Description

We’re recommending buying shares of CSH which post the November 2014 spin of its online consumer lending business Enova is the largest US pawn company and on a stub basis trades at 5.6x EBITDA, , a ~45% discount to competitor First Cash Financial Services (FCFS). While we view the Enova business model as a creative and flexible means of targeting the large and growing subprime unsecured lending market and view shares as a reasonable value, given the regulatory risk we prefer to hedge the exposure.

Bull Case:

1. Post Spin CSH is a pure-play U.S. pawn company with reduced regulatory risk and will eventually re-rate towards competitor First Cash (FCFS) which trades at 10.2x NTM EBITDA.

2. Pawn lending has been around for millennium and carries lower regulatory risk than other forms of subprime lending

3. Company will soon announce a new CEO who could take fresh look at capital allocation, de novo strategy, and the corporate cost structure.

4. Company’s low-teens EBITDA margins are ~500 bps below FCFS domestic operations, implying upside via better operations and lower corporate overhead. 3Q14 CSH announced a restructuring program expected to save $20mm and we believe further cuts could be forthcoming.

5. Company leveraged at 1.5x debt/EBITDA leaving powder for share buyback and mom and pop pawn acquisitions.

6. Company has lapped tough gold comps with 3Q14 scrap gold gross margin 9% of total merchandise gross margin vs. 43% in 2011.

7. Pawn has reoriented its business towards general merchandise with Jewelry now 60% of collateral base, inline w/historical levels, vs. 73% at peak in 2011.

8. During downturn company has strengthened retail pawn operations and 3Q14 same-store metrics outperformed peers.

9. Payday lending (PDL) is now 10% of net revenue vs. 21% in 2011

10. August 2014 CSH exited troubled/unprofitable Mexico locations which were a $2.4mm LTM EBITDA drain at the time of sale.

11. US regulatory pressure targeting aggressive off-shore online lenders and the most aggressive payday lenders has reduced competition.

12. Regulatory concerns coupled with weak industry results during the gold slide has led to tepid Street sentiment.

Domestic Pawn Overview

CSH is the largest US pawn company with 828 domestic pawn locations, a 7% share of the 12,000 US locations. The company’s top five states are Texas (260), Ohio (120), Florida (76), Georgia (48), and Tennessee (41). The U.S. pawn industry is highly fragmented with the three large public players controlling less than 20% of the market.

CSH’s average customer is 36 years old, is employed, and has a $29K income. The customer does not need to have a bank account and underwriting is based on collateral and borrower’s history with CSH. The company’s average pawn loan is $131 with a term of 30 days plus a 30 day grace period, carries a 20% fee which translates to 120% to 135% annualized yield, and has a 40% to 60% LTV. Roughly 70% of loans are repaid with the company seizing the collateral of the remaining 30% which is then sold via the stores or in some situations via wholesale channels. The collateral is approximately 64% jewelry, 19% electronics, 8% other, 5% tools, and 3% musical instruments. Qualitatively jewelry margins have been relatively stable longer-term while electronics margins have been under pressure.

Pawn lending has lower regulatory risks than other forms of subprime lending and is an ancient and generally accepted form of secured lending. This is at least partially due to the loan being extinguished in a relatively short time frame regardless of payback which means the loans don’t carry the risk of longer-term interest accruals as can be the case with payday lending. Additionally it is generally regulated at the state and municipal level which reduces the likelihood of a major national regulatory change drastically impacted profitability. The primary regulatory variant is changes in the number of approved licenses granted.

Reduced Payday Lending Exposure

CSH has reduced its exposure to PDL which accounted for 11% of 3Q14 net revenue compared with 15% in 2011 and 27% in 207. 3Q14 PDL loan fees declined 16% y/y due in part to the 3Q14 decision to cease offering the produt in 160 retail locations, the 4Q13 decision to close 28 Texas PDL only centers, as well as proactive efforts to transition these customer to Enova. The company will cease offering the product in an additional 160 locations in 4Q14 and will only continue to offer the product in Ohio where it is working to expand its product offering to provide alternatives.

