Description

Industry Overview

Historically, pawn shops have the reputation of being a sleazy business that preys on the disadvantaged.  A pawn shop offers individuals the ability to receive cash or a loan by selling or pledging one’s personal property as collateral.  Pawning personal property is a short-term loan.  An individual exchanges a personal item for cash equal to between 40-70% of the appraised value of the property.  In order to get the item back, the individual needs to repay the original loan plus interest.  If payment is not made 60 days after the repayment is due, the pawn shop has the right to sell the item.  

Individuals who use pawn shops to cover short-term cash needs usually do not qualify for a traditional loan due to the size of the loan (average pawn loan is less than $150) and/or because of the lack of a banking relationship.  A recent FDIC survey found that approximately 27% of American Households were either under or unbanked - that equates to nearly 67 million American adults.  For these working-class Americans in need of short-term money, pawn shops provide immediate access to cash to help cover living expenses by either selling or “pawning” personal property.  

The pawn process is quick, straightforward, and regulated by municipal, state and federal statutes to provide protection for the individual, as well as the pawn shop, from dealing in stolen goods.  Each state sets the maximum monthly interest rate that a pawn shop can charge.  However, unlike traditional loans, the rates and “service charge” a pawn shop charges can vary dramatically from state to state.  On average, 80-85% of pawned items are redeemed within 2 months of being pawned, creating repeat customers.  

When compared to traditional bank loans, pawn shops interest rates and service charges can appear onerous, hitting annual percentage rate (APR) levels of 240%.  But it is important to remember that these individuals are using pawn shops because they do not have access to traditional bank loans.  A credit card cash advance with its average APR above 25% might be an alternative to pawn, but these loans are uncollateralized and balances grow monthly unless paid off in full.  Of course, this assumes that a pawn customer has the ability to receive a credit card.  Another option is a payday loan which can hit APR levels greater than 600%.  Legislation surrounding payday loans differs from state-to-state with most states regulating the term and amount that can be borrowed.  The Consumer Financial Protection Bureau (CFPB) wants to go even further by mandating the same credit checks required for banks and capping the APR levels.  This has caused many Payday Lenders to preemptively close their doors, leading many of the under and unbanked individuals back to the pawn shops.

Today, pawn shops have become mainstream, moving from the back alleys of impoverished neighborhoods to upscale malls and office buildings.  The majority of the approximate 13,000 pawn shops in the US are family run, customer friendly businesses that have been designed to look similar to a retail outlet.

Company Overview

EZCorp, Inc., with its 517 US stores, is the 2nd largest pawn shop operator in the United States with a 4% market share.  Together, with First Cash, the two leading pawn shop companies control only 13% of the US pawn market.  The remaining industry is highly fragmented amongst small store owners.  In addition, EZPW also operates 240 stores in Mexico, 27 Cash Max financial service locations in Canada, and owns a 31% stake in Cash Converters International based in Australia.  US Pawn represents nearly 85% of EZCorp’s revenue with Mexico and International contributing the remaining revenue.

EZCorp was one of the few companies to not only weather the financial crisis but to actually expand both its store footprint and revenues.  Its share price bottomed in early 2009 and then proceeded to triple over the next 2 years, as high gold prices and demand for short-term cash drove profits.  At the time, EZCorp was also providing payday loans which were a very profitable segment of their business.  Emboldened by their success, management began investing its growing free cash flow in adjacent businesses in the financial service industry in and outside of the US.  By late 2011 early 2012, the economy began to rebound, gold price began to fall, credit eased, and the demand for pawn and payday loans were in decline.  EZCorp’s Management was slow to react to the cycle and was spending too much money on store renovation, too little on employee retention, turning its inventory slowly, and was hoarding gold instead of scrapping it (a strategy that paid off extremely well when the price of gold raced higher).

But management was not the only one fueling the excesses of the company.  The board of directors entered into a Third Party Transaction with Philip Cohen, the sole owner of Class B voting shares, and controlled 100% of the vote, paying his company $500,000 per month for “advisory services.”  Basically, for $6 million a year, anytime the EZCorp wanted to acquire a pawn shop, Philip Cohen’s Madison Park LLC would review the deal, as well as provide an opinion and strategic planning.

By late 2013, the EZCorp, its business model, its management, the board of directors, and even Philip Cohen were under attack and scrambling for cover.  In a tumultuous 2014, the management team, some board members, and Cohen’s $6 million stipend were all thrown out.  A new management team, including EZPW’s past CEO from 2000-2010 and the current CEO of Bank of Queensland, were hired as COO and CEO respectively.  These individuals, as well as other on the management team were, selected to refocus the company’s business model, as well as bring legitimacy back to the company.  Since late 2014, the company has exited nearly all of its non-core pawn businesses to refocus its attention solely on its pawn business.  Besides shutting down all of its payday loan business in the US, EZCorp’s most notable divestiture was its 94% ownership of Mexican consumer lending company, Grupo Finmart.  The divestiture created a $90 million receivable, with the remaining $70 million to be paid over the next 3 years.

