Description

EZPW was written up about 2 years ago by chuplin1065 and there is a wealth of information in the commentary section there. Given the significant developments that have occurred over the last 2 years, an update on the thesis seems reasonable.

Business Model:

EZCORP is a specialty finance company focused on delivering instant cash solutions to customers through its 1,356 pawn and consumer lending locations and online operations in the United States, Mexico, Canada, and the United Kingdom. The Company is the second largest operator of pawn stores in the US, with 493 locations. The pawn business is highly attractive, with loans typically earning 20% per month and annualized yields in the triple digits. Loans average $135 with terms ranging from 60-120 days and are heavily collateralized with loan values of 25-65% of estimated resale value and up to 80% of scrap value. Collateral redemption rates by customers are north of 80%, enabling the same collateral to be used repeatedly by customers for multiple loans over time. While the US pawn industry is relatively mature, it is highly fragmented with only ~10% of the country’s approximately 13,000 pawn stores accounted for by the three largest pawn store operators (Cash America, EZCORP, First Cash Financial Solutions). Much of the remaining 90% are owned by independent mom & pops who own one to three stores and present attractive acquisition options for a rollup strategy.

On the specialty financial services side, EZCORP provides a variety of loan products including payday loans, lines of credit, installment loans, and auto title loans through its 500 financial service stores and online lending platforms. The specialty financial services industry in the US is mature and more concentrated than the pawn industry, with the ten largest short term consumer loan companies, including EZCORP, operating approximately 45% of the total number of physical locations. Within Mexico, in addition to offering the above loans, EZCORP owns 76% of Grupo Finmart, the second largest payroll withholding lender in the country. Payments on these loans are withheld from the paychecks of government workers, reducing default rates, and have annual yields of approximately 56%. Recently, Grupo Finmart began securitizing and selling these loans to third party buyers, accelerating revenue recognition and cash flow. The Company expects to increase this activity going forward.

Sell Off:

EZPW is down 40% over the last year as earnings have eroded, corporate governance has come into question, and regulatory noise has become louder. Meanwhile, short interest has increased from 2 million shares to 6.4 million and the sell side has all but given up on the stock. Over the last 12 months, the average analyst price target has come down from more than $22 (55% of analysts rated the stock a buy in August 2013, with the other 45% rating it a sell) to $11 currently (0 buys, 8 holds, 1 sell).

Earnings: The decline in gold prices has been a large contributor to the decrease in earnings power. At its peak in 2011, gold scrapping accounted for more than 40% of total earnings versus less than 10% today, as falling gold prices compressed scrapping margins. To help reduce the impact of this margin compression, the Company shifted more product to higher margin, but slower turnover, retailing of forfeited jewelry. Given the stabilization in gold prices, lapping of last June’s quarter when the negative gold impact began, and scrapping’s limited contribution to earnings today, any further deterioration in scrapping earnings as a result of gold prices should be limited. On the lending side, as the price of gold dropped, jewelry loan values were reduced and collateral shifted more towards general merchandise (electronics, musical instruments, etc.). Because general merchandise loans average about 33% the size of jewelry loans, EZCORP has needed to generate 3x as many general merchandise loans to offset each jewelry loan. In doing so, however, gross margin on merchandise sales has fallen as gross margin on general merchandise is below that of jewelry.

The other contributor to the decline in earnings has been the rapid increase in operating costs. In FY 2014, operations expense is expected to be roughly 41.5% of revenue, compared to 33.9% in 2012. This increase was largely due to costs to open new stores as the company expanded its base too quickly (in 2013 alone, EZCORP opened 157 new stores, more than the previous two years combined). In addition to the cost to open the new stores, outsized operating costs chewed into margins as new stores don’t hit the company’s 15% ROIC targets until year 3 and the Company had to spend to fix store-specific issues that resulted from expanding too aggressively. Spending for planned growth in the online businesses that never materialized, other infrastructure spending (IT investments), and costs related to acquisitions also contributed to the bloated expense structure. As discussed below, the company is focused on reducing its cost basis and financial performance going forward.

Corporate governance: EZCORP has a dual class share structure. Class A shares are owned by the public and have no voting rights. Class B shares, which make up roughly 6% of total shares outstanding, have full voting rights and have been owned by a single individual, Philip Cohen, since the Company’s IPO. As a result, Mr. Cohen controls the outcome of all issues requiring a vote of stockholders and has the ability to control EZCORP’s policies, operations, and board members. Recently, governance appeared to be trending in the right direction. Stirling Brinkley, the Company’s long time Executive Chairman and the Board’s primary connection to Mr. Cohen, announced his retirement in April 2014, resulting in a more independent Board of Directors. Shortly thereafter, the Board cancelled a long time consulting agreement with Madison Park (an entity controlled by Mr. Cohen), in which it had been paying $7.2 million each year to Mr. Cohen for vague “advisory services”. The stock immediately rallied close to 25%. However, on July 18, Mr. Cohen stepped back in, firing the CEO and two Board members, causing the stock to drop 15%.