The company’s average PDL is for $525, has a term of 14 days, and carries a 20% fee which translates to 200% to 250% annualized yield. PDL yields have been stable over time. 90% to 95% of loans are repaid and the customer can only roll the PDL four times and each time must pay off fees, thus is only allowed to roll the original principal. By comparison, a 2014 CFPB paper showed 15% of US PDLs are followed by a sequence of loan rolls at least 10 loans long. So while PDL lending will likely remain in regulatory crosshairs we believe CSH’s operation carries a relatively lower risk.

We find the company’s provisioning policies reasonable with 10% of the loan reserved on origination which is based on historical trends. The provision goes to 25% to 30% once defaulted and increases again at 30 days. The loan is written-off at day 60.

Reserving looks reasonable as retail operations have increased the loan loss provision over past couple of years which troughed at 15.3% at 12/31/10 and stood at 35% in 3Q14. We are unsure if the reserve build was due to a shift in underlying customer (perhaps higher quality sent to Enova) but seems more conservative from an accounting perspective.

We expect 2015 PDL lending to decline at a 15% clip and will account for 10% of net revenue. Given its profitability this will be a ~$0.20 EPS headwind but the remaining business should garner a higher multiple. Additionally the company may be able to shift some of these customers to traditional pawn lending.

Gold Headwind in the Rearview Mirror

CSH and the pawn industry benefited immensely from the late 2000’s gold bull market which peaked with commercial gold scrappings accounting for 48% of disposition COGS in 2011 and 2012, up from 27% in 2006 and as low as 8% in 2001. The increasing scrap mix corresponded with commercial margins increasing from 29% in 2008 to 32% in 2010 and 2011 as gold wholesalers paid top-dollar for the precious metal assuming the bull market would last. Additionally store operating costs likely benefited from the relatively simple process of buying gold and selling it wholesale.

These trends reversed in 2013 and throughout 2014 as the gold price decline led to 9 month 2014 commercial disposition margins of 10%, one third the 2011 and 2012 levels. Commercial dispositions were only 7% of merchandise gross margin, down from a peak of 43% in 2011 while commercial proceeds from merchandise dispositions dropped to 21%, inline with pre-gold boom levels. Simply put it appears the most difficult comps have now been lapped although the company remains exposed to gold as 60% of its collateral is jewelry and underlying gold pricing drives loan amounts.

Source: CSH Analyst Day; Nov 2013

Operational Improvements

CSH responded to the gold price decline by shifting focus to general merchandise lending which it admittedly neglected during the gold boom. The company noted a renewed emphasis on divesting gold via the retail channel vs. scrap channel. Management is focused on basic store-level blocking-and tackling such as improving inventory availability while also introducing a successful sales force commission scheme that will go chain-wide in 4Q14. We suspect the company’s August 2014 decision to exit the Mexican market, which lost $2mm on a LTM basis, has led to more focus on U.S. retail operations.

While none of the operational initiatives seems groundbreaking they cumulatively appear to be bearing fruit as same-store trends have improved in 2014. Notably 3Q14 same-store revenue was positive for the first time since 2012. Additionally, same-store growth has outpaced FCFS in each of the past two quarters, reversing a trend of significant underperformance:

Margin Improvement Opportunities

We believe the renewed focus on improving store operations and driving general merchandise lending is the primary driver for the increase in retail operating and administration expense. However expensive levels are now back to pre-gold boom levels implying this headwind should at least subside and potentially represent a level where operations can be leveraged.

Competitor FCFS consistently generates 20%+ EBITDA margins while CSH LTM retail-only EBITDA margins were 12% (fully baked for corporate allocation). FCFS’s Mexican operations are modestly more profitable although we don’t think they explain more than ~50% of the margin premium. In the U.S. CSH’s stores generate ~40% more revenue per location thus we think CSH could improve margins to at least the mid-teens+ level, potentially spurred by the new CEO.

Management seems to realize is cost structure needs rationalizing and on the 3Q14 CC announced $20mm in cuts mostly from corporate layoffs. Management also noted cutting corporate costs was a priority and indicated this would happen both pre and post spin. Discussions with the company lead us to believe additional cuts could be announced in early 2015 with the new CEO as a possible catalyst.