On Tuesday, June 27, 2017, EZPW announced a $125 million convertible debt offering.  For a company with a market capitalization of roughly $485 million at the time of the announcement, the market appeared concerned with the possible share dilution.  Five years ago, with its share price around $12/share, EZPW issued a $230 million 2.125% convertible debt with a $16 conversion rate that is due to expire in July of 2019.  In 2014, the market reacted negatively to the convert.  However, at the time, $16/share was considered to be a fair price for the company and the impact was somewhat muted.  This time the market was not as well mannered and drove the stock price down 15% by the end of trading day.  This negatively impacted the prospective strike price, which most likely would have been around $12/share (a 33% premium to the $9/share stock level at the time) instead of the announced $10/share (roughly 30% premium to the $7.70/share at the close of trading).  However, the 15% decline in share price could have created a nice entry level.  

Business Model

Since 2014, EZPW’s business model has become less complicated as the company has returned to its core roots as a pawn shop operator.  Centering its strategies around the company’s stores, EZCorp’s new business model reflects its attention to improving its pawn loans outstanding while managing its inventory (collateral that was surrendered or originally sold for cash).  Both metrics are highly correlated to store profitability and to one another.  If merchandise margins are too high, management feels EZCorp is appraising the collateral to conservatively and missing out on potential pawn loans.  A low merchandise margin indicates that the company is being too aggressive on its loans, valuing the collateral at too high a price.  Management has recognized that a 35 - 38% merchandise margin is the“sweet spot” and is the ongoing target.

To achieve this target, EzCorp has implemented some basic strategies at the store level to include:  Improving employee training focused on pawn loan pricing; customer service; and improving employee retention; and incentive metrics pivoting from revenue growth per store to store profitability.  Over the last year, EZPW has also spent around $5 million developing a new point of sale (POS) system to track customer behavior, trends, repeat business, and manage inventory.  Management expects to have the system fully deployed by the end of 2017.

On the corporate side, the company has been outspoken about its goal of reducing corporate overhead by an additional 25% to $50 million by 2018 while continuing to reduce its debt.  The proceeds from the company’s recent convertible bond placement will eliminate its $50 million term loan and revolver, reduce its current 2019 convert balance by $35 million, and stockpile cash for future store purchases in the US, Mexico, Canada and Latin America (EZPW has entered into a non-binding letter of intent to acquire pawn shops in Latin America).  

Investment Thesis

The pawn business is easy to understand but challenging to execute.  Increased regulation and the inability to spread the growing fixed operational costs over a number of stores makes it very challenging for small operators to compete, creating an environment that is ripe for consolidation.  At first glance, it appears that EZCorp is not faring any better than many of its peers.  However, much of the recent decline in revenues and earnings stems from management’s decision to reduce the company’s footprint to its core pawn business in the US and Mexico.  Write-downs, impairment and restructuring charges, along with reinvestments in store operations, has caused the company’s earnings to be negatively impacted.  Starting in 2018, most of these one-time charges and expenses will be eliminated, leading to increased profit and free cash flow.  The improved free cash flow could be used for future acquisitions or reducing its debt, allowing the company to be debt free within the next 4-5 years.

Competitive Advantage

The key to profitability in the pawn industry is growing the company’s pawn loans outstanding while maintaining strong merchandise margins.  Given its current footprint, as well as the recent changes EZCorp has made to its operations over the past three years, there are a number of competitive advantages the company has within the pawn industry.  

With 517 stores in the US and another 240 stores in Mexico, EZPW has the ability to spread one-time costs ($5 million POS system) and ongoing expenses (regulatory filings) over a large footprint - A luxury that over 85% of the pawn market does not have.  In addition, growing the company’s footprint through acquisition becomes an accretive strategy, opening up opportunities in the US, Mexico and Latin America to leverage EZPW’s operations and back office.

The Point of Sale system that EZCorp will deploy in late 2017 is also a significant competitive advantage, as the system will not only help streamline store operations but will allow for real time benefits in managing inventory, as well as pawn loan pricing. Very few pawn shop operators can afford this type of dynamic, in-store system that pays for itself in less than three years.  

EZCorp’s revised incentive plans, both for its store operations and executives, are now focused on profitability instead of revenue growth.  This not only reinforces the key metrics of pawn loan outstanding and merchandise margins but also motivates management to continue to operate the company for profits instead of growth.

