Description

Obscenely undervalued at C$5.45, we believe RCS is worth at least C$20, with the potential for more than double that. Everyone hates the stock as a result of prior missteps by a potentially sketchy management team and future uncertainty in a shifting regulatory environment. But the margin of safety at the current irrational valuation (just 1.1x Adj. EV to pro forma mature brokerage segment EBITDA) is tremendous as the future operating metrics currently implied by the market price are absurdly low by any reasonable measure (15% margins vs. 54% for its closest competitor). Even based on the most recent seasonally weak quarter (artificially depressed by immature stores), RCS is trading at a CURRENT 25% FCF yield (based on the current annualized brokerage segment cash flow divided by the current MV adjusted for net cash and a C$25m sale of the rental division). There are certainly risks here, but we believe that new investors are being more than adequately compensated to take them, while selling shareholders apparently cast aside fundamental analysis in an emotional overreaction to last year’s unexpected negative events.



First Some Necessary Background:

RCS owns and operates 332 payday loan (PDL) stores and 93 furniture leasing locations (within 3rd party furniture stores) in Canada.

Brokerage Segment (PDL Stores) Overview:
There are currently approximately 1,200 PDL stores (industry-wide) in Canada, with roughly 30% owned or franchised by publicly traded Dollar Financial (DLLR), virtually the same amount owned by RCS, another 8% owned by Cash Money (private) and the remaining one-third owned by hundreds of fragmented local operators.

RCS has demonstrated explosive growth as it has more than tripled its PDL store base in the last 2 years (from just 97 in March 2004 to the 332 reported as of March 2006). Stores typically reach break-even well within the first year, but require about 36 months to reach their full potential. Given that 80-90% of store-level operating costs are virtually entirely fixed (rent, labor), new stores create a major drag on profitability initially, but then contribute meaningfully as time passes.


Brief Canadian PDL Regulation Overview:
Section 347 of the Canadian Criminal Code contains a usury provision that sets the maximum annualized interest rate that a lender may charge at 60%. Given that this would amount to just C$1.78 for a 2-week C$100 loan, this provision does not contemplate the need for (and existence of) a small sum, short duration loan industry. As such, RCS is currently structured to operate around Section 347 (with tacit governmental approval) by merely acting as a broker for an unaffiliated third party lender. (This is somewhat similar to the bank/agent model that has evolved in many US states.) RCS does all of the work and collects an administrative fee for itself (generally 20% of the loan value) and remits the 60% interest rate to the third party lender, thus avoiding Section 347. (Incidentally, DLLR actually does make the loans itself, but then uses a slightly different loophole to avoid the usury law.)


Rental-Purchase Segment Overview:
RCS provides a furniture & appliance rental-purchase alternative to captive customers of The Brick and United Furniture Warehouse. RCS CEO Gordon Reykdal knows a great deal about this niche industry, having founded and previously run the only publicly traded Canadian player, easyhome Ltd. (EH CN). EH currently has an approximately 57% share of the estimated 300 location industry, with RCS as the only other major player with a 31% share.

RCS’s growth in the rental space has also occurred at a blistering pace, as the Company increased its base of just 26 stores by a factor of 3.6x in the last 2 years (to 93 locations). The rental-purchase business is a bit slower to reach profitability than the brokerage business (about 12-18 months) and also a little slower to reach full maturity. As such, the segment has to date actually contributed a loss to RCS consolidated figures (generating a C$637k net loss in the most recent quarter). It is important to note, however, that despite the net losses this segment is already making a positive contribution on a FCF basis (C$2.5m in the most recent quarter).



Investment Thesis:

Recent Negative Event Has Tainted Investor Sentiment & Overreaction Has Irrationally Depressed Stock Price.

