OneMain Holdings (OMF)

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September 21, 2016

We purchased OneMain Holdings because it was trading 5x 2017 estimated EPS, and we believe it is a beneficiary of consolidation in the consumer unsecured lending business. We believe as the company realizes the cost savings from a recent major acquisition and deleverages through retaining earnings that the stock valuation will improve.

OneMain Holdings is relatively new to the public markets, but the core operations of the company have a long history. The private equity firm Fortress Investments purchased AIG’s consumer lending business, American General Finance, in 2010 and renamed it Springleaf Finance. Fortress brought Springleaf public in a 2013 initial public offering at $17. The Springleaf stock performed well in 2014 and traded around $35 by early 2015. In March 2015, Springleaf announced an agreement to acquire OneMain Financial from Citigroup. The market reacted favorably to the proposed acquisition due to the potential earnings accretion and bid Springleaf’s stock above $50. The deal closed in November 2015 and Springleaf changed its name to OneMain.

A key component of the OneMain investment thesis is deleveraging its balance sheet. OneMain paid Citigroup $4.5 billion in cash. Because OneMain borrowed this money, OneMain was leveraged over 18x at the close of the acquisition. But, earnings and a sale of a non-core portfolio has already brought the leverage down to 11.4x. The table below shows our estimate of OneMain’s future deleveragingthrough retained earnings and having a loan growth rate below the rate of their capital generation. In our experience, stocks of deleveraging companies with low valuations benefit from the value creation of the debt pay down.

OneMain earnings growth profile is attractive due to cost savings and loan growth. OneMain has significant cost saving opportunities while consolidating the purchase from Citigroup. The benefit of these cost savings are phased in over the 2016-18 timeframe. Essentially, OneMain is able to eliminate duplicative costs and there are substantial overlaps. The table below shows the earnings growth progression. Once OneMain accomplishes the cost savings, we believe the earnings growth beyond 2018 will be attractive because we think the basic economic model of OneMain’s business generates a return on equity greater than 25%. We also think OneMain will be able to grow its loan portfolio with quality loans through its core business.

In the sell-off the first six weeks of 2016, OneMain’s stock materially underperformed the Financials sector and the broader market, but we don’t think there was any new reason that justified this level of underperformance. By Feb. 11th, OneMain was down 54% year-to-date compared to a 17% decline in the Financials sector and a 10% decline in the S&P 500. During this time period, there was no news flow on OneMain to justify the underperformance. Clearly, investors decided to de-risk their portfolios by selling their OneMain shares in Q1. Even though the market has recovered to positive territory for the year, OneMain is still down 27% year-to-date and trades at 5x 2017 estimated EPS. OneMain recently traded for $30.

We believe OneMain is well-positioned in the consumer installment loan industry because the competitive intensity has declined compared to other areas of lending. Since OneMain is a combination of two large legacy players it holds a strong competitive position in the consumer installment lending market. Due to the Dodd-Frank banking regulation law and banking regulators desire to reduce risk within the banking system, commercial banks have pulled back from making consumer installment loans. Some prominent bank competitors have reduced their participation in consumer installment lending such as HSBC, which had purchased Household Financial, and Wells Fargo Financial. We also think OneMain has a significant competitive advantage over online lenders due to the intensive local servicing done by its employees in the branches.

The primary risks to our thesis on OneMain are potential problems with credit quality, potential inability to access the capital markets, and a high degree of financial leverage. OneMain and its predecessors have been making loans for 90 years and were able to navigate the recession of 2008. We monitor their credit statistics on a monthly basis and are comfortable with the recent trends. Since OneMain is not a bank, it is dependent on the capital markets for funding its liabilities. If access to the credit markets shutdown for an extended period of time, OneMain may have problems funding its balance sheet. OneMain uses a combination of loan securitizations and unsecured debt to fund its balance sheet. We do not see any issues with continued access to the capital markets for their loan securitizations. In the unsecured debt market, the ability for OneMain to issue new debt may stop from time to time depending on how the overall credit market is performing. As OneMain retains earnings over the next two years and deleverages, we think it will be able to manage through these market hiccups with more ease. During a recent example of a closed debt market in Q1 of 2016, OneMain was able to access this market in early April and was one of the first non-investment grade issuers to complete a new offering. We expect OneMain to achieve its target leverage ratio by the 3rd quarter of 2018.

With the low valuation and underperformance of the stock this year, we think OneMain has attractive upside. Over the next three years, we think it is reasonable that OneMain will trade up to 10x estimated earnings per share. We believe OneMain’s earnings multiple will expand as the company realizes the cost savings from its recent acquisition and its leverage declines through retained earnings. At 10x earnings, OneMain’s stock would be greater than $60 or more than 100% appreciation from the current share price.

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Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.

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