Description

Introduction

This is the 8th time that EZPW is appearing on VIC, so there is plenty of background. This write up is intentionally brief because EZPW is a rare case of a growing, cash flowing business that is presently trading at or below breakup value despite being primed to benefit from any future economic weakness. Also note that the company reports after the close today.

The short version is that EZPW is the 2nd largest listed pawn company, with ~500 stores in the U.S., and ~450 stores in Latin America, with the bulk of those in Mexico.

I am going to quitclaim any defense of the corporate governance here: it is pretty much terrible as there is an A/B structure that sees minority owner Phillip Cohen controlling 100% of the vote through his ~6% ownership stake, and Cohen historically plundered the company through “consulting fees”, although DE courts have since eliminated the possibility of future plundering.

The company understands that they need to make improvements to corporate governance, and has indicated that there will be improvements announced within the next few weeks when the company releases its next “3 year plan.” In a perfect world pending improvements would include collapsing the A/B structure. However, the world is not perfect and I am not expecting that. That being said,  I think it is a very very low bar for us to a see a change whereby management’s incentive compensation is tied to some kind of per share metric, as opposed to today, where it is just tied to EBITDA and net debt, with no per share component. Reinforcing the likely change are comments from CEO Stuart Grimshaw on the August ’18 conference call, as well as comments made by CFO Danny Chisholm in person. This simple change should pull some bystanders off the fence and into the stock, because the valuation here is so undemanding.

The Business

The US business is largely mature, and has been going through a bit of a rough patch following hurricanes last year in Texas and Florida.  Despite this rough patch, management believes they have been taking share from closest competitor FCFS for ~2 years, and they have led the industry in per store pawn loans outstanding (PLO) over this period. The hurricane impact should be lapped presently, and further structural upside exists in the form of an in-process plan for re-worked store formats that will allow more merchandise to be on display, and an IT upgrade that will allow for higher LTVs through tracking individual customer historical behavior, and merchandise sales information across geographies.

The Latin American business represents the possibility for significant growth through acquisition and operational improvement. Latin American stores have historically been focused largely on gold, and expanding to include general merchandise represents an opportunity to expand pawn loans outstanding significantly as the Latin American lower class evolves into more of a middle class. We are seeing this dynamic – as well as other operational improvements – playout presently, as last quarter was their 17th Q in a row that saw SSS PLO growth.  In my view, there is a legitimate case to be made here that Latin America (and beyond) represent the possibility of a multi-decade compounding story. However, that is a different story for a different price point. At today’s price point the thesis is much more simple.

This Year’s Sell Off

Shares traded up to almost $16 earlier this year, but a poorly executed $15.90 convertible bond offering started a downslide that persists until today, which at this point is likely exacerbated by tax loss selling as momentum players that bought in earlier in the year have had their heads handed to them.  The perception is that Cohen and management do not care about per share value, and were thus fine with (potentially) diluting equity through the convert. There may be some validity to this claim, although I would point out that over almost 30 years shares out have only grown ~2% per year when adjusted for splits and equity financed acquisitions. In any case, if rather than the convert management had made a large acquisition and paid for it with stock at $15.90 (implies ~9x EV/EBITDA, vs acquisitions typically 4-5x), the markets would be crowing about how accretive it was. Instead, largely due to the fact that their A/B structure and reluctance to collateralize straight debt means they would have to pay egregious coupons, management opted for a convert.

Since that time, no large acquisition has materialized, although there have been some smaller ones.  Management has indicated that prior to the convert they were close to a large acquisition, but subsequent to raising the funds, their diligence turned up some red flags, so they walked away.  In May 2018 the company’s private plane was involved in a crash in Honduras, and photos of the crash site revealed the plane’s tail number. This information allows one to track where the plane had been in the previous weeks and months, and overlaying this information with a map of existing Latin American stores makes it appear very likely that future acquisitions are in the works. However, for the time being we are left with a bunch of cash just sitting on the balance sheet, as well as convertible debt that is optically disastrous.

AMLO

While in our view most of the damage to EZPW’s stock is tied to the poorly received convert and tax loss selling, in recent days there has also been concern regarding the political situation in Mexico as AMLO’s party has called for banking reform that will reduce banks’ abilities to collect fees.  Importantly, pawn does not fall under banking regulations in Mexico, nor is pawn viewed as predatory in Mexico:pawn is just a fact of life in a country where bank based credit is almost non existent across most of the geography. In fact, the government runs a pawn network known as Nacional Monte de Piedad, that has been in place since the late 1700s.  If for whatever reason the government did decide to shoot themselves in their own foot and crack down on pawn, there would certainly be headline risk, but compliance is a leveragable expense, leaving the major players well positioned to take share from underscaled mom and pops. This dynamic has played out in the past in the US, where the major players took share during periods of increased regulation.  In summary, I believe any AMLO risk is misguided.

Currency Risk

Latin America represents ~30% of pawn profit, and that level is likely to grow.  Currency risk is what it is, but I would argue that the stock should not remain below breakup value for long, so currency shouldn't matter that much, and/or the business has the potential to compound for a long time if the controlling shareholder can get out of his own way, so currency shouldn't matter over the long term either.

Valuation

There are clearly things not to like here.  However, this is a cash flowing business with a 3,000 year operating history (zero obsolescence risk) that is in the worst possible economic environment (UE @~4% is bad for pawn) that I believe is now trading well below its breakup value (if one gives credit for an investment in Australian public company Cash Converters and the tail end of a receivable attached to a business they sold in September of 2016)  if individual stores were simply sold piecemeal, and below the multiple that management has indicated they can make acquisitions at. This is versus close comp FCFS which presently trades at ~100% premium to estimated breakup value.

There are any number of ways to play around with this and it is definitely imprecise, but examining past acquisitions across EZPW, FCFS and CSH (now part of FCFS) as well as comments from both EZPW and FCFS re: the cost of Latin American de novos indicates that assigning a value between $950k - $1.1M for U.S. stores and $300k - $350k for Latin American stores is conservative. In the past IR has explicitly stated that they think $1.1M is low for U.S. stores, and argued that $350k is low for Latin American stores b/c they have been performing better than expected as they move away from gold only and toward general merchandise.

Moving away from breakup value, EZPW trades at ~5.4x sell side 2019 EBITDA (inclusive of cash converters and the receivable). Historically management has indicated that they can make acquisitions at 4-5x EBITDA, and 6x in an extreme case for very good assets, which should place the stock in range where they should be considering a tender offer for shares.

Sell side has put a 25x P/E target on close comp FCFS, while EZPW is below 10x my forward estimate. To be clear, FCFS deserves a higher multiple due to their better corporate governance, increased scale, lower cost of capital, and history of being friendly to shareholders through dividends and buybacks. That being said, they do not in my view deserve a  10-15 turn P/E premium or a 6-7x EBITDA turn premium.

Lastly, the likelihood of a meaningful acquisition in the not too distant future should lead to a substantial up-tick in EBITDA, as well as multiple expansion as the growth story gets back on track and memories of the poorly executed convert fade.  For illustrative purposes, if they can buy $20M of EBITDA at 5x, at an 8x Multiple (~5 turn discount to FCFS) the stock would trade at ~$15, or ~60% upside.

It should be noted that the above scenario does not include any uptick from an economic weakening in the U.S., which should drive PLO, and thus earnings (although truly dire recessionary environments will lead to a softening of the retail side of the business).

Catalyst

improvements to corporate governance

acquisitions

economic weakness