While it is unsettling that one person has the ability to change management and the firing of Board members looks to be partially retribution for cancelling the Madison Park agreement, the management change appears to be largely in the best interest of shareholders. In speaking with EZCORP management, they confirmed that Mr. Cohen is not involved in the day to day management of the company. While his attitude is hands off management of the company, his ownership stake properly incentivizes him to ensure the growth strategy is optimal and the best people are in place to drive operations. Previous CEO, Paul Rothamel, had slowly shifted the business focus from lending to retail, a shift that both EZCORP and its primary competitors conclude was harmful, as it reduced loan turnover and fee generation. New CEO and former CFO, Mark Kuchenrither, has already started to turn focus back to the core business of lending. In addition, while Mr. Cohen has access to the Board through recently appointed Board member Lachlan Given, recent additions to the Board, including Stuart Grimshaw, Joe Rotunda, and Tom Roberts are quite strong, making the current Board one of the more independent and impressive that the Company has had in years. As it relates to the Madison Park agreement, EZCORP confirmed that it does not anticipate the advisory contract coming back given this robust new Board of Directors (management noted that Joe Rotunda is very unlikely to ever approve a new Madison Park agreement as he hated the contract when he served as CEO).

Regulatory: Payday lenders have come under increased scrutiny lately with the Obama administration’s “Operation Chokepoint”, commentary by the Consumer Finance Protection Bureau (CFPB) in the US, new rulemaking by the Financial Conduct Authority (FCA) in the UK, and increased regulations by local municipalities. Cash America and First Cash Solutions have both made moves to de-emphasize their payday lending operations and, as discussed below, EZCORP is shifting more lending away from payday towards other forms of unsecured lending.

The CFPB has rule-making authority over short term lenders (though it does not have the authority to regulate fees). In an April 2013 report, the CFPB acknowledged the clear demand for small dollar credit products but expressed concern regarding the risk of sustained use of some products, and specifically, the risk of debt spirals. The CFPB has issued rules around almost every issue it has studied and it will likely do so here. Currently, potential regulations are in the pre-rule stage and there is signficant uncertainty regarding what the CFPB will ultimately do. By looking at the FCA’s actions as a guideline, however, general expectations by EZCORP and its competitors are that the CFPB will likely focus primarly on collections practices on payday loans (largely ignoring other unsecured lending) and set limits on loan rollover frequency, which would decrease rates of return and force lenders to more thoroughly pre-qualify borrowers. While the CFPB initially estimated its next input would be released in September, an agency contact recently said the timing will likely be delayed. The most likely timeline of steps is a small business review panel conducted by the CFPB to assess the impact of regulations on small businesses, followed by a formal regulation proposal several months later, followed by a 2-3 month comment period, culminating in a final rule (6-12 months after the initial small business review).

Divergent View:

While payday regulation has the potential to negatively affect EZCORP’s earnings, the outcome will not be binary for the Company. EZCORP has already been shifting its loan business based on regulatory changes and consumer preferences. The Company’s payday loans have decreased while other loan types, such as auto title and installment that have significantly less regulatory scrutiny, have accelerated, compensating for the decline in payday earnings. Auto title and installment loans are now the two fastest growing segments at the Company. While this leads to a lower total portfolio yield given the lower yields available on non-payday loans, the annualized yield profile of non-payday is still well into the triple digits. As a result, rather than the entire payday loan revenue stream going away in a binary fashion, what makes more sense is that payday becomes a smaller portion of the book and yields on payday loans compress by roughly half, to a level closer to that of pawn loans. Compressing yields on the current portfolio would result in a negative pre-tax earnings impact of roughly $65 million, reducing 2016 net income from $115 million ($2.06 in EPS) to $69 million ($1.24 in EPS), assuming zero offsetting reduction in operating costs. At the current price, the stock would be trading at 8.3x the reduced 2016 EPS level with the significant regulatory overhang largely removed.

The more likely scenario is that as payday gets regulated, the majority of the industry (predominantly the mom & pops) will close its doors given the increased expenses necessary to make these loans. EZCORP has already been spending $750,000 each quarter for these costs, a burden smaller players can’t shoulder. As a result, regulatory action likely creates a market with fewer competitors, and while the loan profile becomes lower yielding, the Company picks up additional volume such that the overall impact on the business is not signficant. One example of this already occuring is in Colorado, where after payday regulations were implemented in 2011, many mom & pop shops closed, enabling EZCORP to increase its loan balance and actually generate higher earnings.

