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Why MicroFinancial Will Be the Market’s Next Ten-Bagger

It’s a very rare thing to find a potential ten-bagger like this. I think it’s only happened three or four times since I began investing in 1995. This is the kind of Peter Lynch stock that you catch when its an underfollowed microcap, that just happens to provide something people really need, and for which a highly fragmented market allows it room for potentially explosive growth.

MicroFinancial Inc. (MFI ) also happens to operate in an area I have experience in. Its part of the alternative finance sector that I’ve been working in for almost 10 years.

Peter Lynch always said to invest in something you understand, and in this case, it’s my expertise.

MFI leases business equipment and provides other forms of business and consumer financing. The businesses it assists might be startups, or they may be established. Even better, MicroFinancial doesn’t have to market directly to these businesses. A national network of equipment vendors, brokers and other dealers advertises on their behalf.

The equipment most often leased includes water filtration systems (25% of total revenue), food service, security, cash registers, salon, copiers, health care and fitness, and auto repair. This stuff is the backbone of American enterprise yet there aren’t many distribution channels, and these items are expensive to purchase. Consequently, many smaller businesses with restricted capital prefer to lease that equipment. And like Rent-A-Center (RCII ), these are basically rent-to-own deals, where leasees can buy the equipment if they wish, or return it.

Need a cash register for your McDonald’s (MCD ) franchise? Maybe you are a mechanic that specializes in fixing Toyota (TM ) vehicles and you need certain equipment? You won’t be charging that stuff onto your credit card you’ll need to lease it from a company like MicroFinancial.

MFI has a $150 million credit facility, and its own robust free cash flow, to finance lease originations. It does this in every state, of which Florida (13%) and California (11%) have the most originations.

MicroFinancial often will buy the equipment from the dealer after a lease application is approved. The leases are usually non-cancellable with a 42-month average term, and MFI does all the back-end work on the deal, such as invoicing, payments and collections. Thus, like the aforementioned Rent-A-Center, MicroFinancial buys something, then leases it out at a rate that allows it to generate a great return on its investment.

How efficient are these leases in terms of generating that cash flow? The average yield on these leases is a whopping 27.6%, a metric that also has been stable for years. Thus, the company effectively plays off the arbitrage of its credit facility, where it draws down capital at Libor + 1%, or Prime (about 3% to 4%). Meanwhile, net charge-offs as a percentage of average gross investment is down to 8.08% from 11.7% in 2010.

There is competition in the sector, in the form of the dealers themselves offering their own financing options, other lease financing companies, and regional banks. However, financials like Bank of America (BAC ) have been reluctant to lend in this environment.

In addition, MicroFinancial is true to its name in that it is a “microticket” provider. Its deals are small (under $10,000), which also is attractive to small businesses. That’s because, while competition does exist, other finance companies want big deals. They want multimillion-dollar leases for lots of equipment. These guys have capital to deploy, and they want to deploy it now. Consequently, little businesses and startups have a hard time finding capital or affordable leases. They cannot go to General Electric (GE ) subsidiary GE Capital, and companies like CIT Group (CIT ) don’t even want to hear from them.

Thus, the model is similar to why payday lenders like Cash America (CSH ), EZCorp (EZPW ), First Cash Financial Services (FCFS ) and DFC Global (DLLR ) appeared in the early 90s. Small-dollar, short-term consumer loans were simply too small and generated too little income to make up for the expenses that banks and finance companies incurred, so the payday lenders appeared. Companies like MicroFinancial are analogous, but they serve businesses rather than consumers.

By the way, there’s another segment to MicroFinancial. Do you have a home security system? You pay the alarm company a monthly fee, right? These security companies will sell off that monthly revenue stream for a certain multiple to MicroFinancial. Thus, if the customer retains the alarm monitoring past that multiple of months, Microfinancial is literally collecting free money. If you’re like most homeowners, you likely never switch alarm services, so this is just straight-up juicy cash-on-cash returns.

The bottom line is that this is a business that is all about free cash flow, and the company excels at generating it even amid a sluggish economy. In 2009, despite the financial crisis, it generated $58 million of FCF, followed by $73 million in 2010, $83 million in 2011 and $90.5 million in 2012.

That cash flow comes on a four-year 125% increase in net income and a 33% revenue increase, while expenses have only increased 10% and provision for credit losses has declined.

As I said, this is a cash flow business. From a growth standpoint, it will be dependent on the state of the economy. That MFI has grown cash flow by 50% during this recession and slow recovery is amazing. Imagine what happens when the economy really improves, and businesses ramp up.

Meanwhile, though, MFI still takes that money and throws it right back into the business, investing in equipment to further lease out, while still putting out a nice 3% dividend to investors. That payout, made quarterly, has increased from 15 cents annually in 2009 to 24 cents today

There are a few other metrics I love:

1. Insider ownership is 40%. That’s fantastic. You will have a hard time finding any public company where management’s interests are as aligned with shareholders.
2. Net margins are at 15%, which is outstanding for a finance company.
3. The company has several private equity funds with ownership. This is significant because P/E firms often seek very high returns on their capital. They obviously like what they see here. It also bodes well for a potential buyout down the line.
4. Several well-respected mutual funds (including the WisdomTree family) own shares.
5. Finally, only one analyst follows it. This is a stock waiting to be discovered by the masses.

And I think they will discover it. There’s tremendous long-term secular opportunity here. When the economy picks up, I think business will explode for MicroFinancial.

The one thing to note is that MFI has relatively thin volume at only 75,000 shares traded daily, so make sure if you do trade, youre making limit orders and using stop-losses.

At 10 times next year’s earnings, with inflating annual free cash flow, a niche and fragmented business, and management that is generating 27% yields on investment, I believe this might be a classic Peter Lynch ten-bagger.

I’m long the stock. You should be, too.

As of this writing, Lawrence Meyers was long MFI, EZPW, BAC and GE. He is president of PDL Broker, Inc.. which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books  and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com  and follow his tweets @ichabodscranium .