Description
The Payday Loan
Sector – Sucked Down with Sub-Prime. The
Long Case for EZCorp (EZPW)
We believe that it is time to aggressively invest in the
payday loan space which, in our strong view, has been inappropriately punished
with the sub-prime sector. We outline
the Payday Loan Industry below and argue that the sector has not at all been
affected by the sub-prime meltdown and now trades at very compelling valuations. In addition, we propose a specific
recommendation, EZCorp (EZPW) which, in our opinion, is trading at an
extraordinarily cheap valuation and has 40-70% upside within nine months as
well as excellent longer-term prospects.
The Payday Loan
Industry
What is a Payday Loan?
The Payday Loan Industry, sometimes also referred to as the Payday
Advance Industry, is a consumer finance segment that involves the unsecured lending
of small sums of money, typically $500 or less, for short periods of time,
typically two weeks. The borrower is
charged a fee, usually amounting to 15% to 20% of the advance amount, rather
than an interest rate and, even if the advance is not paid when due, interest
does not accrue. The relatively large
fee and short-term nature of the loan imply a very high annual percentage rate
(“APR”), which may be equivalent to 200% to 400%. Permissible fees and loan durations are
regulated and vary according to state law.
The industry emerged in the early 1990’s and grew as a
result of a number of factors. Firstly,
there was strong consumer demand for a service of this type resulting from,
amongst other things, a significant increase in the cost of bounced checks,
late payment penalties, and the lack of availability of alternative short-term
credit products. Secondly, enabling
legislation was adopted in many states providing guidelines and consumer
protections under which the industry would operate. Due to the different
legislative models payday loans are marketed under a variety of names. For simplicity, we will use the term “payday
loan” to cover all advances of this nature.
Although the cost of a payday loan appears high, it often
represents compelling value to the consumer.
The reason for the strong demand is the cost and convenience of this
form of credit related to available alternatives. For example, a payday advance is cheaper than
a bounced check, late fee to a landlord, or utility reconnect. This is a
compelling value proposition for certain demographic groups and industry bodies
report a remarkably small amount of customer complaints, implying satisfaction
is high.
The industry is currently estimated to have more than 22,000
payday advance locations across the US and to extend about $40 billion
in short-term credit to millions of Americans that experience cash-flow
shortfalls between paydays. There are many private and public companies
operating in the space including EZCorp (EZPW), Cash America (CSH), First Cash
Financial Services (FCFS), and QC Holdings (QCCO). This is a defensible segment in consumer
finance as an entirely different and specialized infrastructure, for example
compared to banks, is required to profitably operate in this line of
businesses.
Customers can source loans through a variety of payday loan
providers. Firstly, through stand-alone
storefront businesses that offer payday advances as their sole product and
source of income (also know as mono-line providers). Secondly, through multi-service providers
such as check cashers and pawn shops that offer payday advances as an ancillary
line to their other services (also known as multi-line providers).
From no enabling state legislation in 1990, more than half
of the US states as well as
the District of Columbia
have enacted specific enabling legislation for the payday advance
industry. A large proportion of the
industries store base is located in Texas. The Texas
legislature sits every two years. In the
recent session the only bill relating to the industry was one regarding
information disclosure and it was returned to committee meaning there will be
no possibility of regulatory change in that state until the next session in
2009.
The industry has two national lobby groups, The Community
Financial Services Association of America (CFSA) and Financial Service Centers
of America, Inc. (FiSCA), as well as a number of state organizations. Significant
materials on the industry are produced by these national organizations.
How Has the Payday
Loan Industry Been Affected by the Sub-Prime Meltdown?
How has the profitability of the Payday Loan Industry been
affected by the sub-prime meltdown? In
short, we do not believe that it has at all.
Payday loan customers are known as “under-banked.” For example, discussions with various
executives and analysts have indicated that only an estimated 15% of customers
have mortgages and that few, if any, credit alternatives are available to them. In addition, studies, for example by Experian,
indicate that payday customers are likely to honor their payday loans before
other obligations. Our discussions with
industry experts have indicated there has not been a down trend in loan losses
and that one is not anticipated.