Prior to the Q4 2005 earnings release, investors believed that RCS as a non-recourse broker was immune to any increase in loan default rates as the risk was entirely borne by a third party lender. The Company’s disclosures perpetuated this notion: “Under the terms of written agreements with the lenders, all risk associated with uncollectible loans rests with the lenders…”

However, on Sept. 8, 2005, RCS dropped a bombshell on its investors by disclosing that loan default rates had increased dramatically (explained below), but most importantly, that RCS was going to make its third party lenders whole for the economic pain this would cause them. The Company revealed that while it was not legally obligated to do so, its lenders would not continue to lend to the Company (effectively shutting it down) unless the lenders could continue to generate a return of roughly 25% on their capital. RCS announced that it would begin making an administrative allowance provision for such make-whole payments that would be on the order of 12-24% (currently around 20%) of brokerage revenues, permanently impairing its expected profitability – this figure had historically been closer to 2% of brokerage revenues and was actually as high as 32% in the quarter that the announcement was made. Investors were shocked and felt both blindsided and misled (RCS had just raised C$35m in a C$14.50 per share private placement that closed nearly 4 months after the new no rollover policy was adopted, yet the Company provided no indication that default rates had been affected). Massive selling ensued and the stock fell 36% in just one day and another 28% the following week.

The cause of the increased default rates that required this now significantly higher administrative allowance provision was a new “no rollover policy” that the Canadian PDL Association had recently imposed on its members (basically the 3 large players) in an attempt to self-regulate industry behavior ahead of potential official governmental regulation at some future date. (This is somewhat similar to the rollover guidance issued by the FDIC that rocked the US PDL industry in April 2005.) Rollovers are the practice of allowing a customer to “pay off” their PDL by just signing up for another PDL, creating for some a permanent spiral of exorbitant cumulative fees and escalating balances that can quickly overwhelm the earnings power of the borrower. These loans were historically the most profitable as the default rates were extremely low. The decision to require borrowers to fully repay a loan before taking out a new loan effectively lowered overall loan volumes and increased the industry’s default rates.

Investors, driven by anger, fear and uncertainty drove RCS’s shares down an eventual 85% by March of 2006 (to a low of just C$4.43).


Explosive Organic Earnings Power Has Been Masked by New Store Openings.

In order to understand the true earnings power of the existing store fleet (which is currently being masked by the fixed costs of the still immature stores), the Company uses their oldest 20 stores (which are now an average of about 4.5 years old) as a proxy for the expected performance of the remaining fleet. According to the Company’s 2005 annual report, those stores each generated C$174k in brokerage revenues during Q4 2005, implying annualized per store revenues of nearly C$700k. However, the most recent quarter (which was a seasonally weak one as well as an overall disappointment), revealed that these stores generated C$131.2k in revenues during the period, implying an annualized revenue run rate of C$525k per store. We have chosen to use this more conservative figure to allow for a margin of safety should the overall environment deteriorate. Assuming no additional store growth beyond the current quarter (during which an additional 9 locations will have been opened), RCS’s existing fleet of 341 brokerage locations can be expected to generate C$179m in brokerage revenues upon reaching maturity (the current average store age appears to be approximately 18 months).

Turning to profitability, we have learned from management that the store-level economics of a mature location (fully accounting for the “no rollover” policy) anticipate a 20% administrative allowance provision (with some room for upside given the Company’s 12-24% guidance range) and 40% (largely fixed) operating expense margin, implying a store-level EBITDA contribution margin of 40% (this figure is virtually double the current reported margin given the profitability drag created by the huge number of immature stores). This implies a brokerage segment EBITDA upon maturity of just the current store base of C$71.6m. Management also provided us with a fully-loaded corporate expense figure of C$7.5m-C$8m, of which C$2m-C$2.5m is supporting only the rental-purchase segment. Subtracting the median corporate expense guidance for the brokerage segment (C$5.5m) from the implied mature store-level EBITDA yields a fully loaded, mature brokerage segment EBITDA (on just the existing PDL store fleet) of C$66.1m or C$3.23 per share. At yesterday’s closing share price (C$5.45), RCS is trading at an absurd 1.1x the pro forma EBITDA potential of just its existing PDL stores (adjusting for the current net cash balance and a conservative C$25m value for the rental-purchase segment) before giving any effect to the value of continued fleet expansion or potential new high margin ancillary product revenues.


Strong Industry Growth Potential Allows for Upside to Our Valuation.

