Value Investors Club / WORLD ACCEPTANCE CORP/DE (WRLD)

Description

Investment Overview:

Taking a contrarian position, we are long the shares of consensus "Sell" rated World Acceptance

(WRLD), one of the largest sub-prime US installment lending companies with 1,243 branches

across 16 states. WRLD has seen its stock fall ~69% in the last 9 months (-50% prior to February)

based on investor’s misunderstanding of recent accelerated growth in WRLD’s business. WRLD

has a 20+ year track record of high teens compounded book value per share growth and 20%+

ROE’s. With ~27% of the float short and ~26 days to cover, we believe now is the time to invest

in WRLD as its share price is temporarily depressed because of investor misinformation around

near-term earnings power and we believe the short thesis will soon be proven wrong.

WRLD’s short thesis has been consistently debunked and has evolved over time. For years there

was concern around regulatory scrutiny, yet WRLD was found blameless under one of the most

aggressive enforcement divisions of the CFPB run by Richard Cordray. The new short thesis is

that WRLD is close to its debt covenants because of CECL and that charge-offs, which are

elevated, will keep rising. These are easily debunked - WRLD generated a significant amount of

income and cash flow in the important March quarter and management stated there is a lot of

headroom on their debt covenants. Management has guided that charge offs should start to

come down as the mix on new customers moderate and the portfolio becomes seasoned. The

only reason charge offs are elevated is because WRLD has been growing its loan book rapidly,

and that new customer charge-offs are initially at higher rates. Our calls with both management

and an analyst on the short side indicate that the shorts are misinformed about WRLD’s

business model and strategic plans.

A critical part of our investment thesis on the stock is that WRLD’s business has not significantly

changed from a structural perspective relate to the past, and that following a period of a couple

of years where the company has dealt with a number of temporary issues, the financial model

will mean revert back to prior historical levels. WRLD is currently investing in significant new

customer growth, which has temporarily depressed ROE’s and earnings. On normalized

earnings, WRLD is currently trading a P/E of ~5.1x, and we expect normalized earnings to more

than double in the next 5 years. We think WRLD has the potential to be a $250-300 stock in 5

years based on management’s 5-year target of $25/share in EPS, which given the current

~$54/share price, gives us a large margin of safety. Additionally, we view WRLD as a low risk

investment, given decades of consistent growth and profitability and an under-levered balance

sheet.

The other significant driver of growth in the next few years will be ongoing buybacks. Prescott

General Partners, a successful Florida-based value fund and longtime board member, owns

~26% and is driving for all of WRLD’s net income to be allocated towards share repurchases. We

expect WRLD to lever back up to its historical 2x debt/equity over the next few years, which will

free up additional capital for buybacks.

We believe GAAP consensus sell-side EPS forecasts over the next few years significantly

understates normalized earnings, which we believe are north of $10/share. Historically, WRLD’s

ROE has ranged between 20-30% and book value per share (BVPS) today is ~$59.47, leading to

normalized earnings of $10+/share. As new customer growth moderates and the portfolio

becomes more seasoned over the next few years, the company will return to its 10-year ROE

average of 20%+ and EPS will grow towards $25/share. With the share price cut by ~69% from

the July 2019 high, significant buybacks in the future, and investor expectations low, we believe

a large short squeeze is a likely and will be a catalyst to a drive a significant share increase.

Steady State Earnings Power:

Below is a model showing our assumptions to arrive at steady state earnings. The average

charge offs over the past twenty years were 14.6%. We are assuming 15% charge offs in our

analysis to be conservative. Stock based compensation should be added back because WRLD

has a unique stock compensation program that is front end loaded on the income statement

and is temporarily depressing earnings. Stock compensation on the income statement will be

de minimis in a few years, and so should be treated as a temporary expense.

Sensitivity of EPS to Charge offs:

The below analysis shows the sensitivity of earnings to charge-offs, and also why earnings are

temporarily depressed. Charge-offs are elevated as WRLD grows their loan book because new

customers charge-offs are initially at higher rates. As new customers become a smaller portion

of the overall book, charge-offs will decline and earnings will increase.

5-Year Steady State Directional Model (FYE March):

The following is a 5-year financial model we created prior to the impact of the COVID-19 crisis

to illustrate the general direction WRLD’s financial model will evolve based on the company’s

growth plans and charge-offs mean reverting back to steady state levels. However, we

recognize that it is likely that results in the next couple of quarters will temporarily weaken due

to the impact from the virus on the economy and lenders like WRLD tightening lending

standards, and as a result FY20 results will fall below our projections. Thus, our estimates are

not intended to suggest precision, but to illustrate directionally how the model should

evolve. As our model significantly differs with sell-side consensus estimates over the next few

years, should the company come anywhere close to delivering on management’s 5-year target

for EPS of $25/share it will likely result in a major shift in investment sentiment, large upward

earnings revisions and significant share appreciation.

