Medallion Financial TAXI (NAS) Q

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1 Medallion's long-term value is slowly eroded by an inability to meet its cost of capital. Vincent Yu Equity Research Associate +1 (312) Maclovio Pina Senior Equity Analyst +1 (312) The primary analyst covering this company does not own its stock. Research as of 6 August 2012 Estimates as of 6 August 2012 Pricing Data as of 6 August 2012 Currency amounts expressed with "$" are in U.S. dollars (USD) unless otherwise denoted. Contents Analyst Perspective 1 Key Investment Considerations 1 Morningstar Analysis Analyst Note - Thesis 2 Valuation 3 Scenario Analysis Risk 5 Financial Health 5 Capital Structure 5 Bulls Say/Bears Say 6 Management 7 Morningstar Analyst Forecast 8 Analyst's Perspective 6 August 2012 With the recent 17% increase in New York City taxi fares, pending auction of 2,000 New York City medallions and gradual U.S. economic recovery, Medallion Financial in a strong position to maintain its market share of the medallion industry. In fact, Medallion like many of its competitors has nearly no credit losses on its medallion loan portfolio because of the medallions' value as collateral. We believe, however, that Medallion will continue destroying shareholder value owing to its status as a Business Development Company (BDC), which restricts the amount of leverage that Medallion can use. In an industry saturated with credit unions which have access to lower cost of funds and higher leverage, this rule constricts the returns on equity that Medallion is able to generate. Coupled with the fact that new competitors such as Capital One COF are entering, industry profits will be suppressed and Medallion will continue to be unable to return its cost of capital to investors. Key Investment Considerations Medallion has never been able to generate returns equal to its cost of capital owing to the competitive nature of the medallion lending industry and Medallion's inability to increase leverage. Although Medallion is required to pay out 90% of its taxable income, Medallion has distributed over 100% of net income as dividends in the past few years. The market price might reflect this behavior, but it is unsustainable. Medallion's managed loan portfolio has grown in the past five years but half of the loans are financed by Medallion Bank; the holding company's earnings are connected to the bank's only through paid dividends. Vital Statistics Market Cap (USD mil) Week (USD) Week Low (USD) Week Total Return % 24.5 YTD Total Return % 2.7 Last Fiscal Year End 31 Dec Yr Forward Revenue CAGR % Yr Forward EPS CAGR % 16.8 Price/ 1.76 Valuation Summary and Forecasts Fiscal Year: (E) 2013 (E) Price/Earnings Price/Book Price/Tangible Book Dividend Yield % Financial Summary and Forecasts (USD Thousands) Fiscal Year: (E) 2013 (E) Net Revenue 19,029 19,166 20,660 23,847 Net Revenue YoY % Net Interest Income 22,668 23,689 24,027 23,547 Net Interest Margin % Pre-Tax Pre-Provision Earnings 9,873 10,763 10,780 10,395 Pre-Tax Pre-Provision Net Income 2,701 5,055 6,235 9,505 Net Income YoY % Diluted EPS Diluted EPS YoY % Sources for forecasts in the table above: Morningstar Estimates Profile Medallion Financial is a specialty finance company focused on taxi medallion lending although it also originates commercial and consumer loans. Medallion operates as a Business Development Company (BDC) and consequently is required to pay out 90% of its investment income as dividends and is subject to no income tax. The company conducts a significant portion of its business through its portfolio company Medallion Bank which is FDIC-insured. Page 1