3Q14 CC; 10/24/14:

CEO

Additionally, I mentioned on our last call, that both our Board and management recognized that post-spend Cash America must rationalize its ongoing corporate overhead structure to align properly with the revenues of the remaining storefront business. We've already taken significant steps to reduce the overhead costs in the remaining Cash America business, with a completed or eminent separation of approximately 134 administrative co-workers. Tom will discuss the financial implications of workforce reduction in his prepared remarks. We still have work ahead of us to find additional administrative cost savings, which will be one of the key focuses of our final 2015 planning process. But I'm confident we will be able to probably align our administrative costs to the expected remaining revenues in the Cash America retail storefront business

Each 100 bps of margin improvement is ~$11mm of EBITDA and perhaps $2 to $3 of incremental share value.

Capital Deployment and Growth

CSH has primarily used its cash to repurchase shares, grow the spun Enova business, and acquire pawn chains. With Enova spun we expect management will look to repurchase shares and acquire chains. While we rate management’s capital allocation policy as average at best but it is worth noting diluted shares declined 8% from 2011 to 3Q14.

Domestic pawn growth has been driven primarily via acquisition with management targeting a 4.5x to 5.0x LTM EBITDA multiple for mom and pop stores and 6x to 7x multiple for regional chains. The company’s rationale for acquiring vs. buying include permitting, challenges in staffing new stores while not cannibalizing managers from existing stores, and a relatively long break-even period for new stores. The company admits few synergies exist when acquiring stores and regional chains.

In August 2013 CSH bought two regional chains including 42 stores in Texas and 34 stores in Georgia. The Texas chain was purchased for $104mm, or $2.5mm/store and 7.2x the acquired loan balance. Texas issues few permits so the implicit barrier to entry likely increased the price. The Georgia chain was purchased for $62mm, or $1.8mm/store and 5.6x the acquired pawn loan balance. By comparison CSH currently trades for $826K/store and 3.0x its loan balance.

While store count and acquired loan balances don’t necessarily translate to cash flow and value creation we have struggled with the math of acquiring chains at seemingly higher valuations than the stock’s current trading multiple and believe a new CEO could reevaluate this policy. We wonder if the new CEO might consider ramping organic store openings given a cost $750K to $1mm, 1.5 to 2 years to achieve profitability, and 15% to 20% ROIs once ramped.

Valuation

Our 2015 base case EBITDA estimate is $122mm using the following assumptions:

1. Pawn loans:

   1. 3.5% SS loan balance growth

      1. Modestly above historic levels given prior two year negative growth

   2. No change in pawn loan yields

2. Merchandise

   1. 70 bps improvement in retail gross margin yields to 34%

      1. 500 bps haircut to 2008-2013 avg

      2. 500+ bps haircut to FCFS

   2. No change in commercial gross margin yields

   3. No change in retail vs. commercial mix

3. PDL

   1. 15% y/y decline in consumer loan fees, inline w/recent trend

   2. 80 bps NTM improvement in consumer LLP given assumption company continues to decrease storefront PDL via moving away from lowest credit quality customers

4. Expenses

   1. 3% operations and admin growth

      1. Below +7% LTM to account for management commentary on improving retail operations and focus

   2. $13mm corporate cost cuts (Mgmt announced $20mm run-rate cut on 3Q14 call)

5. 2015 EBITDA (after corp) = $122mm

   1. 11% margin

   2. Management guidance = $110mm to $135mm

Valuation:

Based on the prior estimates we derive the following valuation scenarios:

1. Base Case = $32; +47%

   1. 2015 est EBITDA = $122mm

      1. 2009-2013 ex corp avg = $185mm ($156mm - $211mm)

      2. We expect $52mm of corporate costs in 2015 implying an apples to apples range of $104mm - $151mm

   2. 8x multiple

      1. 20% discount to FCFS

   3. Implies $1.2mm/store

      1. FCFS = $2mm+

2. Downside Case = $17; -21%

   1. 2015 est EBITDA = $110mm

      1. 10% haircut to our base case estimate

   2. 5x multiple

      1. Inline with FCFS trough multiple

   3. Implies $0.7mm/store

3. Upside Case = $46; +113%

   1. 2015 est EBITDA = $140mm

      1. Assumes 170 bps of margin expansion vs. our base case

   2. 10x multiple

      1. Inline with FCFS multiple

   3. Implies $1.7mm/store

Catalyst

• New CEO
• Margin Expansion
• Stabilization of gold prices
• Capital Allocation
  • Monetizing ENVA stake
  • Under-leveraged balance sheet / opportunity for buybacks