Description

First Cash is a very safe recovery trade while also being an opportunity to enter a long-term compounder at a very reasonable price. 

I will keep this writeup rather short as I’ve already gone into deep detail in this industry for my EZPW writeup (https://www.valueinvestorsclub.com/idea/EZCORP_INC__-CL_A/7841410120). Long story short, I believe the market is giving us a compelling opportunity to buy a long-term compounder at a very reasonable price. The business is currently going through the biggest short-term headwind the industry has seen since FCFS and EZPW went public over 20 years ago. Moreover, the pawn lending business seems to be rather highly misunderstood with a bit of an ick-factor to it, further compounding the situation. 

Notable Qualities of Pawn Lending:

• Counter-cyclical, but still does well in good economic environments which I find especially appealing given the world today. For example: First Cash’s average EBITDA margin from 2009-2012 was 22.7%; their margin from 2015-2019 was 16.2%. Similar numbers can be seen during other cycles. The only real macro risk is massive stimulus, which obviously we have seen recently. However, it is also the reason for the opportunity. 

• Pawn lenders are highly cash generative. From 2016-2019 (which would typically represent mediocre operating environments), First Cash averaged a 12.7% FCF margin. This is without excluding growth capex. 

• Returns on capital/incremental capital are attractive. There are plenty of companies with ROEs upwards of 20%, but far fewer companies with ample opportunity to reinvest at those rates. First Cash has historical ROEs of 15-20%. However, these are perpetually understated due to the footprint of immature stores which are near term drags on earnings. Per management, after 5 years of operation, they typically see ROICs for acquisitions of >20% and ROICs for new stores of >30% (these numbers are based on Latin America, which is where 91% of their additions have been in the past 4 years). 

• The industry is highly fragmented meaning there is a huge opportunity for consolidation at the rates stated above. The only 2 public pawn lenders are FCFS and EZPW. They only represent ~10% of the industry while the rest is mostly owned by mom and pops. Acquisitions can typically be done at mid-single digit multiples due to unsophisticated operators. 

• Regulation, while a constant perceived high risk factor, is actually very stable for pawn lenders. In fact, the only changes in recent years have been minor and have actually increased max interest rates in multiple states. 

• If your sole business is pawn lending, there is virtually zero blow-up risk no matter the environment. In recessionary environments, your business booms. In nearly all other economic environments, your business still operates with attractive numbers. Logically, one would think that the only risk to a pawnshop’s business model is massive amounts of free money being given out by the government. However, the interesting thing about pawn lending is that this actually presents zero risk to the business in the short-term (as does any other poor operating environment for them). This is because of PLO (pawn loans outstanding) unwind. As revenues and PLOs fall during poor operating environments, that PLO unwind actually results in massive amounts of FCF. Just as an example of this, during the first full quarter of covid, FCFS generated 7% of its market cap in FCF and EZPW generated 47% of its market cap in FCF. In just a single quarter! Each generated nearly enough cash to pay off their entire respective debt loads. Furthermore, despite revenue being down >20% throughout most of covid, First Cash has still managed to remain meaningfully profitable. Someone could argue the history of EZCorp as proof my idea of blow up risk isn’t true. However, all of EZCorp’s issues have been a result of capital allocation outside of their business pawn business or outright greed and breach of fiduciary duty by its controlling shareholder (he has literally taken money out of shareholder’s pockets and put it into his own). Despite all of that, the business itself has actually done alright for the past 5 years. The reason for poor shareholder returns over that timeframe is largely due to poor market sentiment and an extremely low multiple. These aren’t concerns with First Cash, as management have proven themselves to be good operators.  

Optics of the Pawn Lending Business

Many people tend to look at pawn lending as predatory and pass on the opportunity either due to an ethical dilemma or perceived regulatory risks. I strongly disagree with this view for the following reasons:

Pawn lending is a necessary business. Roughly 65 million people in the US are unbanked or under-banked. Roughly 60 million people in Mexico and 45% of the remaining LatAm population are unbanked. While pawn may seem like a predatory business, the reality is that for lower income households, pawn is an important part of their cash needs. 

