Dollar Financial is a rapidly growing operator of payday loan stores in Canada, the UK, and the US. They trade at the lowest valuation multiple in the industry despite having what I believe to be the fastest growth, best store economics, best competitive position, best management, most attractive geographic markets, and most geographic and product diversity (which is important in terms of regulatory risks) in the industry.  Most importantly, we are on the cusp of a very near-term event (regulation of the payday lending industry in major Canadian provinces) which should:

a)      allow them to raise prices up to the new lending limits

b)      accelerate their growth rate

c)      weaken the competitive landscape

d)      eliminate uncertainty which, although not a risk of the company, may be placing a cloud over the stock

Deducting the present value of ~$100 M NOL, the company trades for 12.2x CY07 EPS of around $2.00.  Despite having a vastly superior business as compared with all other public payday lenders, this is essentially the lowest P/E multiple in the industry.  The valuation discrepancy is further magnified by the impact that payday regulation in Canada will have.  With the industry in Canada finally regulated, DLLR will be able to increase their prices up to the new fee caps.  This would increase earnings by as much as 50% -- potentially more depending on what the rate caps are set at – which would increase that $2.00 earnings stream to $3.15, making the current valuation only 7.8x.  Considering that the company will be growing these earnings by 30 - 40% annually, with high returns on capital, in very large and under-penetrated markets, with dominant consumer franchises makes the current valuation of only 7.8x this earnings power very cheap.

 

Before delving into more specific qualities of their business, an explanation of how payday lending regulation in Canada will affect DLLR and the rest of the Canadian industry is important.

 

 

There was a writeup of the #2 player in the Canadian market, Rentcash, on this website around June of last year.  It is probably worthwhile reading this for additional background information; however, I should note that my opinions on the company and industry differ substantially from those of the author.  Surprisingly, the writeup fails to address the impact on Rentcash and the overall industry of various potential fee cap structures – which is unfortunate considering that Rentcash’s future profitability and economic viability, along with the rest of the industry, is hugely dependent upon the nature of the regulations imposed in the major Canadian provinces.  Implicit in the analysis is that it will take years for fee caps to be set, and when they are the limits placed on total lending fees will be set in excess of $30 per $100 of principal.  I believe that both of these assumptions are highly unlikely, and that the resulting impact on Dollar Financial, Rentcash, and the rest of the industry will be dramatic.

 

 

At present, lending fees charged in Canada vary dramatically.  The total fees charged to the consumer can contain interest charges, brokerage or processing fees, and other ancillary fees, and these fees can either be fixed or vary with loan size.  Certain reports will also try to lump in a cheque cashing fee, but this is clearly a separate transaction.  Dollar Financial is unique in the industry in that their lending fees are around $12.50 per $100 of principal, a rate which is well below anyone else in Canada.  Rentcash, on the other hand, charges fees that appear to be higher than anyone else in the industry, and which exceed $30 per $100 (26% of principal + 59% interest + $6 fee).  The #3 player, Cash Money, appears to charge ~$20 per $100, and Stop ‘n’ Cash appears to charge ~$25 per $100.

 

The first obvious conclusion from this data is that it seems to be highly unlikely that the fee caps in major provinces will be set above $30 per $100.  It does not make any sense that provinces would go through the trouble of setting fee limits which are ABOVE the highest fee rates being charged in the industry.  Doing this would, if anything, increase the overall fees charged to consumers as lower-priced players can comfortably increase their rates in the now regulated environment – which is the exact opposite of what is intended by the new regulations.

 

So if the fees are not likely to be set in excess of $30 per $100, where are the likely to be set?  I think it is reasonable to look at the US.  While fees in Florida are as low as $13 per $100, the average rate across the US is around $15-16 per $100.  Also, I do not think that one can make the argument that Canadian consumers have inherently higher loss rates as DLLR (the only company operating in both the US and Canada) has dramatically lower default rates in Canada (1.8% in Canada vs. 3% in the US), and which I believe are lower than those achieved by any payday loan operators in the US.  Nonetheless, I think that the rates will likely be set at $17 – 18 per $100, which is near the higher end of rates in the US.  Due to Dollar Financial’s dominance in Canada, regulators likely cannot afford to make the rates much lower than this or they would risk giving MoneyMart a monopoly in Canada as all other PDL stores are forced to close down.