2 Morningstar Analysis Without access to cheaper funds or ability to increase leverage, Medallion continues to destroy economic value. Thesis 6 August 2012 Medallion Financial is a specialty finance company focused on taxi medallion lending although it also originates commercial loans. Medallion has a strong position within the medallion lending industry in terms of volume but the intense price competition in the industry, Medallion's inability to increase its leverage and its competitors' access to cheaper deposit funding compared to Medallion's 3% cost of funds (with 8% yield on earning assets), severely restrict Medallion's ability to generate value for investors. Thus although we believe Medallion will maintain its strong position in the industry, Medallion is poised to continue destroying shareholder value. On the surface, there are several things to like about Medallion Financial's main business. Medallion loans make up about two-thirds of Medallion's net investment portfolio. In the medallion lending industry, government-restricted supply of medallions ensures the artificially high market price of medallions; through selling repossessed medallions, this has allowed industry participants to suffer nearly zero loan losses on their medallion loans. Medallion itself controls a sizeable portion of this market including financing 25% of all New York City taxi medallions. In terms of funding costs, Medallion's portfolio investment Medallion Bank operates as a FDIC-insured company allowing access to less expensive sources of funding; however, the Bank, and consequently cheaper funding costs, can only finance around one-third of Medallion's total loan portfolio because of capital requirements. Finally, Medallion's organization as a Business Development Company subjects it to no income tax, allowing it to distribute the majority of its investment income as dividends to its shareholders. Medallion however competes in an industry inundated with participants that can both finance their loans with cheaper sources of funding and use more leverage. In terms of leverage, Medallion's four main competitors, Melrose Credit Union, Progressive Credit Union, Montauk Credit Union and LOMTO Credit Union have an average asset-to-equity ratio of 4.8x while Medallion has a 5-year historical of 3.3x owing to leverage restrictions upon Business Development Companies (BDCs). As for funding costs, while Medallion finances half of its total managed loan portfolio with cheap deposits via its portfolio bank, the holding company's loans are financed through more expensive borrowed funds from banks. Finally, larger companies such as Capital One COF and Doral Financial are beginning to enter the taxicab market. With a highly competitive market and consequently no market power in pricing medallion loans as well as a regulated ability to control both funding costs and leverage, Medallion's ability to generate returns will be suppressed, in our view. The other one-third of Medallion's investment portfolio is made up of commercial loans and investments in its subsidiaries. Secured mezzanine loans make up around 75% of the commercial loan portfolio and increases in reserves for mezzanine loan losses as well as repayments led to a 30% decline in the net value of the commercial portfolio this past year. As the U.S. economy gradually recovers, we expect Medallion to slowly re-grow its commercial loan portfolio. In investments towards subsidiaries, Medallion dedicates a substantial portion of capital to Medallion Bank in order to ensure the bank meets capital ratio requirements and lists Medallion at book value upon its balance sheet. In turn this allows Medallion Bank to provide dividends to the holding company. With Medallion's extensive network of brokers which has historically referred 30-35% of serviced loans, we expect Medallion Bank to continue growing its asset base as it has in the past. Owing to Medallion's unconsolidated structure however, the Bank's growth will only affect the holding company's earnings through the dividends paid by the bank which has been around 30% of bank net income the past 2 years. Moving forward, we believe that Medallion is wellpositioned to maintain its share in the medallion lending industry and will continue to grow its total managed portfolio as it has in the past 5 years. Several growth catalysts for Medallion's business exist. Medallion Bank which paid $0.31 per share in Page 2

3 Morningstar Analysis Price/ Morningstar data as of 6 August 2012 times its book value compared to its trading price to book of 1.1. Given the firm's inability to meet its cost of capital, we believe this makes sense as economic value in the firm is gradually eroded. Historically, the company has never met its cost of equity. In the past three years for example, Medallion has earned an average ROE of 2.5% failing to meet its cost of equity of 10%. dividends and $0.57 per share in income taxes in 2011 has applied for LLC tax treatment and if successful would avoid all income taxes. New York City further has plans to sell 2,000 additional medallions and although the state has passed the policy, its execution is awaiting three pending lawsuits. Finally through its network of brokers, Medallion should be able to capture growth in existent and new geographic markets for medallions. However, Medallion has historically never been able to meet its cost of capital; and because lending is essentially a commodity business and Medallion is unable to access a lower cost of funds or increase its leverage relative to competitors, we believe Medallion will continue to destroy economic value for shareholders. Valuation, Growth and Profitability 6 August 2012 We assign a fair value estimate of $6.40, a significant discount to its current trading price. We believe that Medallion's unsustainably high dividend payout attracts short-term investors and particularly yieldstarved bond investors in the current low-rate environment. The current market price however does not reflect what we believe to be the long-term economic value that Medallion can offer to shareholders. Our fair value estimate values Medallion at about 0.7 On the portfolio side, we model the holding company's loans as stagnant in the near future as future portfolio growth gets assigned to Medallion Bank due to the bank's cheaper cost of funds. We further believe interest margins will grow slightly to 4.8% from 4.7% in the next year as interest rates continue to drop owing to Medallion's liability-sensitive balance sheet. Once the U.S. economy recovers and as new competitors enter the market however, we believe Medallion will see margins drop down to 2008-figures at 4.4%. Focusing on costs, the company has suffered virtually zero credit costs on medallion loans. In the commercial mezzanine space we forecast charge-offs increasing 40% in the next year as the economic slowdown continues before slowly returning to 2011 figures in the next five years. Finally, we believe noninterest expense will be relatively consistent with an efficiency ratio hovering under 60%, which is within the 55-65% range that Medallion has had in the past four years (excluding non-recurring investment writeoffs). Scenario Analysis Our downside case results in a $4.70 fair value estimate. This scenario assumes that U.S. economic growth is slow, competition increases in the Medallion lending industry owing to new players, and that Medallion's leverage restrictions are increased. With a slow economy, we project Medallion's commercial loan portfolio as suffering annual 5% decreases for the next two years, similar to what the company faced Page 3

