Description

In this market where I can’t tell which way the wind is blowing (recession/no recession), I am attracted to FCFS which outperforms the market in both environments. Case in point, since Jan 1, 2009, FCFS is up about 430% with dividends reinvested vs. S&P 500 up 385% with dividends reinvested. However, during 2008, the S&P was down 38% and FCFS was up 29.8%. Over the last ten years FCFS has traded at a forward multiple of 18X EPS, and today it is trading at 16.1X EPS.

Beyond the fact that FCFS is a compounder that outperforms in bull markets and massively outperforms in down markets trading at a discount to the market and its historical forward multiple, we think the operational setup is quite good. The sell side has earnings growth decelerating from 13% EPS growth year over year last quarter to 5% growth year over year this quarter. We think that is off for several reasons.

First, based on a recent deck that has not been incorporated into sell side numbers (See Q3 2023 Business Update P. (5): https://investors.firstcash.com/static-files/6757c032-189c-4fed-abea-672bd7f272b4) , US Pawn Loan Growth (PLO) which is the principal driver of earnings, accelerated in Q3 from 6% growth to about 9% growth. Mexican PLO grew from flat to 22% growth (4% on constant currency). Also, American First Finance (AFF) (Retail POS Payment solutions 19% of earnings) which had been growing at north of 20% for the last two quarters has decelerated to 13%. The reason why this is positive for earnings is that AFF must book all projected and reserve for all losses in its rent-to-own program up front before recognizing revenue pursuant to CECL. This has caused a drag of about $0.20 to $0.25 per share for the last two quarters, and that should reverse to be a net add with the slowing of rent-to-own growth this quarter. Finally, US pawn (54% of income) added 82 locations to bring the total to 1182 as of September 1, which are expected to add over $20MM of annualized store-level EBITDA. Sell-side did not revise numbers to include the additional stores which will contribute to earnings for one month.

In short, we think FCFS beats earnings on October 26th when they report. FCFS also pays a modest dividend and has repurchased $174 million of stock over the last 12 months, which is about 3.9% of the outstanding shares. Regardless if there's a recession, we see the US economy weakening in 2024, and that should benefit FCFS.

Since July, Douglas Ripple, who sold AFF to FCFS and holds 6.5 million shares, has been selling through a 900K share 10b5 plan. As of Friday, he sold 491K shares and has been consistently selling above $98 a share. Why is he selling? We think Mr. Ripple has had a near-death experience with his 7MM share position in CURO, which was a $20 stock in Q4 of 2021 and now trades at $0.94. As a result, Mr. Ripple is likely seeking to diversify a bit. For now, there is a bit more liquidity available because of Mr. Ripple's sales.

FirstCash is the leading operator of pawn stores in the US and Latin America. It is also a leading provider of retail point of sale payment solutions focused on serving credit-constrained consumers through its 2021 acquisition of American First Finance (AFF). Based in Fort Worth, FirstCash was founded in 1988 with its first location in Haltom City, Texas and went public in 1992 with 23 locations. The company doubled its locations to 50 by the end of 1996, representing 0.6% domestic market share. Today, the company has 10% domestic market share with 1,182 locations, and an additional 1,775 locations in Latin America. Over that time, FirstCash management, some of whom have been with the company since the IPO, has created tremendous value for shareholders. Since the IPO, FirstCash has returned 4,300% to shareholders versus the S&P 500's return of 1,715%.

We believe forward returns will be attractive for four reasons:

1. FirstCash's legacy pawn business is re-accelerating after a prolonged period of headwinds including unprecedented monetary and fiscal stimulus, record low unemployment, and the strongest domestic wage growth in 40+ years.
2. The AFF acquisition is performing better than underwritten, currently under-earning and has many opportunities for future growth.
3. The consolidated company has a long runway to re-deploy capital at high rates of return.
4. The stock is undervalued and trading at a trough multiple in front of an acceleration in profits.

Pawn shops are one of those sleepy industries with excellent market structures. Like casinos, most jurisdictions limit the amount of pawn shop licenses and the locations where they may operate. For example, the city of Las Vegas, one of the best markets for pawn shops in the US, only grants an incremental pawn shop license when the city's population increases by 250,000 residents. Incumbents have a huge advantage over would-be competitors, especially if they are well-funded and can roll-up the industry. This restriction on incremental store growth enables these businesses to earn outsized profits versus what they would in a perfectly competitive market.