The above analysis is based on RCS maintaining its existing fleet size and assumes no further store growth, something that has not occurred in the Company’s history. To illustrate how conservative such an assumption is, consider the following:

The PDL industry in Canada is newer than that in the US, having only been around for about a decade. The US market is still growing rapidly, but even at its current size consists of more than 24,000 locations – or one per 12,000 people. Equal penetration in Canada would imply a market size there of 2,600 locations, more than double the current total (1,200). If RCS were to just maintain its share of the market (which to-date has been rapidly increasing), these figures would imply an eventual RCS fleet of 738 PDL stores.

RCS believes that the Canadian rental-purchase market is also still quite underserved and that it could accommodate an additional 200 stores (a 66% increase). Moreover, the 8,400 rent-to-own stores in the US imply that the Canadian rental-purchase market could actually sustain a total of 900 stores (triple the current number) at similar penetration levels.


New Ancillary Services Will Have High Contribution Margin.

To date, RCS’s brokerage locations have primarily been monoline PDL stores offering only a single product. However, given the extremely fixed cost nature of the Company’s locations, there is tremendous profit potential in increasing the suite of products offered to customers. Even if ancillary products have a lower gross margin than the core PDL product, their marginal contribution to operating profit could be substantial. (DLLR has learned this quite well and check cashing now represents a substantial portion of that company’s revenues, leveraging its existing infrastructure.) RCS has only just begun to expand its product suite to take advantage of these favorable fixed cost economics. Products just recently introduced or soon to be rolled out include a Payment Protection Plan (PDL insurance), Western Union (money transfer), Check Cashing, Mortgages, Injury Advances, Income Tax Preparation, Bill Payments and Prepaid Credit Cards. There is potential for substantial revenue and margin enhancement as a result, none of which is included in the figures we have used herein.



Attractive Acquisition Target for US Players.

Given the blistering pace of new store openings over the past 2 years (with no apparent regard for the negative impact on reported financials), we believe that the Company’s strategy has been to create a full scale national PDL franchise with strong brand recognition and defensible geographic locations as quickly as possible before another competitor enters the lucrative Canadian market – and RCS’s 30% market share in just a few short years has shown that they have been able to do exactly that. In advance of potential governmental legislation that will finally fully legitimize the Canadian PDL industry, making it more attractive RCS’s US peers, we believe that the Company has successfully become an extremely attractive takeover target. As the only other Canadian PDL provider with more than 100 locations and with a market valuation that is at a significant discount to DLLR, we believe that an acquisition of RCS would be the most reasonable way for a US competitor to enter the Canadian market once the regulatory environment becomes more certain. It is also important to note that due to the current broker/lender structure (which would no longer be required in an environment of improved regulatory certainty), RCS’s cost of capital is about 25%, significantly higher than its US peers, creating an opportunity for immediate substantial earnings accretion.


Upcoming Asset Monetization Provides Catalyst.

The rental-purchase division unnecessarily clouds the RCS story as it masks the power of the higher growth, higher profitability, less capital intensive brokerage segment. Management has indicated to us that they understand this fact and are considering separating the businesses (which should allow for multiple expansion). We believe that the Company’s near quadrupling of the rental footprint in just 2 years (to more than 30% market share by location) has been an attempt to gain rapid scale to allow for an impending monetization, a clear catalyst for this story. Management has also lead us to believe that this segment can be sold for at least C$25m.

To determine whether this valuation is reasonable, we look to easyhome (mentioned earlier) as the only publicly traded Canadian player. EH currently trades at an EV to 2006E Sales of 1.41x (C$170.6m current EV and C$120.8m consensus 2006 Sales). Given the obvious immaturity of the RCS rental-purchase locations, the revenues of just the existing store fleet are expected to grow dramatically over the next few years (they increased 84% year-over-year in the most recent quarter, for instance). However, even just using the most recent quarter’s revenues (C$6.9m) implyies an annualized run rate of C$27.7m before accounting for any further anticipated benefits as the fleet matures. Even this conservative figure implies a value of C$39m for the rental-purchase segment or fully 40% of the Company’s entire current EV (C$99.2m).

To use another valuation metric which might better account for eventual maturity, one can look to EH’s current EV per location of C$1m (C$170.6m enterprise value and 170 rental locations). Assuming similar profitability upon maturity would imply a value of C$93m for the rental segment alone or 94% of RCS’s current EV. We believe these valuation methodologies lend substantial support to management’s conservative valuation estimate.



