Description

Full disclosure - I have to submit a writeup this week, and I don’t have any original ideas. What I can do is try to provide more clarity on risks and potential upside on something that’s been written up many times before but is still ridiculously cheap. 

That company is EZCorp - a counter-cyclical, cash generative business in a fragmented industry with fairly high ROIC moving forward. It has low fundamental downside and attractive upside.

It is selling for less than 10x FCF, a significant discount to past takeout multiples, and below NAV. There are clear risks here which deserve a discount but not this big of a discount. Meanwhile, those risks and corporate governance are getting better.  

EZ Corp has been written up 9 times on VIC, so what’s different this time? Well for one, I’d like to point out that the majority of these writeups have returned greater than 2x over the next 2 or 3 year timeframe. To explain why I believe now to be one of those times, I’d like to go over the history.  

History

EZCorp went public in 1991 with 66 stores. EZCorp’s pawn business back then was not refined like it is today. There was no inventory management system or loan analysis, and most collateral was gold or silver jewelry. In short, it wasn’t a great business and only worked well in times of economic downturns or high gold prices. Using the proceeds from the IPO and a secondary offering, they expanded to 297 stores by 2000. However, results were very inconsistent. Over this decade, there were multiple large inventory write-offs, merchandise margin fluctuated wildly, and PLO (pawn loans outstanding) growth was heavily reliant on the economy. Share price declined from $3.25 (split adjusted) at IPO to a range of $.50-1.50 in 2000.

In 2000, Joe Rotunda took over as CEO and turned around the store level operations of EZCorp. He set up new inventory control procedures and cut down on store level expenses. For the decade moving forward, EZCorp saw higher PLO per store growth (even through times of booming economy), higher inventory turnover, more stable/lower inventory per store, less aged inventory, and more stable gross margins. They went from:

2000 - 300 stores producing $10mm CFFO, share price ranged from $.30-$1.75

2010 - 1000 stores producing $124mm CFFO, share price ranged from $10-23

Depending on your basis, EZCorp was anywhere between a 5x to a 75x over this decade. Granted, these results must be taken with a grain of salt. During this decade, not only did the price of gold skyrocket, but EZCorp also experienced massive growth in their new payday loan segment (which no longer exists).

In 2010, Joe Rotunda left and the new management took the company in a much different direction. Instead of focusing on lending in pawn, they began focusing on retail. They tried developing an online marketplace of pawned goods similar to EBAY. They entered adjacent businesses that wound up destroying capital. Store level expenses ballooned, PLO began to suffer, and inventory management went out the window. In short, they quit focusing on their core competency, which was pawn lending. By 2014, CFFO had fallen to $74mm while debt had grown to over $400mm (from $15mm in 2010) and a high percentage of their inventory needed to be written down as it couldn’t be moved. 

This shouldn’t be super revelatory… but when pawn shops are working at the store level, they have high returns on capital and are great businesses/investments. When they’re unfocused or inefficient at the store level, the opposite is true. One need only look at EZCorp’s results in the early 2000’s or First Cash’s results for the past 20 years to fully appreciate the compounding potential of a company in this industry. 

I think current management has proven that they’re very good operators at the store level. Although they seem to be struggling with capital structure and aligning with shareholders, they’re trying to improve. Since current management took over in 2014/2015, PLO per store has grown steadily faster than competitors. Store level and corporate expenses have come down. Their inventory management has been good ever since the firesale of aged inventory in 2015 due to previous management’s blunders. Most importantly, they are once again 100% focused on pawn lending. Most of the mistakes in the past stemmed from capital pissed away on worthless ventures. That doesn’t seem to be a problem currently.

Store Level Operations

So what makes a good store operator? It’s all about a combination of managing inventory and driving PLO. Obviously driving PLO is going to be the main influencer in whether or not a given store does well. PLO’s are the earning assets. It’s either translated into pawn service charges or into inventory which is then sold for a profit. So any increase in same store PLO has extremely high incremental net margins. Driving PLO can come from a few places - mainly by manipulating loan to value (and therefore inventory gross margins) or by driving foot traffic through the store.