Payday loan providers are not dependent on the credit
markets for funding – in fact many are debt free - and in any event are not particularly
interest rate sensitive given the very high APR compared to their cost of debt.
While we do not have statistical evidence, it seems
intuitively logical that stress amongst sub-prime consumers may even benefit
the Payday Loan Industry through increased demand for products. Conversations with executives and analysts indeed
lead us to believe that this could well be the case.
The Long Case for
EZCorp (EZPW)
EZPW is, in our view, one of the best run operators in the
Payday Loan Industry and currently trading at an extremely cheap
valuation. The company is a multi-line
operator whose traditional business was pawn shops. The company added payday lending to some of
its pawn stores as well as built new stand-alone payday store-fronts. As of
September 30, 2006, EZPW offered pawn loans from 280 EZPAWN locations and 369
EZMONEY loan stores. Its store base has
been rapidly increasing.
At a share price of around $12.00, EZPW has a market
capitalization of approximately $500 million and is debt free. The company currently generates returns on
equity of around 20%. EZPW has aggressively
expanded its product offerings and store base and has grown sales at
double-digit rates for over five years.
Margins have consistently improved over this period. We look at the company as having a
predictable, recurring revenue model with strong cash flow generation.
In addition, the company has “hidden assets” including a
minority interest in a UK
publicly-traded pawn operator as well as excess cash. The UK pawn operator, Albemarle &
Bond (AIM: ABM) is carried on EZPW’s balance sheet at cost (rather than market
value). The difference between the
market value and cost of A&B is approximately $45 million (or around $1 per
share). In addition, of the over $30 million
of cash reported on the balance sheet at September 30, we estimate that less
than $10 million is required for working capital and hence, conservatively,
there is around $22 million (or around $0.50 per share) is excess cash. Hence, total “hidden assets” equated to around
$67 million (or over $1.50 per share) at June 30, 2007. (Since that time, the company participated in
a private placement in A&B in the amount of around $13 million which we
will ignore as it does not meaningfully impact this analysis.)
Taking into account these hidden assets, EZPW trades at a
current year P/E multiple of less than 12x (year end is September 30), and an
estimated FY2008 P/E multiple of less than 10x.
The company generated an after-tax free cash flow yield including growth
capex of 7% on an LTM June 30, 2007 basis and in excess of 9% for that same
period excluding growth capex. The
company’s projected earnings growth rate is 15-20% per year over three to five
years.
How do we get comfortable with forward earnings? The company generated $0.70 per share for the
year ended September 30, 2006. While
earnings benefited slightly from a spike in the gold price and a small one-time
benefit due to the shortening the term of pawn loans, on an overall basis, we
believe that this earnings level represents a representative base from which to
build up projections. The company’s
store base is rather immature with 40% of stores under two years old. If history is a guide, stores typically take
four years to mature. For example, data
released by the company shows that the portfolio of loans (i.e., income generating
assets) from a store can increase 25% from year 1 to year 2. On the last earnings call management stated
that stores that were over two years old at the last anniversary had grown
their loan portfolios by more than 20% year-over-year. So
there is strong visibility into the considerable growth within the existing
store base. In addition, the company has
been aggressively expanding its store base, an endeavor that has been more than
fully funded by internally generated cash flow.
EZPW plans to open nearly 50 stores just in the September 2007 quarter
alone. We expect the company to grow
rapidly over the next three to five years.
The company has guided to $0.88 per share for the year
ending September 30, 2007. EZPW has a
history of exceeding guidance and with three quarters of the current fiscal
year behind them management is likely to have confidence in this guidance. Analysts are also projecting $0.88 per share
for the year ending September 30, 2007 and $1.07 for the year ending September
30, 2008. We believe that these
projections are achievable and perhaps even conservative.
Our view is that the current valuation is extremely cheap
and we expect that the stock will trade between $17 and $20, representing upside
of 40 – 70% within nine months.
Notice: Funds
affiliated with the author are long shares of EZPW.
Catalyst
The market realizing the the pawn broking/payday lending space is not impacted by the sub-prime meltdown or issues affecting the broader credit markets.
Next quarters earnings