Cash Store Financial (TSX:CSF) is a publicly traded payday lending company based in Edmonton and traded on the Toronto Stock Exchange. The C$94MM market cap company has no active sell side coverage and is not widely followed by institutional investors. However, the company’s performance has been greatly improving after some hiccups a few years ago and there are several catalysts that should make this stock a double over the next 12-18 months. CSF is also the most attractive acquisition candidate for US strategics that want a footprint in the underpenetrated Canadian market once the regulatory process is finalized (expected in the next 12 months). The company currently trades at about 2.3x forward EV/EBITDA and a 31% unlevered FCF yield and is using cash to actively repurchase stock and pay dividends to shareholders. We believe that a few more quarters of improved performance, upcoming investor meetings and aggressive share repurchase will drive the stock significantly higher over the next several quarters. Also, it is important to note in this environment that the company has no debt, $16MM in cash and generates a ton of FCF.

 

 

CSF operates 384 payday loan stores throughout Canada, which represents nearly 30% of the estimated 1300 outlets in Canada (Dollar Financial is the largest player in Canada with 419 stores, but also operates in the US and UK).

 

For those not familiar with the industry, you might be surprised by the demographics of the typical customer, which look remarkably similar to median education and income levels. Based on a Canadian study conducted by Pollara, the average customer has household income of $40-45k and over 50% have post-secondary educations. Nearly all have checking accounts and the vast majority are employed full-time. The demand for short term credit is acute, as many customers have typically bounced checks, paid late fees, or overdraft fees to essentially “finance” their short-term credit needs. A payday loan is quick, with convenient locations/hours, and has high customer satisfaction. Generally, a customer comes in requesting about $300 and writes a post-dated check on their next payday (10-18 days) for the loan amount plus the fee (generally $20-25/$100 borrowed). The customer either returns to the store to pay off the loan in cash on their payday or the store deposits the post-dated check on the applicable date. The credit process verifies employment, income level, contact information, references and an active checking account. There are no traditional FICO-like scoring models utilized for these products.

 

 

De novo stores generally take 6-9 months to breakeven and take 2-3 years to ramp up their portfolio. The mature stores generate in excess of $400k of revenues with a 35% contribution margin and a 38% branch level EBITDA margin. CSF spends about $50-60k for leasehold improvements and $50-$100k for start-up losses, resulting in a quick payback and a ROI that most retailers can only dream of.

 

 

The company provides good disclosure on the store-level operating performance by vintage. The key takeaway is that the company has tremendous earnings growth potential by virtue of the improvement in revenues and branch operating income over the next few years as their 2005-2008 stores approach maturity. I estimate that the existing store base will grow branch level operating income by $17MM (42%) over the next few years, and this is without any assumption of continued same-store sales growth or further reductions in loan losses, which the company believes they will see.

 

 

 

Some investors have shied away from the US payday companies because of an increase in the perceived regulatory risk. In Canada, the trend is quite the opposite and I expect the regulatory environment will be certain and stable within the next 12 months. I expect valuations to improve substantially and would expect CSF to be approached by several strategic and financial buyers once everything unfolds.

 

The payday loan industry was essentially unregulated prior to 2007, yet the industry ballooned from several hundred stores in 2000 to nearly 1,200 stores by 2007. The constraint to make expensive short-term loans was regulated by section 347 of the Criminal Code of Canada, which criminalizes the charging of usurious interest rates above 59% APR. Obviously, 59% APR does not work for fee-based 2-week loans and would not cover the overhead or loan losses associated with providing this type of credit. To operate legally, CSF utilized the “broker model” whereby CSF charged a 20% origination fee to arrange a 59% APR loan provided by an independent third-party lender. CSF voluntarily made retention payments to the 3^rd party lenders as an inducement for them to make these loans and to reimburse them for loan losses. This is very similar to the “CSO model” used in Texas by virtually all of the US operators.

 

While the company has legal precedent to use this model, there has always been a concern that perhaps this loophole would be closed off, even though their had never been any enforcement of S347 by the government. Starting in 2006, the Federal government starting reviewing their approach towards the industry and concluded that they would be better off regulating the industry at rates that allow the industry to exist and be competitive, but provide better protection and disclosure for consumers. In May 2007, Bill C-26 received royal assent and went into force.

 

Bill C-26 exempts payday loan firms from the federal 59% APR cap for loans under $1500 and under 62 days in maturity. The federal government pushed the decision on rate caps and the exact consumer protection measures down to each province. Thus, to technically be exempt from the 59% APR cap, each province must 1^st pass their own legislation and the payday lender must be licensed in the relevant province.