LTV has a large impact on PLO growth. You see LTV come through the financial statements via the gross margins of retail goods. Too high of a gross margin means you’re appraising pawn collateral too conservatively and short changing yourself on possible pawn loans. Too low of a gross margin means you’re valuing collateral at too high a price and missing out on merchandise profitability. It’s a delicate balance, and EZCorp’s management has learned that the most ideal GM range is between 35-38%. They are consistently within this range. Poorly run pawn shops often times utilize lower LTVs to drive gross margin for retail. This pushes potential loan customers to competitors as customers want as much money as possible for their collateral. Using the ideal LTV ensures capturing customers while also remaining profitable in retail.  

Foot traffic is also important in driving PLO growth. Historically, pawn shops have focused on jewelry (gold mostly) as collateral. This limits not only potential loan customers, but also retail foot traffic. EZCorp has improved mix away from pure jewelry towards general merchandise, especially in newly acquired stores (I’ll talk more about this later). You can get a really good idea of the physical change seen in stores on slides 34/35 in EZCorps 2018 investor day presentation. Not only is the presentation much more inviting, the presence of general merchandise is successful in capturing foot traffic (especially in latin america).

Lastly, you have store level incentives. This is very relevant due to EZCorp’s recent history. Before the management shakeup in 2014, store level incentives were based on net revenue. This incentivized low LTVs and high gross margins for retail. There’s no incentive to move old inventory, or even to filter loans based on inventory that can be moved. This causes old/unmovable inventory to build up, which is a hidden expense. This was the cause of the big EBITDA hit EZCorp took in 2015, as they liquidated old inventory. Pawn shops can operate for years looking profitable while stockpiling old and unmovable inventory, but this will eventually lead to large inventory write downs. EZCorp has since implemented a new store level incentive system that focuses on store level profitability instead of net revenue. On top of that, EZCorp has introduced new analytics designed to track inventory. This should allow them to move inventory before it depreciates. 

The combination of better aligned incentives, analytics, ideal LTV, better inventory mix, and more appealing storefronts combine to make EZCorp well run at the store level. And I’m not just saying this, it shows up in the numbers. Following are charts of EZCorp’s US and Latin American PLO growth, merchandise margin, and aged inventory over the past 5 years.  

Latin American PLO Growth Versus First Cash Over Past 13 Quarters:

 US PLO Growth Versus First Cash Over Past 14 Quarters: 

Store Metrics Versus First Cash:

Reduction In Aged Inventory and Merchandise Margin After Firesale in 2015:

US Left, Latin America Right

Consolidated Merchandise Margin and Retail Mix:

These graphs show a number of things. Mainly, since new management in 2015, merchandise gross margin has been stable and lower than previous management, which means they’re utilizing higher LTVs. This has driven superior and significant PLO increases when compared to both previous management and First Cash. Inventory is being managed far better than under previous management. EZCorp’s store level metrics are actually generally better than those of First Cash. Finally, retail mix has rapidly moved towards general merchandise, which drives foot traffic and therefore PLO, as well as makes the company less exposed to the price of gold.  

Risks

I will readily admit, there’s a lot not to like about EZCorp. There’s a controlling shareholder, previous management destroyed a lot of capital, current management has struggled with capital raises, and there is constant talk of regulation risk in the space. I want to better detail these risks and their counterpoints, as I haven’t seen this in previous writeups. 

1.Controlling Shareholder, Phillip Cohen

Since EZCorp’s IPO in the 90’s, Phillip Cohen has been the controlling shareholder. He owned ~80% of the B-shares (which have 100% of the vote) back then and 100% currently. Clearly this deserves some sort of discount. But most of the negative sentiment revolves around his abuse of power rather than the simple existence of a controlling shareholder. This stems from the third party transaction his company, Madison Park, entered into with EZCorp some years back. EZCorp was paying him $7.2mm per year for “advisory services” (the description of which is to do basically everything executive management is paid to do). To understand how ridiculous this was, those fees represent over 10% of EZCorp’s free cash flow over the duration of the arrangement. I believe this led many investors to believe Cohen doesn’t care about the share price and will find other ways to profit off of EZCorp. 