A final scenario that the Street is ignoring is the potential for EZCORP to divest or spinoff its financial services business, similar to what Cash America has proposed. In speaking with management, it is clear they are very cognizant of the negative impact that financial services regulatory risk is having on the stock’s valuation. The Company is evaluating internally the necessity of the financial services business, given the pawn business has a clear path to 15% ROIC with significantly less regulatory risk, and what EZCORP’s valuation might be were it to divest this business. While this scenario appears less likely to occur, given management’s current internal 90 day review to ensure all businesses have a line of sight to 15% ROICs, it is certainly an option.

Outside of the impact from regulations, EZCORP also has two “hidden assets” on its balance sheet. The Company currently owns 31.3% of Cash Converters, a buy/sell and financial services business listed in Australia. The stake is currently carried on the balance sheet at $90.7 million despite being worth $145.0 million. Adjusting for this value takes tangible book value per share to $9.79 from $8.79.

EZCORP is also not as levered as it initially appears. While the Company carries $382 million of consolidated debt on its balance sheet, only $230 million is recourse to EZCORP, with the remaining $152 million attributable to Grupo Finmart and non-recourse to EZCORP.

Valuation:

EZCORP is expected to grow revenue by 2.7% in 2015 and 3.5% in 2016 driven by mid-single digit growth in US merchandise sales and pawn service charges and low single-digit growth in US scrapping sales and consumer loan fees. In Mexico, jewelry scrapping sales are assumed to continue to fall by low single-digits given competitive pawn pressure in the country, while consumer loan fees grow at low single-digits and other revenues stays steady as Grupo Finmart continues to grow and securitize its loan book. Operations costs are expected to fall to 40.5% of revenues in 2015 and 38.0% in 2016, still well above the level as recently as 2012, while administration costs decline marginally as cost rightsizing, discussed below, occurs. Assuming a tax rate of 30% results in diluted EPS of $2.06 in 2016 as net income approaches $115 million.

As a result of the factors discussed above, EZPW is trading at 6.9x next 12 months earnings and 4.9x EBITDA, close to its all-time trough valuation and similar to the level in the depths of the 2009 recession. Over the last 3 years, EZCORP has traded at a forward 12 month EPS multiple of 5.8-11.7x and averaged 7.8x, while forward EV/EBITDA has ranged from 4.3-7.1x and averaged 5.3x. While not perfect comps given both companies have moved away from the unsecured lending business, its closest peers, CSH (US pawn) and FCFS (Mexican pawn, higher growth), trade at 10.1x and 18.2x forward 12 month earnings, respectively. Even World Acceptance Corp, which is pure specialty finance lending and is at much higher risk from CFPB regulation, trades roughly in line at 6.8x. 2016 earnings should be priced in on a forward 12 month basis in the final quarter of 2015 as EZCORP’s fiscal year ends in September. Assuming marginal multiple expansion and applying a base case 7.5x forward P/E and 5.0x EV/EBITDA on 2016 expectations implies stock prices of $14.70 and $15.42, respectively. Taking the average of the two results in an expected stock price of $15.06 (46% return). Significant multiple expansion is possible as the CFPB clarifies potential regulations, thus removing a large portion of the regulatory overhang, and the Company announces the findings of its 90 day business review in early November, which would clarify the go-forward earnings profile of the business. Re-rating multiples even slightly to 9x EPS and 6x EBITDA results in an expected return of 82%.

On the downside, adjusted tangible book value of $9.79 (-4.9%) should serve as a support level for the stock. Similarly, using the $1.24 in 2016 EPS from the downside regulatory scenario discussed above and applying a multiple of 8x results in a stock price of $9.92 (-3.6%).

Investment Thesis:

The EZCORP thesis is predicated on margin expansion as the Company focuses on improving ROIC and reducing the operation costs that have ballooned over the last two years. Mark Kuchenrither has taken over as CEO and immediately initiated a 90 day review of every component of the business and all new investments with an eye to return all units to ROICs of 15% and strategically divest those that are structurally unable to achieve that level. In speaking with the Company, one of the primary outcomes of the 90 day review is significant expense reductions. Management confirmed that operations expenses more in-line with previous levels are the ultimate expectation as some short term investments (IT) are winding down, and believes returning to ~33% of revenue (versus 43% in 2014) over the medium term is reasonable. Management confirmed there is also room to reduce administration expenses, as the Company is too heavy on corporate support services, and all departments are going to come under cost review and will likely undergo some rationalization during the 90 day review. New stores starting to cover their expenses by hitting earnings inflections should also help operating leverage.