Pawn is a significantly better option than all other alternatives. On average, loans made are $100-120 and interest rates vary between 13-25% monthly (yes, the headline rate is high). However, typical terms range between 30-60 day. It’s secured lending so worst case scenario is you lose your collateral. Even the most egregious of pawn terms sees customers 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 for interest compounding (a major issue with credit cards as well, another alternative), forcing customers to pay ridiculous multiples of the initial loan. Pawn lending’s reputation may be tainted simply because it exists in the small consumer lending industry, but it satisfies a large demand and is fair with its customers. Pawn lending’s interests are aligned with its customers (it’s in both parties’ interest for the customer to pay back 30-60 days of interest and get their collateral back), while payday/credit card lending’s interests are in direct conflict with their customers (it’s in the lender’s interest for customers to roll out balances as this allows them to compound on bad loans). Yes, pawn lending’s headline rates are high. However, with just a 1-2 month payback period, the total interest paid still remains low even in the worst situations. 

What it all boils down to is this - the use of collateral sets pawn lending apart from all other small consumer lending. It ensures no predatory terms are placed upon the customer while still providing a win-win for both the lender and the customer. 

Why Does This Opportunity Exist?

It’s not hard to understand why this opportunity exists. Demand for pawn lenders exists due to the unbanked/under-banked nature of a large portion of the US and LatAm. This core group of customers has not had cash needs since the onset of covid due to stimulus and unemployment compensation. These are obviously short-term in nature. With the vaccine rollouts, I assume a majority of the economy will be close to normal prior to the end of 2021 (besides a few changes in the workplace which may be permanent). First Cash has already steadily seen loan originations rising from its April/May lows (down 60% yoy). Their current loan originations are down around 15% yoy. However, there is a bit of a lag between loan originations boosting overall PLO and that eventually translating into earnings. Given the above, I would expect PLO levels to recover to normal levels by the end of 2021. This would make 2022 the first full year of normalized earnings.

Valuation

First cash has traded at a fairly premium multiple in the past. Since 2016, it has consistently traded at ~13-16x EV/EBITDA, a ~15-20x FCF multiple, or a 20x-30x PE. Since covid hit, First Cash’s earnings have contracted, but their multiple has largely remained the same (currently ~15x EV/EBITDA). So the majority of the play here is a rebound in earnings. However, a few meaningful positives have occurred over the past year. Despite the rough year (and thanks to the PLO unwind), they were able to decrease net debt, lower their interest rates, and deploy a large amount of capital into acquisitions and new store openings in 2020. All of these should combine to boost 2022 earnings to levels well above those of 2019. 

2019 Earnings

Net Income Per Share

$167,900 3.89

2022 Earnings

+ Interest Savings

+ M&A

+ Share Repurchases

$188,231 $4.52 

What is the correct multiple on a business like this? Considering the good management, defensive nature of the business, and high returns on incremental capital with a massive runway for growth... I don’t find the 20-30x backward looking multiples egregious. I think this is a very high quality company which deserves a high quality multiple. We are in the midst of the worst operating environment the pawn industry has ever seen, and First Cash has retained a 22x PE multiple. With that in mind, I wouldn’t be surprised if First Cash gets re-rated to 25-30x in 2022. That would result in a $113-135 share price or 65-95% upside over the next 2 years. 

To be fair, I don’t think a PE multiple is the best way to value this business. However, it is the least messy way of making a valuation case. With that being said, it doesn’t take much effort to bridge the above into First Cash trading at ~12x 2022 FCF. 

Risks

• Stimulus and unemployment compensations continues for longer than anticipated

• A meaningful portion of the business’s revenues are denominated in MXN

Catalyst

- 2022 rebound in earnings

- Continued acquisition growth in fragmented industry