Counterpoint: 

The audit committee eventually terminated the agreement, and the Delaware Court eliminated any possibility of it being reinstated in the future based on the argument that the transactions “were not legitimate contracts for services but rather a means by which Cohen extracted a non-ratable cash return from EZCorp.” This means that Cohen’s only avenue to profit off EZCorp is now share price appreciation. 

I would also like it to be noted the past proves EZCorp can be extremely successful under Cohen’s control. There has really only been one large blunder under Cohen, and that was the poor management post-Rotunda from 2010-2014(which I will detail later). Outside of that period, the company has been run well. 

2. Current Management and Capital Structure/Raises

In the past 2 years, management has really struggled with capital raises. Because of its tumultuous past, EZPW would have to pay over 10% rates to get straight debt. This has led them to rely on low coupon convertibles to fund acquisitions. They’ve completed 2 of these offerings in the last 2 years. The first in 2017 for $143mm priced at $10 per share. The second in 2018 for $172mm priced at $15.90 per share. Both were poorly executed. The first was done at far too dilutive of a price, and an acquisition wasn’t announced until 6 months after the offering. The second was actually done at a fairly good price, but only 2 small acquisitions were announced a few months afterward. They’re still sitting on a large pile of cash at the cost of dilution to shareholders. 

Here are the numbers on the raises. It’s worth noting that the 2017 EBITDA multiple is off a very depressed base:

Not the work of a management team that understands how to drive value for a company. The potential for dilution plus the botched offerings did a number on the share price both times. The first sent shares down ~15% the following day. The second started a 50% slide over the next 6 months. 

Counterpoint:

Management knows they messed up and they’re trying to be better. Ever since the extremely dilutive 2017 convert, you see management talking about ROIC, returns in excess of cost of capital, longer term thinking, and compensation incentives have been changed to combat dilution. They understand the importance of the delta between the return on acquisitions and the capital used to fund it. 

The market is clearly upset about these capital raises, with no clear allocation plan immediately following the raise. But consider the following numbers about raises/allocation over the past 2 years:

Raised: $315mm in convertible debt

Allocation: 

- About $110mm spent on mainly Latin American Acquisitions

- About $10mm spent on new store openings

- $195mm spent retiring 2019 convertible notes

So all in all, they’ve raised $315mm and spent almost exactly $315mm on growth or debt paydown in the past 2 years. The debt may not have been raised at great prices, but considering they can make acquisitions at 4-5x EBITDA, they’re still creating value. And that’s not even considering the massive operational improvements generally made after and acquisition gets added to their portfolio.   

Another important factor - although probably not something I’d brag about - the converts are not dilutive unless the share price appreciates considerably. 

3. Current Management CompensationThe new management has proven themselves to be adept at turning around store level operations, but they’re still Cohen’s cronies. They are egregiously overpaid, and the previous hurdles for the long-term incentive plan were not in the best interests of shareholders or the long-term success of the company. 

Grimshaw, EZCorp’s CEO, has averaged a higher pay than First Cash’s (their only public competitor) CEO over the past 3 years. This despite the fact that First Cash has over double the revenue, and an outstanding total shareholder return over all periods of the last 20 years. Shares in EZCorp, on the other hand, are worth â…“ of what they were 8 years ago, and are down around 10% from when Grimshaw took over 5 years ago. Lachlan Given, the Executive Chairman of EZCorp, has made about $2.5mm a year for the past 3 years and it’s entirely unclear why. The only reason I can see for both is that they are friends of Cohen’s predating their time at EZCorp. In the case of Given, he actually works for Cohen at Madison Park (the LLC used to siphon off egregious amounts of cash from EZCorp). 