FirstCash owns 1,182 domestic pawn locations, of which 42% are located in Texas. The next largest states for the company are Florida (8%), Ohio (6%), North Carolina (5%), and Tennessee (5%). Five of FirstCash's top six states, and eight of its top eleven, had the highest nominal population growth in the US from 2020-2022. In total, the states where FirstCash operates grew their population by 2.55 million people, or 2.6%. To put this in perspective, total population growth in the US was 1.77 million from 2020-2022. So not only does FirstCash experience structural benefits related to pawn stores that allow it to earn outsized profits, it also operates those stores in the best markets in the country. We believe the migration trend towards states in which FirstCash operates will continue.

The pawn business has not been smooth sailing over the past few years. The pandemic ushered in sweeping actions by the government to blunt the impact of stay-at-home policies. By flooding the system with money, the government saved the economy, but not without consequences. Inflation surged, labor became scarce, unemployment dropped to a record low, and wage growth accelerated to a pace not seen in the past 40 years. Direct stimulus payments, the cessation of student loan payments, and the child income tax credit improved consumer balance sheets. By the summer of 2020, pawn loan originations were down 30%-35%. For the next year, this situation largely persisted, with pawn loan assets down 24% year over year in Q1 2021. Pawn loan receivables and originations grew over the 2020 and early 2021 levels from the bullwhip effect created by very low base rates, but total pawn receivables didn't eclipse 2019 levels until the end of Q1 2022.

"Inflationary economic environments have historically driven increased customer demand for both pawn loans and value-priced merchandise offered in pawn stores. In addition, credit tightening from competing unsecured lenders has historically driven additional demand for pawn products." – FCFS management

FirstCash does not hold quarterly conference calls or attend investor conferences, but the company does give its thoughts on a forward outlook in its earnings releases and will meet with investors who are willing to make the trip to their headquarters. We typically meet with FirstCash management a couple of times per year and had a chance to visit with their CEO and CFO this September.

The impact of the pandemic has passed, and the pawn business has entered a normalized environment. Beginning this year, pawn receivables were up 10%, and the company expects to maintain mid-single-digit or better growth in pawn receivables in both markets through 2023. The pawn business has strengthened since the company gave that outlook in early February. Pawn receivables were up 6% in Q1 2023 and as of September are up 9% year over year. A 300bps increase in pawn receivable balance would result in an exit rated of up 10-11%. Receivables growth is the best forward indicator for earning growth in the pawn segment, and we expect a continued acceleration in pawn earnings through the year. There could be further upside to pawn receivable growth, depending on certain external factors. Bank of America is forecasting the >$20B tailwind to consumer income from Social Security, SNAP payments, tax refunds, gas expenses, and student loan payments to turn into a $7B headwind by December. If this plays out, we expect pawn receivables and EPS to grow at an even faster rate.

FirstCash acquired American First Finance (AFF) in Q4 2021. AFF is the fourth largest provider of POS payment solutions to non-prime retail customers in the US. AFF primarily offers Lease-to-Own to subprime consumers at the point-of-sale. The customer applies to AFF on their mobile device via a QR code, so there's no POS integration or physical footprint needed. Furniture, automotive (primarily tires), and jewelry are the three largest segments of AFF's merchant partners. AFF is currently offered at 9,800 doors, up from 6,525 at the time of acquisition. Excluding the 1,182 FirstCash doors, AFF doors have grown 33% since the acquisition five quarters ago.

The AFF transaction might not immediately appear similar to FirstCash's legacy pawn business, but in reality, they share many common aspects. Both pawn and AFF transactions are underwritten in a similar manner. For instance, in a typical pawn transaction, a customer brings an item to the store, and FirstCash provides cash on loan with interest in exchange for the item. The loan is collateralized by the item, which is used as inventory and sold directly to retail customers if the customer doesn't retrieve it.

In comparison, an AFF transaction involves a customer purchasing an item, like tires for $1,000. The merchant pays AFF a fee, usually 25%-30% (around $250-$300 in this example). The loan is financed at 30% interest, with the balance ($700-$750) and interest/fees owed to AFF. Additionally, AFF takes a Current Expected Credit Loss (CECL) reserve at loan origination, which accounts for future expected losses, typically around 35% of the loan amount.