Valuation:

Conservative Fair Value is Substantially Higher than Current Price.

RCS’s peers (AACE, AEA, CSH, DLLR, FCFS, QCCO) currently trade at 7-8x 2006E EBITDA and about 6x 2007P EBITDA. Applying the lowest of these multiples to the expected mature EBITDA of just the existing brokerage locations yields a value of approximately C$400m or roughly C$19.50 per share. We hypothesize above that the rental-purchase segment can be monetized for at least C$25m (based on management’s guidance) or C$1.22 per share. Adding in the C$12.3m of net cash (roughly C$0.60 per share) yields a fair value for RCS’s shares of more than C$21, implying nearly 300% upside from yesterday’s closing share price.


Upside is Tremendous.

Should RCS continue to grow its PDL fleet as it has been successfully doing, the store base could quickly reach 500 locations (or more) as the penetration of the Canadian PDL industry begins to look more like that in the US. Additionally, if the Company were able to increase its revenues by 15% over the assumption used above (to C$600k per store) as a result of its introduction of the ancillary product offerings described above, it is reasonable to assume that the store-level EBITDA margin could expand at least slightly to 42% (for comparison, analysts estimate DLLR’s store-level Canadian brokerage EBITDA margin to be about 54%). At this level of profitability, the brokerage division (after taking corporate expenses into account) could be worth as much as C$844m (or C$41 per share) using DLLR’s current 2006E EBITDA multiple of 7x. If the rental-purchase segment were monetized more towards the middle of our valuation range (given above), say C$40m, then the implied value of RCS’s stock would be roughly C$44 per share, fully 8x yesterday’s closing share price.


Valuation Offers Massive Downside Protection.

To appreciate just how absurdly low the current share price (C$5.45) actually is, let’s look at what metrics the market is currently implying for the core PDL business and judge whether or not these estimates seem reasonable. Subtracting out the net cash on the balance sheet yields a market implied value of C$4.85 for RCS’s operations. To be conservative, let’s assume that the rental-purchase segment is only sold for the C$25m implied by management (a fraction of the value implied by the comparable metrics above). This leaves a market implied valuation of just C$3.63 for the brokerage operations. Let’s assume that the PDL fleet does not grow at all beyond the 341 stores that will be in operation at the end of the current quarter. Furthermore, to be extremely conservative, let’s assume that the annual revenue generating ability of these stores is only C$385k per year (derived by annualizing the comparable store sales figure from the recent seasonally weak quarter – a figure substantially impaired by significant new store openings). These calculations yield pro forma annual revenues for the segment of just C$131m. Assuming that the corporate expenses remain at the midpoint of management’s guidance and that this severely haircut cash flow stream deserves a multiple of at least 5x EBITDA (nearly a 30% discount to DLLR’s current 2006E trading multiple), then the current RCS share price is implying that the market expects RCS’s store-level brokerage EBITDA margin to be just 15.5%. This figure implies more than a 60% discount to the 40% store-level margin guidance issued by management and more than a 70% discount to the 54% store-level margins that analysts estimate DLLR is generating in Canada. Moreover, this assumption would imply a significant margin decrease from the 26% store-level brokerage margins achieved in 2005 with a substantially immature fleet. In short, we think this market price implied assumption is unrealistic and irrational even assuming meaningful negative changes to the Canadian PDL industry.



Risks:

Potential Legal Liability.

Although neither the federal nor various provincial governments of Canada have officially challenged RCS’s brokerage structure as a violation of Section 347, there are currently a number of class action customer complaints (Alberta, British Columbia & Ontario) that have been brought against the Company alleging that it is in breach of this regulation. DLLR is in a similar position and is defending itself vigorously while working (through the Canadian PDL Association) to clarify the regulatory environment to prevent such future claims. While we cannot opine as to how these cases will turn out (and neither does the Company), we have read that a number of individual claims have been settled by the presiding judge demanding that the claimant repay the loan in full (ie, no principal losses for the broker/lender) and that the broker return any fees collected in excess of the Criminal Code.