The LTIP structured at the start of the turnaround (2015) did not do a good job of aligning management’s interests with shareholders. The equity awards, which accounts for about half of the executive’s compensation, vested based upon EBITDA growth and net debt. 80% of the awards were based upon EBITDA growth while 20% were based upon net debt. What this incentivized management to do (or at least how they worked around it) was to make debt fueled acquisitions regardless of price paid. As long as it boosted EBITDA, they got paid and paid a lot. 

Counterpoint:

EZCorp has added 7 new independent directors in 2019, 2 of which are on the compensation committee. This is likely to do with the backlash over not just compensation issues, but other corporate governance backlash. This is at least a step in the right direction. 

So once again, they understand compensation and incentives are an issue with shareholders. I’m not going to defend the quantity of compensation as it’s clearly ridiculous (most likely because of Cohen), but incentives are something that have been changed. Moving forward, the LTIP will grant awards based upon net income and EPS rather than EBITDA growth. This should make management more conscious of terms of convertible debt as well as prices paid for acquisitions.

4. Regulatory Changes

Regulation changes are a large perceived risk with EZCorp, but any regulatory changes for the worse are unlikely. 

In the US, caps on interest rates are regulated by state governments. In Mexico, interest rates are regulated by the federal government. Unfortunately, sentiment on EZCorp gets pushed around by regulatory changes in other small, predatory consumer lending industries like payday. This is likely because EZCorp used to have a rather large payday lending segment. However, there isn’t much else to say here about actual regulatory risk. Regulations in pawn lending haven’t changed much in the past few decades, except for a few states actually increasing rates.  

Counterpoint: 

There’s a lot of misinformation about what regulatory changes affect their ability to operate. 

For instance, in July of 2018, there was a regulatory ruling on consumer lending in Ohio. It was specifically limiting consumer lending rates to 10% interest per month, while pawn in Ohio is already limited at 6%. So not only did it have literally zero effect on EZCorp as a pawn lender, but they actually have zero stores in Ohio. This caused a 15% drop in the share price over the next week. 

Another instance was a potential bill proposed in Mexico in 2018, which was primarily targeting banking and atm fees. It was eventually refined in March of 2019 to require banks to offer zero-fee accounts to low income clients. Not even closely related to EZCorp’s business, and this drove negative sentiment around the stock for months.

The reality is that pawn lending may be an unsavory business, but it’s a necessity and so much better than any of the alternatives. On average, the loans are $100-120 and interest rates vary between 13-25%. Typical terms range between 30-90 days. It’s secured lending, so worst case scenario is you lose your collateral. Even the most egregious of terms sees people paying less than $100 of total interest. Compare this with payday lending, where you have linked checking accounts and the power to profit off of bad loans. This creates the potential of interest compounding, forcing customers to pay ridiculous multiples of the initial loan. Pawn lending may get the reputation of being tainted simply because it’s in the small consumer lending industry, but it satisfies a large demand and is fair with its customers. Likely because of this, there haven’t been any significant regulatory changes in pawn lending in the past 3 decades, and it’s unlikely there will be any in the near future. It may have constant periods of volatility due to tangentially related regulatory rulings, but actual regulatory risk in pawn lending is likely a nonfactor.  

Upside:

1. Latin American Expansion

This is a rather new opportunity for EZCorp. They began their Latin American expansion in 2006 but didn’t really accelerate acquisitions/de novo openings until the turnaround in 2015/2016. The market doesn’t seem to fully comprehend how attractive this expansion is.

The ROIC of acquisitions and new stores in the United States is not that attractive. EZCorp’s overall US based ROIC is somewhere in the low teens, around 13%. However, their Latin American pawn ROIC is currently upwards of 20%, and that’s before operational improvements have had a chance to mature their store profile. EZCorp believes they can achieve 25% ROIC on acquisitions and 35% ROIC on new stores by year 5. At first, these numbers seem slightly ridiculous. After all, their largest acquisition to date for 100+ stores in Mexico earned 12% ROIC in its first full year under EZCorp. However, the market is missing how much operational leverage can be squeezed out of these Latin American stores.