4 Morningstar Analysis Nature of Liabilities (E) 2013 (E) Loan/Deposit Ratio % Short Term Debt (% of Liabilities) Liquid Assets (% of Assets) Leverage (E) 2013 (E) Assets/Equity Tangible Common Equity/Tangible Assets % Source: Morningstar Estimates between 2008 and Charge-offs to commercial loans also return to 2009 levels with 6% increases in charge-offs for the next two years. Consequently, collection costs on such loans and professional fees increase by an average of 6.4% over the next five years. Weak loan demand combined with increased competition in the medallion lending space lowers net interest margins to figures as in the peak of the recession at around 4.1%. Finally, because Medallion's asset-coverage ratio is ordained by SEC exemptive orders, we assume that the SEC strengthens these rulings in the midst of a weak economy further limiting Medallion's leverage from 3.3x in our base case to 3.0x. Our upside case results in a $7.30 fair value estimate. We assume that Medallion Bank will receive LLC tax treatment, the New York City auction for 2,000 medallions is successful and that the SEC lightens the exemptive orders upon Medallion. With Medallion Bank receiving LLC treatment we assume that all originally taxed income is passed onto the holding company as dividends, increasing Medallion's net investment income to over 30% above our base case income figure. This is reflected in the net interest margin. With the medallion auction we assume that Medallion is able to capture 25% of the auctioned medallions in accordance to Medallion's current market share at a loan-to-value ratio of 40% (the average ratio on their medallion loans). This results in roughly a 40% increase in Medallion's medallion loan portfolio from 2011 to Finally with a steadily recovering economy, we project the SEC as lightening the asset coverage interpretations for Medallions allowing it to increase its leverage from 3.3x in our base case to 3.5x. Lending is essentially a commodity business where competitors are able to differentiate through controlling costs. Medallion's inability to achieve a lower cost of funds owing to its status as a Business Development Company (BDC) rather than a bank prevents Medallion from increasing its margins, endowing it with no moat. Although credit costs are controlled by the artificially high sale price of taxi medallions, this holds true across the industry. Finally, even though we believe that Medallion's relationship with a network of brokers will continue to refer Medallion with around 30-40% of its business, this relationship does not allow Medallion to have market power in terms of prices. Historically, Medallion has never met its cost of capital and achieves lower returns on equity than all of its major competitors; because of the leverage restrictions upon Medallion and Medallion's inability to access cheaper funds, we expect Medallion's returns to continue falling short of its cost of equity. We view Medallion as having a stable moat trend. It is well-positioned to continue sharing existent and new markets with its competitors given the network of brokers that Medallion relies upon to receive business. Although larger competitors such as Capital One COF are entering the market, we believe that the only way competitors can compete for market share is through lowering price which is unprofitable for both new entrants and current competitors. In terms of competitive advantages, we do not believe Medallion will develop any. Regulations upon Medallion as a Business Development Company prevent it from Page 4