 

The best resource for following the legislation is the CPLA website:

http://www.cpla-acps.ca/english/home.php

 

Most of the provinces have passed legislation with the licensing requirements, disclosure and consumer protection issues, but progress has been slower than expected on the rate cap decisions. Most provinces are holding hearings to discuss the rate cap in front of public utility boards. The industry is well represented by the Canadian Payday Loan Association (CPLA), CSF and some smaller private operators. The industry has also come well prepared with studies from Deloitte & Touche, E&Y and several academic and market studies. The D&T study shows the average cost of providing a payday loan is $26-$27/$100, which reflects the lack of scale of the many small competitors in the industry (I estimated CSF’s cost/$100 to be in the $15-$17 range). While there is some consumer advocate resistance, the CPLA and industry has been proactive about self-regulation and pushing for enabling legislation and seem to have a compelling basis for a favorable rate environment. Unlike the US, the directive is that the industry needs to exist and the regulations should allow competition among reasonable operators, while weeding out the extreme fees or operators who don’t play by the rules. Based on our survey of operators, we generally find Dollar Financial to charge the lowest fees at about $20-$22/$100, CSF at $22-$25/$100 and smaller operators at $25-$32/$100.

 

Thus far, only 2 provinces have passed rate caps and the decisions are on the far end of the spectrum. Manitoba was 1^st and came out with a $17/$100 cap, which was blasted by the industry and is currently under appeal. I believe industry has a viable case in winning the appeal and it appears the 3-person committee overstepped their boundaries and didn’t follow their mandate from the Finance Minister of Manitoba (which clearly stated that the government should not drive companies out of business, that consumers show an interest in having the service and that the service should be offered in a way that is “just and reasonable”). The decision from the committee admitted that many small operators will have to shut down and offered no quantitative reasoning for their rate.

 

Nova Scotia was the next province to rule and had the chance to even reconsider their thoughts after the Manitoba ruling was announced. Nova Scotia announced a $31/$100 cap which they believed will promote a competitive industry while pruning some of the bad apples. They specifically denounced Manitoba’s decision in a harshly-worded commentary. This was viewed as a strong positive for the industry and is more consistent with the approach we believe is being taken by the provinces that are still under debate. While the exact timing of future decisions is uncertain, we believe there will be 1-2 more data points by year-end with the rest of the provinces ruling in 1H 2009. Our expectation is for most of the provinces to cap rates in the mid-$20’s to low $30’s with some likelihood of a province or 2 coming in with a lower rate. It is important to note however, that there are no provinces that are even discussing a rate as low as Manitoba and there is virtually no risk of an industry killing bill like we see in the US.

 

It’s also important to note that in the case of a lowball rate in 1-2 provinces, CSF’s financial impact will be mitigated by the fact that they will be the last man standing (along with Dollar Financial) and thus should see loan volumes increase dramatically and wouldn’t likely see a material decline in profitability (although its clearly a bit of a wildcard). Almost all of the mom & pop operators in Manitoba will close if the ruling is not successfully appealed, given their higher cost structures and lack of scale. In addition, CSF can charge higher optional/ancillary fees to increase the total fee charged to consumers.

 

CEO Gordon Reykdal owns 18% of the company and management/board members own another 5-6%. In addition, 2 US funds own 23% (per Bloomberg), thus the float is probably only 50-55% of the 19.3MM outstanding shares. We think that management is competent (though not spectacular), and has delivered on their promises of improved performance and returning cash to shareholders. They have focused actively on improving the 4-wall economics through process improvements and investments in systems and regional support. CSF has not directed much attention to investor relations or sell-side coverage (and has been buying back their stock on the cheap), but plans to hit the road and meet with US and Canadian investors this fall which should get the story out more broadly.

 

 

CSF recently reported their Q4 and FY June 2008 results, which showed continued momentum in same stores sales as well as improving branch-level margins and overhead leverage. The company has reduced loan losses 12.2% of brokerage revenues in Q4 and expects that trend to continue in FY 2009. The improvements have been primarily company-specific improvements such as development of an internal collections department, more focus on proactive client management (i.e. calling the customer to set a specific time to repay the loan) and reducing loan sizes to 1^st time customers (it’s hard to burn a payday lender more than once). Our assumptions for FY 2009 are 3% comp sales growth, loan losses of 12.7% of revenues (down from 15.4% in FY 2008 but up from 12.2% in Q4) and 54 new stores. The book tax rate should return to a more normalized 33-34% and the company will be able to utilize $4.5MM of NOLs to shield cash taxes. We are projecting EBITDA of $34.6MM and FCF of $24MM. The company has been aggressively repurchasing stock and intends to do so for the foreseeable future. CSF has repurchased 1.6MM shares since July 2007 (representing 8% of total shares) and has about 1mm shares left on their authorization. The company also has a 17.5c/yr dividend and is selectively looking at small tuck-in acquisitions. We believe the company will be valued at $11-12 (6x EBITDA / 10% FCF Yield) by the end of FY June 2009 if they reach their financial targets and the regulatory process heads in the direction we expect. Based on conversations with bankers and industry consultants, we expect strategic interest from several publicly traded and private-equity backed payday firms based in the US once the remaining provinces announce their rate caps.