- & near-prime auto lender based in Alberta, Canada. RIFCO struggled in recent years due to the Western Canadian recession. Growth stalled (receivables balances plateaued in F2015) and losses increased (charge-offs gradually increased from F2015 to F2019), but the company remained profitable despite the struggles.
RIFCO was beginning to turn around in 2019 (annual originations hit their third-highest total on record that year), but the pandemic derailed progress and led to loan repayments. Six quarters removed, receivables balances are rapidly rising again as have quarterly profits.
We see higher used car demand/prices (better origination growth and lower losses) and higher oil prices (Western Canadian employment should be boosted by greater activity in the oil sands) continuing to support and improve results at RIFCO in the short to medium terms. Further, RIFCO will work better under the wing of a larger financial company due to access to cheaper cost of funds and a higher transactional currency.
RIFCO’s average cost of debt is ~5.1% whereas Chesswood’s is ~3.1%. The facility used to finance this acquisition had an effective interest rate of 4.4% as of Q3/F21 and was repriced lower with the acquisition, implying that lenders are not concerned with the increase in leverage. There is room in this facility to refinance a good portion of RIFCO’s receivables.
RIFCO management has always spoken to the fragmented nature of the alternative auto finance market in Canada. With Chesswood trading at a much higher multiple, the acquisition scope broadens. While there are likely some expense synergies in merging with Chesswood Group, subsequent acquisitions in auto finance should produce much greater synergies.
We think the price paid for RIFCO is very attractive (1x book value) and does not reflect the improvement in results and outlook. Higher used car prices and a burgeoning Alberta economy/oil sector are great for the new owners. RIFCO is earning $8 million annualized (roughly 30%-40% of pre-pandemic core Chesswood’s earnings) and Chesswood acquired it for $28 million, of which 75% was financed with cash/debt. We calculate nearly 20% accretion in F2022E, though we have not included this in our projections above!
Plenty Of M&A Potential Here
As we’ve laid out, the core business is booming and RIFCO seems to be one of those pay-two-quarters-receive-a-dollar type acquisitions. We would be happy to see Chesswood continue to acquire smaller entities in both equipment finance and/or auto lending, but Chesswood has clearly shown an ability to originate receivables and which further supports our Strong Buy thesis.
Loan growth in the banking industry has struggled since 2016. While the onset of the pandemic accelerated loan growth, it has quickly turned negative again, while deposit growth simultaneously accelerated and continues to grow at multi-year highs. Banks clearly have excess deposits to lend against but are struggling to extend credit through their traditional channels. Consequently, we have seen many banks look to M&A of late to solve loan origination problems, especially in specialty verticals. Recent examples include:
Truist’s (TFC) $2B acquisition of Service Finance, a point-of-sale home improvement financing provider.
Banco Popular’s (BPOP) $188MM acquisition of K2 Capital Group, a healthcare-focused equipment leasing and finance business.
Ameris Bancorp’s (ABCB) acquisition of Balboa Capital, an equipment finance provider with originations expected to reach $415MM in ’21.
First Financial Bancorp’s (FFBC) $121MM acquisition of Summit Funding Group, an equipment financing platform with originations expected to reach $400MM in ’22.
- Peoples Bancorp’s (PEBO) acquisitions of North Star Leasing and Vantage Financial.
The Summit Funding transaction listed is particularly interesting as CHW’s originations are currently running triple that rate, suggesting significant upside for the core business. Given the precedents above and the dynamics at play in the banking industry, we believe that Chesswood is a takeover candidate either as a whole or one of its individual businesses (such as Tandem Finance).
Valuation & Comparables
Our preferred valuation metric for Chesswood Group is P/B as it allows us to compare against a broad set of peers absent historical earnings estimates (Chesswood was only covered by one analyst for many years).
As we can see from the image above, the company traded between 1.0x and 1.4x prior to COVID and has returned to the high end of that range, despite a significant increase in ROE.
For comparables, being a small-cap, pure-play equipment finance company, there are few. CWB, BRKL, PEBO, and UMPQ are all banks with longer average duration loan books and only a small portion of their loan portfolios in equipment finance. EFN deals more with commercial fleet management. Accord has a variety of equipment and commercial finance exposure, but is not covered nor is it particularly large.
As we can see, Chesswood does rank on the low end of the valuation metrics (P/B & P/E) and on the high end of the ROE and earnings growth metrics. We believe that ultimately one of these two will change. Either our projections will prove inaccurate or value will be realized. We believe that the market is discounting the company’s ability to execute, which is likely driven by the lack of growth prior to the pandemic.
We know there exists an historical relationship between ROE and P/B within this peer group and more broadly within the financials space. This is clear from the image below. That Chesswood stands so far out from this relationship is also particularly clear.
As mentioned above, we see >50% upside. We see book value per share growing from $8.94 as of Q3/F21 (fully diluted basis) to $11.00 (exclusively due to net earnings growth) by Q4/F22. We then anticipate the P/B ratio to increase from ~1.5x to ~2.0x which would be a fairer multiple given Chesswood’s projected ROE and the PB-ROE relationship that exists amongst peers.
This investment does not come without risk. As we stated, asset yields at Pawnee Leasing have compressed significantly and there is potential for this to continue. Our projections include additional asset yield compression and we note that the company’s prime receivables origination mix has stabilized.
Chesswood is growing very rapidly. There is a risk that they will not be capable of financing their growth. We would note that plenty of room exists on existing funding facilities. Further, Chesswood has securitized a portion of its receivables in each of the last three years. We note that the projected growth would likely require them to access securitization markets for funding more frequently.
While we expect the economy to remain strong, provisions could increase beyond what we expect. Rapid receivables growth in financials can be concerning, but we note that the company has served its core businesses for many years and the pandemic has generated an unprecedented recovery in economic activity. Further, inflation actually benefits Chesswood by increasing the price of equipment and ultimately, its receivables.
Lastly, we assume healthy operating leverage in the years ahead, but greater expense growth could be required. We think the model naturally generates robust operating leverage as most of the receivables are originated through brokers (Pawnee and Blue Chip) or directly from vendors (Tandem) and thus does not require the company to hire additional salespeople. We also note that during the years of significant asset yield compression at Pawnee, the still generated operating leverage.
Chesswood produced a 15% ROE during the pre-COVID period and traded around book value. ROE hit 20% last quarter and nearly 25% on a FCF basis. We project it to move higher in the coming quarters and this does not even factor in earnings from RIFCO. With the stock currently trading at 1.5x book value and in excess of a 20% FCF (2023E) yield, we anticipate strong earnings growth and multiple expansion leading us to conservatively view upside at ~50%. There is also the potential for one of Chesswood’s businesses (or perhaps all) to be acquired which would create further upside for shareholders. You can buy this company at a 20% FCF yield, but we do not expect this opportunity to last for long!