5 Morningstar Analysis achieving the lower costs or higher leveragethat it needs to increase returns. If this organization were to change, however, we will reevaluate our assumptions and the possibility of upgrading to a positive moat trend. Risk Investment in Medallion is subject to a series of regulatory and transparency risks. Two-thirds of Medallion Financial's investment portfolio is dependent upon continued government regulation upon the quantity of medallions. Although it is not likely that medallions will be deregulated given the special interest groups vested in this issue, demand for medallion loans is derived from the price of medallions themselves. In terms of transparency, Medallion classifies 91% of its assets as assets whose values are not readily market-observable and thus require inputs and assumptions. By nature of the company as a BDC, this means that a large portion of Medallion's net asset value is determinable by management. Without more transparent accounting methods, it is difficult to assess the value of Medallion's assets. Medallion's ability to generate returns on equity. Further, Medallion is regulated to pass out 90% of its taxable income as dividends. Historically, Medallion has passed out more than 100% of its taxable income as dividends and the ratio of this payment to earnings has been volatile. Management bases the dividend calculations upon the net asset value (NAV) of the holding company. However, due to the opaque nature of NAV measurements we believe Medallion's dividend payments will continue to be volatile. Financial Health The holding company is not subject to financial capital requirements because it is not chartered as a bank. Still, the tangible common equity to tangible asset for the holding company has roughly been 30% for the past three years because of specific Business Development Company regulations preventing Medallion from taking upon more leverage. The subsidiary Medallion Bank maintains a 17% Tier I capital ratio. Capital Structure With a 30% tangible common equity to tangible asset ratio, we believe Medallion is under-levered. Because Medallion is regulated in terms of how levered they can be however, Medallion is forced to use equity to raise its asset base. This ultimately restricts Page 5

6 Bulls Say/Bears Say Bulls Say Medallion competes in the medallion lending space and loan losses on such loans have historically been close to zero. Bears Say Medallion has leverage restrictions that prevent it from achieving the returns on equity necessary to meet its cost of equity. Medallion is not taxed and Medallion Bank has applied for LLC treatment which if successful could allow Medallion Bank to avoid tax as well. The recent 17% increase in New York City taxicab fare along with the potential sale of 2,000 additional Medallions, would allow Medallion to quickly expand their Medallion loan portfolio in the middle of an economic slowdown. Medallion competes with competitors who are able to finance lending with cheaper funds and until Medallion converts its business organization, will continue to do so. As new competitors enter the market, Medallion's margins will only decrease as lending is essentially a commodity business. Page 6

7 Management & Ownership Medallion Financial is a family-founded enterprise led by father and son Alvin, Chairman, and Andrew Murstein, President, respectively. The Murstein family owns roughly 9% of the company. In the past nine months, Alvin Murstein has sold roughly 55,000 shares, or roughly 20% of his stake. We like that every officer excluding general counsel has worked with the firm since With the company attributing roughly 25-35% of its originated investment transactions in the past three years to management's relationship with a network of brokers and dealers, we believe management allows for Medallion to retain its share of the market. In the past 12 years for example, the company has grown its investment portfolio at a CAGR of 5.7%. Therefore because of Medallion's recent track history with acquisitions and questions regarding management's dedication to growing the value of the firm, we rate stewardship as poor. We are wary however, of management's recent track record of acquisitions. The current investment portfolio (outside of loans and Medallion bank) includes a variety of companies including a NASCAR race team. Recently, management also announced the purchase of a lacrosse team although it is difficult to assess the value that such acquisitions offer, we are wary of management's tendency towards such acquisitions. For example, Medallion formed two Special Purpose Acquisition Companies in 2009 Sports Properties Acquisition Corp. and National Security Solutions, Inc. Both however were written off to a total realized charge of $7,740,000, roughly 2% of the company's net investment portfolio value, in Furthermore, Medallion's organization as a business development company and not a bank leads us to question management's ability to effectively increase shareholder value. Medallion has consistently been unable to meet its cost of capital in the past 10 years and as such has consistently destroyed economic value. Full conversion to a bank would give Medallion access to cheaper funding and increased leverage. Even so, Medallion has returned a large amount of its earnings towards dividends, and although we do not question the fact that Medallion values and is willing to reward its shareholders, we do question the dedication that Medallion has towards growing the value of the company as a whole. Page 7

8 Morningstar Analyst Forecasts Financial Summary and Forecasts Growth (% YoY) 3-year Hist. CAGR Forecasts Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec Year Proj. CAGR Net Interest Income Pre-Tax Pre-Provision Earnings Net Income Diluted EPS Profitability 3-Year Hist. Avg Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec Year Proj. CAGR Net Interest Margin % Non-Interest Income (% of Revenue) Efficiency Ratio % Return on Average Assets % Return on Average Equity % Return on Tangible Equity % Leverage 3-Year Hist. Avg Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec Year Proj. CAGR Assets/Equity Tangible Common Equity/Tangible Assets % Valuation Summary and Forecasts (E) 2013 (E) Price/ Price/Earnings Price/Book Price/Tangible Book Dividend Yield % Discounted Cash Flow Valuation USD Mil Firm Value (%) Per Share Value Present Value Stage I Present Value Stage II Present Value of the Perpetuity Total Common Equity Value before Adjustment Key Valuation Drivers Cost of Equity % 10.0 Long-Run Tax Rate % 0.0 Stage II Net Income Growth Rate 5.0 Perpetuity Year 15.0 Other Adjustments Equity Value Projected Diluted Shares 18 per Share (USD) 6.26 Page 8