 

In CY07, the company will likely have around $120 M in gross lending fees in Canada.  An increase in lending fees will drop to the bottom line, and so an increase of the lending rate from around $12.50 to $17 per $100 will increase this EBIT level by around $43 M and increase EPS by around $1.13, from just over $2.00 to around $3.15.  If the fee caps generally turn out to be more moderate at ~$24 per $100, similar math indicates that EBIT levels would rise by $110 M and increase EPS by around $2.88 to around $4.90.  Finally, just for fun, if Rentcash somehow got their wish, a $30 per $100 price level would yield a $168 M increase in EBIT, and would increase EPS by around $4.38 to $6.40.

 

While the company has suggested that they would increase fees when regulations are finally in place, there are obviously no guarantees that the company will follow through with this, or with the time period over which these price increases are taken.  This is particularly true if the fee caps are set at an extremely high level – I would imagine that the company will want to take the high road and keep a meaningful price gap between the competition so that they can continue to lobby regulators to adopt more consumer-friendly fee caps.

 

 

The other interesting side-effect the new fee caps will have will be to weaken the competitive landscape.  An analysis of the potential impact on Rentcash (DLLR’s largest competitor), for example, is particularly enlightening.

 

Rentcash’s oldest stores (over 3 years old) generate revenues of around $420k per unit.  In 2006 they had around $89.6 M in direct expenses in the brokerage division on an average store base of ~308 stores.  This implies a store operating cost of around $290k / unit.  While DLLR’s store operating costs are slightly lower, RCS includes their hefty lender retention payments in this number, so this appears to be conservative.  This yields around a $130k margin per unit.  If rates are set at $17.50 per $100, this would constitute a roughly 39% decline in revenues (from ~$28.50 per $100 they currently recognize.  As a result, mature store revenues would fall to $260k per unit and store contribution would turn negative to ($30k) per unit.  Stores less than 3 years old would all be generating over ($100k) losses per unit, which are staggering losses for stores that would only be generating $150 – 200k in revenues per unit. 

 

Now there are obviously a number of variables and factors that prevent this analysis from being precise (their exact current blended fee rate, overall market growth, ability to add and grow new products like cheque cashing, etc.), so I do not mean to suggest that Rentcash will necessarily be driven out of business with a high teens rate cap.  That said, I do believe there is a fairly high probability that Rentcash’s revenues and profitability will be significantly impacted, causing them to generate losses in the short-term, and preventing them from achieving anything more than marginal profitability (certainly nowhere near the EBITDA per unit that MoneyMart does) in a $17-18 per $100 fee cap environment.

 

Finally, it was also suggested in the Rentcash writeup on this site that investors consider shorting Dollar Financial to hedge out the regulatory risk in Rentcash.  I obviously feel that this is a truly absurd recommendation.  If rate caps did come in very low around Dollar Financial’s current pricing, Rentcash would easily be forced out of business while Dollar would be able to not only maintain pricing but reap the benefits of having significant amounts of business driven to their stores.  This would obviously have disastrous consequences for an investor that is long RCS and short DLLR.

 

* * *

 

I’ll now address each of the previously stated reasons why DLLR has both an excellent business and the best operations in the industry.

 

 

Revenues are split roughly 50% in Canada, 25% in the UK, and 25% in the US.  By EBITDA, the split is around 60-70% Canada, 25-30% UK, and 5-10% US.  In terms of products, the revenues are around half payday loans and half cheque cashing + money transfer.  The only competitor that approaches this level of diversity would be Advance America.  Although AEA’s operations are entirely US-based, they do have good diversity by state, which is the level at which these businesses are regulated.  They do not, however, have any cheque cashing business.  A few other competitors like First Cash Financial achieve a bit of diversification through stores in Mexico, but it should be noted that as far as I know this market is still completely unregulated and as a result remains a bit of a question market.  Considering that various US states in the past have altered regulations to make payday lending less attractive or even uneconomic, having a diversified revenue base is important in minimizing risks.  As a result, Dollar’s geographic and product diversity give them the lowest risk profile in the industry.