The performance of AFF's loan book has been strong, and FirstCash has maintained conservative reserves similar to pre-COVID economic conditions. The company has tightened approval rates and credit standards without facing resistance from merchants. AFF loans have outperformed internal projections, with initial vintages experiencing loss rates around 32%, 300 basis points better than the initial CECL reserve projections of 35%. Consequently, FirstCash has been able to release some of the initial CECL reserves in recent months, but it continues to put 35% reserves on new vintages to remain conservative and account for economic changes.

Over the last several months, AFF has implemented a new internally developed dashboard aimed at merchant acquisition. The dashboard equips sales representatives with the necessary tools to communicate approval rates, application quality, and profitability lift projections to prospective merchants. This consultative approach, combined with AFF now operating under a more consistent partner with greater access to capital, has contributed significantly to accelerated door growth. Organic door growth (excluding FirstCash doors) has reached 24% and 27% in the two most recent quarters, respectively.

The challenge with profitability lies in the nature of CECL reserves. As a company rapidly grows its loan book, GAAP credit provisions dampen the profitability of the entire book, as CECL reserves are taken entirely when the loan is originated. In Q1 2023, this effect resulted in an earnings drag of approximately $15 million, equal to $0.25 per share. On a normalized basis, the company would have earned $1.50 in adjusted EPS, which is 20% higher than the reported $1.25. This impact is expected to continue in Q2 2023 due to the company's continued lap of slower H1 2022 origination volume, primarily caused by lower furniture demand. However, in H2 2023, profitability is expected to improve as AFF laps stronger origination volume growth, leading to significant earnings growth.

FirstCash management believes it can consistently achieve 15% growth in AFF door count for the foreseeable future. This growth will come from both new and existing accounts, with AFF gaining traction in the medical service space. The company sees a long runway for door growth, considering similar opportunities in adjacent fields and recognizing the favorable economics of new doors compared to legacy doors.

FirstCash generates significant excess cash flow and has a long runway to redeploy that capital into high return projects. In the past eight years, FirstCash has generated a total of $1.8B of cash from operations and $1.6B of free cash flow. Cash from operations grew $377mm during those eight years, from $92.7mm to $469.3mm. During that period, FirstCash has deployed $1.86B of capital in the form of capital expenditures, pawn store acquisitions, and the acquisition of AFF. With only 10% market share in US pawn and growing its Latin American store base by 60 units per year, there is a long runway for FirstCash to continue to deploy capital and achieve its historical return on invested capital of approximately 20%.

The company's highest priority for cash is growth in the pawn business. It deploys capital into domestic M&A of pawn stores, greenfield locations in Latin America, and real estate in the US. The company has purchased the real estate under 1/3rd of its US stores. The book value of these assets is $300mm, while the market value is more than $500mm. When acquiring stores in the US FCFS usually pays 7-8X EBITDA which works well since FCFS trades at 12X EBITDA.  First cash also pays a dividend and repurchases stock with excess cash flow. The current dividend is $1.32 annually (1.4% yield), and management expects it will continue to grow with free cash flow growth. The company has been a consistent repurchaser of its stock since 2004. To date the company has repurchased 22.7mm shares at an average price of $52 per share.

FirstCash management is best in class and aligned with shareholders. CEO Rick Wessel has been with the company since the IPO, initially serving as CFO and taking over the CEO role in 2006. CFO Doug Orr joined FirstCash in 2002 as the VP of Finance and became CFO in 2005. Both men have relatively significant equity interests in FirstCash, with Mr. Wessel owning nearly 2% of the company. Compensation metrics are aligned with shareholders, with Adjusted EPS, Adjusted Net Income, and relative TSR featured prominently as target metrics.

FirstCash stock is cheap, and estimates are too low. We believe FirstCash will deliver >$6 per share in earnings this year versus consensus at $5.62. FirstCash has historically traded between 15x-25x EPS and currently trades at 14x our forward EPS estimate. We expect FirstCash will generate more than $300mm in free cash flow this year, and more than $350mm next year, implying a forward free cash flow yield of ~8%. It is rare for FCFS to trade at such a modest valuation, especially in front of an acceleration in profits. We expect H2 2023 results to accelerate meaningfully and surprise the market and expect the stock to react favorably.

Catalyst

Third Quarter Earnings beat

Lower CECL Reserves acreating to earnings

Rising Estimates for 2024

Tighter financial conditions for lower income consumers leads to more reliance on pawn for financing neads