9 Morningstar Analyst Forecasts Income Statement (USD Thousands) Forecast Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Net Interest Income 24,527 22,668 23,689 24,027 23,547 Provision for Losses on Loans 3,507 7,172 5,708 4, Net Interest Income After Provision 21,020 15,496 17,981 19,482 22,657 Non-Interest Income 3,383 3,533 1,185 1,179 1,191 Net Revenue 27,910 26,201 24,874 25,206 24,737 Net Revenue After Provision (excluding Gains on Sale) 24,403 19,029 19,166 20,660 23,847 Gains on Sale Net Revenue After Provision (including Gains on Sale) 24,403 19,029 19,166 20,660 23,847 Non-Interest Expense 19,730 16,328 14,111 14,425 14,342 Operating Income (excluding Gains on Sale) 4,673 2,701 5,055 6,235 9,505 Taxes Minority Interest, net of Income Taxes Income after Taxes 4,673 2,701 5,055 6,235 9,505 Cumulative Effect of Accounting Change After-Tax Non-recurring Items Discontinued Operations Preferred Dividends Net Income attributable to common shareholders, Excluding All After-tax items Net Income attributable to common shareholders, including all after-tax items 4,673 2,701 5,055 6,235 9,505 4,673 2,701 5,055 6,235 9,505 Average Diluted Shares Outstanding 17,570 17,632 17,660 17,660 17,660 Diluted EPS Excluding Charges Diluted EPS Including Charges Page 9

10 Morningstar Analyst Forecasts Balance Sheet (USD Thousands) Forecast Earning Assets Dec 2010 Dec 2011 Dec 2012 Dec 2013 Cash and Due from Banks 17,303 29,352 30,233 31,140 Interest Bearing Deposits at Banks Federal Funds Sold and Securities Borrowed or Purchased Under Agreement to Resell Brokerage Receivables Other Receivables (excluding interest receivables) Trading Assets Investment Securities Held to Maturity Investment Securities Availablefor-Sales 26,201 24,874 25,206 24,737 Financial Instruments Owned, at (trading Other Earning securities) Assets Loans Held for Sales 19,029 19,166 20,660 23,847 Loans and Leases 411, , , ,790 Unearned Discount Allowance for Loans Losses -11,217-14,298-15,107-12,978 Net Loans and Losses 399, , , ,812 Forecast Liabilities Dec 2010 Dec 2011 Dec 2012 Dec 2013 Total Deposits Customer Deposits Federal Funds Purchased and Securities Loaned or Sold Under Agreement to Repurchase Brokerage Payables Trading Liabilities Financial Instruments Sold, but not yet purchased at Other Payables Short-Term Debt 51,250 18,798 19,122 19,691 Long-Term Debt 329, , , ,093 Additional Debt Total Short-Term, Long-Term and Other Debt 380, , , ,784 Deferred Tax Liabilities Other Liabilities (bank acceptance outstanding, accrued expenses, etc.) 5,102 6,040 5,919 5,801 Total Liabilities 387, , , ,277 Non-Earning Assets Premises & Equipment, Net Premises & Equipment, Gross (Accumulated Depreciation) Interest Receivables Goodwill 5,069 5,069 5,069 5,069 Identifiable Intangibles Deferred Tax Assets Other Non-Earning Assets (Other 42,564 49,189 49,189 49,189 Real Estate Owned etc.) Total Assets 550, , , ,038 Equity Common Stock Paid-in Capital 179, , , ,980 Retained Earnings 2,980-4,989 Preferred Equity Treasury Stock -14,225-14,304-14,304-14,304 Accumulated Other Comprehensive Income -12,372-6,737-7,000-6,800 Other Equity 10,093 11,371 12,008 12,680 Shareholders/Equity 162, , , ,762 Total Liabilities & Shareholders' Equity (including Minority Interest) 550, , , ,038 Page 10