On the revenue growth side, EZCORP has a number of levers to drive growth going forward including opening new stores in the US and Mexico (management believes it can expand in a more measured fashion at ~50  new stores per year, which would prevent the growing pains the Company saw in 2013), consolidating the US market by acquiring mom & pop shops, growing Grupo Finmart in Mexico given the market remains severely underpenetrated, increasing online lending, and expanding into new geographies, like Canada. Additionally, online merchandise sales represent an attractive growth option going forward. In Q3, online sales grew 51% YoY and accounted for roughly 10% of total US merchandise sales (up from 6% the previous year) with higher margins in the low to mid 40’s and quicker inventory turnover than typical store front sales. EZCORP currently has over 500,000 items available for sale online through sites like Craigslist, eBay, and Amazon.

Lastly, Mr. Kuchenrither is already making an effort to reduce the Company’s focus on retailing given most of EZCORP’s profits are made on pawn service charges versus retailing forfeited goods. As competitors focused on their lending models, EZCORP shifted its focus to retail. This emphasis on retailing and preserving retail margins caused EZCORP to make fewer loans, resulting in reduced pawn service charges and lower fees as a percentage of consumer loans per quarter. Re-focusing on increasing lending through higher loan to value ratios and increasing inventory turns versus retail margin should aid both margin expansion and ROIC.

Investment Risks/Considerations:

National Regulatory Risk: As discussed above, there is substantial uncertainty regarding what actions the CFPB will take to limit payday lending. While the above assumes payday yields compress to the level of pawn loans and the payday book shifts to other loan types, it is not impossible that the CFPB introduce stricter regulations than the lenders are anticipating, which could negatively impact earnings should new regulations make lending unprofitable. Mitigating this risk is EZCORP’s proven ability over time to migrate its loan portfolios to new types of loans to incorporate new regulation. Furthermore, the CFPB has acknowledged the need for small dollar credit products and larger financial organizations are unlikely to enter the market given the small dollar amount of loans and higher credit risk, making it unlikely that yields compress to levels that would make lending by EZCORP unprofitable. Regarding “Operation Chokepoint”, the Company recently issued convertible notes to replace its credit line in order to limit exposure to banks for funding requirements. Incorporating the corresponding hedges, these notes effectively convert at $20.83.

Local Regulatory Risk: In recent years, several cities in Texas, including Dallas, Austin, San Antonio, and Houston, have adopted municipal ordinances imposing restrictions on certain financial service products that EZCORP can offer. These restrictions make the products less attractive to customers, lessening their demand, and impairing the financial viability of lending in those cities. As a result, EZCORP closed 20 financial service stores in Texas and Florida in 2013. Should additional cities enact similar ordinances, EZCORP’s earnings power in those cities may be reduced. While it is difficult to predict these actions, the Company is not seeing any actions against installment or pawn loan products.

Gold Price Exposure: While the Company has limited remaining exposure to gold through its scrapping revenues, the price of gold does impact the size of the Company’s pawn loans and helps drive traffic through its stores and lending operations by bringing in customers interested in pawning their items. Retail margins would also likely be negatively impacted given the higher margins on jewelry than general merchandise.

Dual Share Class Structure: As discussed above, EZCORP has a dual class structure such that Mr. Cohen owns 100% of the voting rights of the Company. While he has proven a willingness to step in and shake up the Board and management, incentives are largely aligned with common shareholders. Additionally, this ownership structure has been constant since IPO. Investors should not incorporate any assumptions or potential catalysts of Mr. Cohen converting his shares to voting as he has repeatedly indicated to management that he plans on holding his shares “until he dies”. As a result, this dual share class will likely cause a small multiple headwind compared to EZCORP’s comp group indefinitely and makes any sale or buyout of EZCORP unlikely.

Catalyst

Catalysts:

The findings of the 90 day review period should be discussed during the Q4 call in early November, at which time the Company will also likely give full year guidance for FY 2015. Focus on cost cutting and margin improvement as well as specifics on which lines of business may not be capable of achieving a 15% ROIC and what the company plans to do with those businesses should help clear up some of the market concerns.

Similarly, EZCORP is planning on hosting an Investor and Analyst Day in early December at its headquarters in Austin. This will allow investors to become more familiar with the strength of the new Board and better understand the roadmap to a 15% ROIC into the future.

While the FCA in the United Kingdom has been very transparent with its moves, enabling the market to adjust to new regulations, the CFPB has given very limited information as to its plans. Any announcement by the CFPB indicating what payday regulations are likely to be should help clarify one of the largest uncertainties in the stock and start to remove the large overhang on valuation. As discussed above, in speaking with the CFPB, they have indicated that the small business review announcement is likely to be pushed beyond the initial September guidance and any final regulation will likely be 6-12 months after that.