Typical pawn shops in Latin America are not managed anywhere near optimally. They generally focus on gold only and utilize low LTVs for retail gross margin. As I described earlier, this is going to result in very low PLO per store. PLO is going to be the driving factor in operating leverage, because most of your costs are fixed. Any incremental PLO that you’re lending out at 15% monthly yield drops straight to the bottom line.

So the 2 big shifts to drive increases in PLO are improving collateral mix from gold only towards general merchandise and increasing LTVs. 

- Improving mix is far more effective in Latin America than it is in the United States, as consumers in LA are more likely to shop for things like electronics at pawn shops than they are in the US. This drives more foot traffic through the door, which drives PLO growth. 

- By increasing LTVs you make it more likely to capture customers vs. sending them to your competitors. Obviously you want as much cash as you can get for your collateral, so higher loan values drives PLO growth. There’s a downside here, which is higher LTVs means increased risk of forfeiting collateral and lower retail gross margins. This, again, is a place where EZCorp has an advantage over smaller operators. Because of their massive amount of previous loan data/analysis, they have a better handle on the quality of individual customers as well as collateral. 

These are all just words, but the numbers speak for themselves. Same store PLO growth has been in the double digits for 10 of the past 13 quarters. Since 2015, EZCorp’s Latin American stores have averaged 15% yoy same store sales growth. 5 more years of that, and it’s not hard to see management’s projections of 25% ROIC on acquisitions ring true. 

So why are returns in Latin America so high? Latin American managements don’t realize how inefficiently they’re running their stores. Or if they do, they don’t have the balance sheet or foot traffic to support more general merchandise inventory and higher LTVs. Most think they’re getting good prices when selling, but don’t understand the operational leverage that can squeezed out of stores. Acquisitions may look like good deals on current numbers, but looking out a few years makes them look incredibly cheap.     

We can also look at capital deployed versus improvement in the Latin American segment since the start of 2017. EZCorp has deployed about $120mm in acquisitions and de novo openings. In FY2016, the Latin American segment produced $8.5mm in net income and $13.5mm in EBITDA. Looking at run rate 2019, the Latin American segment will likely produce around $32mm in net income and $38mm in EBITDA. That’s an increase of about $24mm net income and $25mm EBITDA on capital deployment of $120mm. Numbers are already not too shabby, even with only 1.5 years under the belt of their largest acquisition. Admittedly, the numbers here don’t exactly work apples to apples. That increase in profitability is partly due to the same store PLO growth of their pre-existing stores at the beginning of 2017. Either way, they’re deploying a bunch of capital in Latin America, they’re already seeing a good ROIC for their Latin American segment, and the segment is growing rapidly bringing a lot of operating leverage.   

2. Buyout Potential

I’m of the opinion that it’s a foregone conclusion First Cash will acquire EZCorp at some point in the future. It makes too much sense for both parties for it not to happen. On top of the synergies, the reduced competition for bids on acquisitions would be worth it alone. The next decade of pawn is going to be dominated by expansion into Latin America due to the aforementioned reasons. Having zero competition on those acquisitions would look very attractive. 

In terms of the likelihood/timeline of EZCorp selling, there are 2 ways to look at it. Both clearly have to do with Cohen and his motivations.

First - Cohen is over 70 years old. EZCorp isn’t some kind of investment vehicle he’ll sit on until he dies. Based on his past shady dealings, it’s clear that all Cohen is interested in is profiting off of EZCorp. This isn’t some type of legacy he’s trying to leave behind or compound with into his grave. Given his advanced age, I think it seems rather likely that Cohen initiated the 2015 turnaround, and intends to sell when the business is firing on all cylinders again (which, despite what the market is saying, is fundamentally not too far off). Any buyout likely sees anywhere from a 40-100% premium over the current price. I’ll go over those details in the valuation section.

The second way to look at it, which really throws a wrench in the first scenario, has to do with Cohen’s son. Cohen’s son, Nick Cohen, was hired as Director of Financial Planning and Analysis in 2018. Nick Cohen is your stereotypical trust fund baby. His track record includes:

- unsuccessful DJ career

- started an entertainment management company of which he’s the only artist

- opened and sold what seems like a semi-successful high-end fashion sneaker store. 