Valuation

Even though EZCorp is much easier to value today than it has been over the past five years (fewer moving parts), there are still a number of ways to arrive at its valuation. On a per store valuation, the monthly pawn loan rate that a pawn shop can charge in its state is directly correlated to the revenue and the value of that store.  Nearly 80% of EZPW’s US stores are located in states with the highest national pawn loan rates.  A back of the envelope calculation is that pawn stores are worth 1x revenue.  For EZCorp, that works out to be roughly $1.2 million per store in the US and $400,000 for Mexico.  This gives EZPW a store value of roughly $716 million.  Subtracting out net debt of $160 million and adding in the Grupo Finmart’s $70 million receivable and $45 million from EZPW’s 31% stake in Cash Converters International brings the company’s valuation to $671 million or $12.20/share.  Using the same valuation method but discounting the store valuation to reflect the recent stock price of $7.70 per share would mean that investors are paying roughly $775,000 per store in the US and $250,000 in Mexico, a 35% discount to the base case valuation.  If store valuation gets back to levels seen in 2013 and 2014, then US stores would be valued at $1.4 million and Mexico at $450,00 or a valuation of $14.30/share.

Another way to look at the company is based on a multiple of EV/EBITDA.  Eighty percent of management’s LTIP is tied to EBITDA.  Although the exact EBITDA target has not been released by the company (expected in November/December of 2017), management has described the number to be “significantly higher” than the $68 million EBITDA achieved in 2016.  If we assume that the target is $110 million than EZPW’s stock is currently trading at 4.3x EV/EBITDA to the LTIP EBITDA target. If we believe that a conservative multiple should be around 8-9x (low-end industry levels), then that would give the company a valuation of just over $16.15/share.

To get a stock valuation more commensurate to the level of First Cash Financial Services/Cash America International or for a merger/acquisition to happen would require the conversion of Cohen’s Class B voting shares into Class A.  At this point, a takeout valuation could easily get up to $25/share, but I would not count on that happening anytime soon.

Risks

There are a number of risks facing EZCorp & its industry:

• Consumer Financial Protection Bureau & Regulation - Emboldened by its current success with reducing (scaring companies out of) the Payday Loan segment of the industry, the CFPB could set its sights on the pawn industry.  But with 67 million people unable to access the traditional capital markets, too heavy a regulatory environment on pawn shops will only end up hurting the people who need the service the most.

• Philip Cohen - Although it is very unlikely that the board would risk litigation by reinstating Cohen’s previous $6 million “advisory service” contract, Cohen still controls 100% of the voting shares, and therefore, controls the direction of the company.  However, now that his $6 million stipend is gone, Cohen is more focused on his equity holding.  His ownership of the Class B shares provides a headwind to the company’s valuation.

• The Economy - The “Pawn Cycle” refers to the cyclical behavior of a pawn shop customer.  When the economy contracts or slows down, a pawn shop’s customer will come in for a pawn loan.  When the economy is improving, these same customers will be back looking to spend the extra money on the merchandise within the store.  Unfortunately, these same customers will often be back pawning the merchandise they just purchased 6-8 month earlier.  For a pawn shop, a slow but improving economy is the most challenging economic environment.  EZPW is well positioned to benefit from any of the economic outcomes as most of the large impairments, write-downs, and corporate expenses have already been taken.

Summary

The US pawn industry is a mature, established industry.  Historically, the barriers to entry were very low creating, what is today, a highly fragmented and saturated market. Regulation, reporting standards, and the need for in-store technology has made it very difficult for smaller “mom & pop” operations to be profitable, creating an environment ripe for consolidation.  This provides a great opportunity for EZCorp to patiently wait for bolt-on acquisitions of stores strategically located.  These transactions can become accretive to EZPW once it implements its POS system, takes over the regulatory filings, eliminates back office overlap, and re-trains employees to focus on pawn loan outstanding and merchandise margins.  The same opportunities exist in Mexico, Canada, and Latin America

Because most of the impairment, write-downs and expenses EZCorp has taken over the past three years has been front end loaded, the company is well positioned to continue to grow both earnings and free cash flow even if revenues were to flat line or even decline.  This improvement along with the deployment of its POS system and a refocused employee base is expected to generate an EBITDA run rate of $110 million by September of 2018.

There are a number of reasons not to invest in the pawn industry, or in EZCorp, in particular.  Like it or not, the pawn industry provides a much-needed service to a large portion of Americans who do not qualify for traditional loans.  In terms of EZPW, the dual class structure with Philip Cohen controlling all of the company’s voting shares gives most investors pause.  Add in his historic $6 million Third Party Transaction “advisory service,” and most investors do not stick around to see how this story turns out.  With the removal of his yearly stipend, Philip Cohen is now more aligned with the shareholders and motivated to see EZPW’s share price increase.  With the recent decline in EZPW’s share price to around $7.70,  I believe the downside to be limited with a meaningful upside opportunity.

Catalyst

• Write-downs, impairment and restructuring charges, along with reinvestments in store operations, has caused the company’s earnings to be negatively impacted.  
• Starting in 2018, most of these one-time charges and expenses will be eliminated, leading to increased profit and free cash flow.