 

 

This is really the most important point, and the biggest differentiator of DLLR from its peers.  Unlike their primarily US-based peers, around 90-95% of profits come from outside the US (Canada and the UK combined).  Although the US is an attractive payday lending market that is thought to still be under-penetrated (24k storefronts could easily be doubled), the Canadian and UK markets are much less mature and as a result have significantly more growth potential.

 

In Canada, there are only around 1200 - 1400 payday loan stores.  While the US has around 8200 people for every PDL storefront, Canada has around 25k.  This implies that the number of stores in Canada have to increase by 3x to approach US penetration levels (and the US itself is thought to be an under-penetrated market).  Furthermore, the Canadian market is much less competitive as no company holds a significant share of the industry in the US.  The largest player in the US, Advance America, has ~2600 stores, or just over 10% of the industry.  In contrast, Dollar Financial has 386 stores in Canada, or around 30 - 35% of the storefronts.

 

As immature as the Canadian market is, the UK is even less mature.  In the UK there are 60k people for every PDL storefront.    This implies that the number of stores in the UK has to increase by over 7x to approach US penetration levels.  Again, the UK market is also much less competitive.  There is around 1000 - 1500 stores in the UK, and DLLR (and its franchisees) operate around 402 of them, giving them somewhere between 25 to 40% of the storefronts.

 

Due to the extreme level of under-penetration in both Canada and the UK, DLLR is in an excellent position to grow their business at a very rapid rate for a long period of time.

 

 

As mentioned, DLLR has around 30 - 35% of Canadian storefronts.  The #2 player in the market, Rent Cash, has 348 stores, giving them just under 30% of the market by store count.  This metric, however, is extremely misleading in understanding how dominant Dollar Financial’s MoneyMart is in Canada.  MoneyMart stores have very large unit volumes which allow them to generate significant operating margins in excess of 50% (despite charging less than half what their competitors charge for the exact same service).  A number of factors which are unique to MoneyMart allow these stores to be extremely profitable.

 

First of all, the MoneyMart brand has a long history and is really the only deeply entrenched PDL/cheque cashing brand in Canada.  MoneyMart was actually started 25 years ago in Alberta.  By 1994, they already had over 100 stores in operation.  By 2000, they had over 200 stores.  And, as mentioned before, they have around 386 stores today.  As you can see, MoneyMart has had a meaningful number of stores in Canada for at least the last 15 years, and has steadily increased in size over this time period.  On the other hand, by the end of 2001 Rent Cash had only 5 brokerage stores; however, they have expanded at a very rapid rate since then.  This relatively long history combined with a significant amount of advertising has resulted in MoneyMart having 85% brand awareness in Canada.  This obviously helps to drive significant unit volumes which are spread over very fixed store operating costs.

 

Secondly, Dollar’s customer base (which tends to biased more towards the middle class than their competitors) and collections processes allow them to post vastly superior loan loss rates, which are around 1.8% of originations in Canada.  Rent Cash, for comparison, based on their reported “lender retention payments”, appears to posting loan losses of around 4.9% of originations, which is 2.7x higher than DLLR.  This is a staggering loan loss rate when you consider that provisions for loan losses are a meaningful expense in this business, around 19% of gross revenues for DLLR.  To put it into context, if DLLR had Rentcash’s loss rates, this factor alone with drop their store-level operating margins by over 30%! (from the 50%+ range to 20%)  In an unregulated environment, Rentcash has obviously been able to partially mask their atrocious loan loss rates by charging exorbitant brokerage fees.

 

The impending regulation of the industry will serve to highlight Dollar’s dominance in Canada as they are able to raise pricing and expand their 50%+ store operating margins while competitors are forced to lower their pricing and thus greatly depress already inferior operating margins.