I don’t know exactly what pushed him towards working at EZCorp. I can only assume it was either a strong suggestion from his father or he decided he finally wanted to start working in the real world. Whatever the case may be, Nick Cohen being potentially groomed for management isn’t good for the likelihood of his father selling.

While this certainly muddies the waters on buyout potential in the near future, I still think it’s very likely First Cash acquires EZCorp at some point in the next decade. 

3. Improving Corporate Governance 

This has been touched on in multiple other sections, but this is the most important detail in driving sentiment in the stock. The combination of a controlling shareholder and bad corporate governance has driven EZCorp’s multiples to about â…“ those of FirstCash. 

Since the management shakeup in 2014, management/corporate governance has improved immensely but still isn’t great:

• Refocused company on pawn lending rather than retail

• Shuttered/sold off non-core businesses 

• Firesold old inventory from previous management, good inventory management since

• Driven high, industry leading same store PLO gains for past 5 years

• Added 7 new independent directors

• Changed management compensation incentives from EBITDA growth to EPS to combat dilutive offerings 

• Pivoted towards acquisitions of high ROIC pawn shops in Latin America

I would imagine corporate governance continues to improve as they attempt to bolster their image.

4. Economic Downturn

Any downturn in the economy could see demand for pawn rise significantly. In 2009, EZCorp saw a 40% increase in revenues on just a 12% increase in store count. 2010 saw another 24% increase in revenues. EBITDA nearly doubled from 2008 to 2010. It’s unlikely we would see something that dramatic, but an economic slowdown would certainly result in a large boost in revenues and cash flow.  

Valuation

Apologies numbers aren’t exact. I made all these tables and converted them into JPEGs a few days ago. It’s only gotten a tad cheaper however. 

Below is a relative valuation, a comparison to the most recent public buyout, and a breakup-multiple valuation. EZCorp looks cheap on any metric you could possibly suggest. 

MJS did a good job laying out a table to illustrate the breakup value in the previous writeup. No sense in recreating the wheel, so I will just update numbers in the table for the most recent quarter. 

To be clear on the breakup values here, I would expect EZCorp’s values per store to be on the higher side of the range. The majority of EZCorp’s stores are in the states with very high caps on pawn interest rates. Their mix in this regard is better than First Cash. Their Latin American de novos generally cost >$300k to open, so I would assume any sale would generate more than that. Especially considering the rapid growth in PLO and improvement in store level metrics in Latin America. 

EZCorp clearly deserves some sort of discount due to Phillip Cohen, the controlling shareholder. But trading at â…“ the multiple of First Cash, a massive discount to the most recent buyout, and at a discount to its NAV is ridiculous. I know many prospective investors probably get an icky feeling even thinking about EZCorp, but it’s simply far too cheap. A fair valuation sees at least 50% upside from here. On top of that, with the massive amount of capital being deployed at good rates, that value has been and will continue to increase every year.   

Conclusion

At the end of the day, you’re getting a cash flowing, counter-cyclical business with scale advantage over competitors at around 7x FCF, â…“ the multiple of its public competitor, and at a meaningful discount to its NAV. The reinvestment potential, which brings massive upside, is just icing on the cake. 

Risks:

• Controlling Shareholder

• Management under-delivering yet overpaid

• Potential for further dilutive capital raises

• It’s in an industry that people love to hate, poor sentiment is common (e.g. inventory firesale in 2015 leads to ridiculous share price despite significant cash flow)

• Regulatory risk is relatively non-existent, but sentiment gets lumped in with predatory consumer lending 

Upside:

• High return on incremental invested capital

• Corporate governance improving

• Potential buyout premium with Cohen aging and looking for exit

• Massive Latin American market with the potential for more accretive acquisitions

• Continued store level operations improvement

• Economic downturn gives significant boost to demand

Catalyst

- Revinestments in Latin America

- Continued Improvements to Corporate Governance 

- Buyout Candidate

- Economic Downturn

- Continued Improvement of Newly Acquired Store Level Metrics