For investors who might be uncomfortable being naked long a situation with so much potential regulatory risk (despite being well-paid to take that risk), we would recommend shorting DLLR against a long position in RCS. As the only other public Canadian PDL player, DLLR is significantly levered to any changes in the Canadian PDL environment. Despite the Company’s diversification across Canada, the US and the UK, analysts currently ascribe approximately two-thirds of DLLR’s value to the Canadian operations. As indicated above, it also currently trades at a substantial premium to RCS.


Potential Regulatory Changes.

In an effort to prevent future class action lawsuits or potential governmental action based on a strict interpretation of Section 347, all 3 major Canadian PDL providers founded the Canadian PDL Association, an organization actively lobbying for controlled regulation of the industry. The Association has self-imposed its own code of ethics on its members (such as the no rollover policy) in an attempt to legitimize the professional players in the industry and ensure that any adverse regulation will be targeted toward the smaller, less scrupulous industry participants.

The CPDLA came very close to having a bill tabled (put on the agenda for consideration) at the federal level last year, but a change in government has delayed their efforts a bit. The crux of the legislation is that Section 347 should be amended to contain a carve-out that exempts PDL providers from the 60% rule and allows the individual provinces to regulate the practice within their borders. Getting a federal amendment passed and then having individual provincial legislation drafted and passed will certainly take some time, but the CPDLA’s view is that this will remove a significant overhang from the industry that has been created by the current uncertainty over potential future legal and regulatory liability.

The risk, of course, is that any such legislation might include a total fee cap that is effectively lower than what is currently being charged. In anticipation of the issue, the CPDLA commissioned a study by Ernst & Young that outlined in great detail the estimated costs of providing PDLs in Canada. The study reached the conclusion that it costs the industry approximately C$20.66 per C$100 of PDLs to provide their service (and of course less for the larger scale operators – a significant benefit for RCS). The study went on to conclude that the total cost of providing a first-time loan was C$39.45 versus just C$18.20 for a rollover/rewrite loan. Given consumer advocates’ aversion to the potential debt spiral created by rollover loans, the CPDLA hopes that the cost of making a first-time loan will weigh heavily in any rate setting discussion. (For comparison, recall that RCS charges a 20% broker fee on the total loan.) Where these individual provincial debates settle out over time will influence (either positively or negatively) the economics of the Canadian PDL industry, however the process will take some time (perhaps years) and our view is that RCS’s current valuation provides ample upside potential even should a substantially negative regulatory outcome result (which we think unlikely).


Management Credibility.

CEO Gordon Reykdal has a serious credibility gap to overcome with investors created largely by the Sept. 2005 announcement (described above) that seemed to have caught everyone off guard. It makes matters worse that the Company completed a private placement at C$14.50 per share just a few months before this announcement (and after a sufficient period of operating under the new no rollover policy to have realized and disclosed that the economics were no longer as attractive as they had been previously). Investors’ ire was compounded by the fact that Gordon had sold 13% of his personal holdings at prices between C$22 and C$23 just 3 months before the announcement that sent shares plummeting.

Despite the above, we do think it significant that Gordon (and his wife) have recently (since November) spent over C$700k purchasing 78,000 shares of RCS in the open market at a weighted average purchase price of C$9.12 (67% above yesterday’s closing price). Gordon’s stake now totals roughly 3.6m shares or 17.4% of the Company, substantially aligning his interests with those of shareholders.

Catalyst

1. Organic earnings momentum. As existing PDL stores mature and throw off significant free cash flow, time is a major catalyst here.

2. Monetization of the rental-purchase segment. The segment is also very close to reaching profitability, a secondary catalyst.

3. Year-end audit. This should erase concerns about the Company’s method of calculating its administrative allowance provision. This has been a source of fear and confusion for investors and analysts, but the method employed appears to be conservative (full write-off on day 91, with potential upside for RCS from any recovery beyond that date).

4. Increased clarity around regulatory environment. This would lower the Company’s legal liability discount, would erase the uncertainty discount over eventual regulatory action and would enhance RCS’s status as a significant potential acquisition target for a US-based competitor looking to enter the lucrative Canadian market.

5. Conversion to a Canadian Income Trust. The Company is currently contemplating this structure as it believes that the cash flow stream generated by its PDL store base is steady and predictable. Given the tremendous FCF generation available for distributions, any reasonable yield would result in a significant valuation premium to the current share price.