 

As for the UK, Dollar Financial is even more dominant in this country.  As mentioned previously, with 402 storefronts, they have somewhere between 25 – 40% of the market.  In the rapidly developing cheque cashing market, they believe they have 40% share.  No other competitor, however, has more than 5 stores, making DLLR at least 8x larger than any of their competitors.  Importantly, UK stores are also highly profitable (I estimate 40%+ EBITDA margins) and generate high returns on capital (I estimate >50% after-tax ROIC).  The barriers to entry in the UK are also particularly high because pay periods are every month instead of every 2 weeks (which essentially cuts your return in half) and because of higher operating and capital costs.  As a result, you really need to offer an array of products.

 

 

This is simply a direct consequence of the above point regarding their incredibly strong competitive position in Canada and the UK.  Because of all of their aforementioned competitive advantages (scale leverage, collections, brand strength, etc.) they are able to post significantly higher operating margins and returns on capital than anyone else in the industry.  In their core markets of Canada and UK which generate 90 – 95% of profits, I believe that their store level operating margins range from 40 – 60% and generate 50 – 100% after-tax returns on capital.

 

 

First of all, they will be able to sustain a rapid growth rate going forward due to the geographies in which they operate.  As mentioned previously, the Canadian and UK markets are significantly under-penetrated relative to the US, which has allowed these regions to grow much more rapidly.  In the cheque cashing business, for example, US comps are roughly flat to down low single digits, whereas Canada is growing 3-4% (as much as 6% recently if you include currency benefits) and the UK is growing around 8-10%.  As a result, they have been achieving SSS increases of around 10 – 20% in both Canada and the UK.  Going forward this growth will be augmented as DLLR intends to ramp up their store opening plans in Canada and the UK, particularly in Canada once rate caps have been set.

 

In Canada, they intend to start opening 60 – 90 new stores annually, which works out to a unit growth rate of 17 – 26%.  Using a midpoint of 75 new stores and an EBITDA contribution of $300k per store yields annual growth of $23 M in EBITDA and $0.59 in EPS (new stores will not ramp immediately to this level, however, existing stores should continue to post strong comps).  With only high single digit unit growth, the UK should similar contribute around $0.15 in EPS growth.  Combined this would suggest incremental earnings of ~$0.75 annually, or a 38% growth rate. 

 

Looking at it differently, Canada and the UK, which comprise the vast majority of profits, should be able to grow units ~20% annually with comp growth of 10%+.  Given the significant operating leverage in these stores, double digit comp growth should be able to drive meaning margin expansion, which would make that 38% growth rate achievable.

 

All in, I am comfortable that they should be able to generate annual EPS growth of 30 – 40%.

 

Any price increases they decide to take in Canada, as mentioned earlier in this report, would of course be incremental to this growth rate.  Furthermore, if a meaningful number of competitors are unable to compete under the new rate caps and are driven out of business, this would drive incremental volumes to DLLR, which would benefit their comp growth in Canada.

 

 

So why is the highest quality company with the fastest growing operations in the industry trading at the lowest valuation on a relative basis (and certainly a very cheap valuation on an absolute basis)?  Well, here’s a few possibilities:

-     There have been so many negative regulatory changes in US states over the years that people automatically assume that impending regulation is a threat to the business, without understanding the specifics that make this situation unique: MoneyMart is already the lowest cost payday lender by a significant margin and the major Canadian provinces have indicated that they would like to keep the industry around.

-     It may be receiving a “cheque cashing” discount.  Another payday lender with a large cheque cashing business, Ace Cash (taken private), always tended to trade a discount to its peers due to declining cheque volumes in the US (offset by face value increases).  What people may not realize is that while cheque cashing is in decline in the US, it is growing at a decent clip in both Canada and the UK.

-     Until somewhat recently the reported earnings were obscured by a very high tax rate due to their prior corporate debt structure (which they have since refinanced).

-     Being essentially a Canadian business in a NASDAQ-listed US corporation, I think that for quite a while after its IPO it didn’t receive a lot of investor attention.  This is obviously starting to change.