WRLD - 5-Year Directional Model

The above model assumes 30 branches per year (per management estimates and recent

trends), as well as 5% SSS growth in loans, also in line with recent trends. We assume WRLD

returns to a 30% EBIT margin, which was its average EBIT margin over a 17-year period from

2000-2017 (we exclude 2018 and 2019 because EBIT margins were depressed due to higher

than normal growth and temporary costs dealing with their Mexico division). We would also

note that our 5-year growth assumptions could prove conservative; WRLD grew revenues in the

teens for 14 years in a row (including 2008/2009). We think it is very possible WRLD can

compound revenue growth higher than our estimates.

Growth Accelerates – But At A Temporary Cost:

With the regulatory issues behind the company, new CEO Chad Prashad has instituted a

number of internal changes focused on growing the business. These include improvements to

marketing programs, enhancing the company’s digital footprint, revised employee incentive

programs, expanding the income tax preparation business, and opportunistic acquisitions. The

result is that over the last 18 months, WRLD’s organic growth has improved with a significant

increase in its base of new customers and an acceleration in the company’s gross loan portfolio.

Additionally, following a period of stagnant growth in new branch openings in the FY14-FY17

period, there has been a renewed focus on opening new branches on a de novo basis as well as

thru acquisitions and asset purchases.

As a result of WRLD’s growth initiatives, over the last 6 quarters, there has been a notable

acceleration in the growth in WRLD’s gross loan portfolio. This is illustrated in the chart below.

Noteworthy, the increase in the recent March quarter came despite a 2+ week impact from

COVID-19.

Over the last 3 years WRLD’s gross loan portfolio has grown by 28%. The following table

illustrates the acceleration in growth over the last 3 years and the change in mix of the loan

portfolio:

The acceleration in growth, especially from new and acquired customers has come at a

temporary cost. The rapid growth in new customers during the last 3 years, from 27.2% in FY17

to 34.5% in FY20, has dramatically shifted the portfolio weighting of customers who are new to

the company. After declining in the FY15-FY17 period, new customer growth has increased

significantly in recent quarters. At the end of the March 2020 fiscal year there was a 63%

increase over the last 3 years in the total loan portfolio from customers who have been with

the company less than two years compared with 15% growth from customers with more than 2

years tenure.

While it is very profitable to acquire customers over the long term, in the short term, new

customers have higher charge-off rates. As a result, over the last few quarters charge-off’s have

increased notably above the long-term average. The investment in growing new customers is

temporarily depressing earnings; in the March quarter charge-offs jumped to a record high of

20.1%. Over the last 4 quarters charge-off’s have averaged 17.8%, which is well above the 10-

year average of 14.6%. Noteworthy, management indicates that charge-offs from seasoned

customers of over two years have remained consistent. The following table presents the

Company's charge-off ratios over the last 20-years since FY 2000.

Due to current FASB accounting, the increase in overall charge-off’s have increased the

provisions expense flowing through the income statement, depressing both GAAP profitability

and ROE. The chart below shows the recent decline in WRLD’s ROE, which is currently well

below its 20-year through-the-cycle average of 21.4%. We believe once charge-offs begin to

mean revert back to historical averages, ROE will also return closer to the company’s traditional

returns as new customers season and WRLD recognizes the high LTV of that customer.

Why The Sell-Side is Wrong:

The shares of WRLD are unloved among sell-side analysts. As per FactSet, three of the four analysts covering

the company have a "Sell" rating on the shares, with a consensus price target of $43/share. Consensus EPS

forecasts for FY21/22 (March fiscal year) are for $5.18/$5.65 per share. The take-away's are that investor

expectations are very low and it appears that consensus forecasts do not assume much impovement in

charge offs looking out 12-24 months.

After speaking with management we decided to discuss our thesis with one of the sell-side analysts.

We found it interesting to compare the notes from our call with the CFO with our notes with a

sell-side analyst to highlight why we believe the sell-side is misinformed and wrong. We think

the contrast between the two highlights why the mispricing exists.

Notes from our call with John Calmes, WRLD’s CFO:

New customers charge off at a much higher rate, but over time that will stabilize, at which point

the provision comes down significantly, but as they become a smaller portion of the loan book

revenue remains stable and margins expand. The market seems to have taken the position that

this is not the case but long-term shareholders understand the story. We can absolutely get

back to 9-10% ROA’s and 20%+ ROE’s. The $25/share target was made with the idea that it was

achievable. BVPS growth should accelerate over the next couple of years – because the cost of

the plan will come down dramatically. Also, revenue should keep growing but provisions should

come down or become flat as the mix changes.

Q: Can EBIT/branch go back to $155,000/branch level?

A: Yes, I think it can exceed that level. It is possible and we are approaching it that way. We are

trying to maximize profit per branch by growing accounts per branch and increasing accounts

per employee.

Operating leverage comes from increasing accounts per employee. We’re at 270-280 accounts

per employee, the goal is to be at 350.

Notes from our call with a sell-side analyst:

We had a productive discussion with a sell-side analyst whom we are leaving unnamed. He

came out of the gate very negative in his views on WRLD, but by the end of the discussion he

admitted he understood why we would be long on the stock. He also was not able to disprove

any part of our thesis.

Rationale for valuation:

• Regional Management (RM) and One Main Financial (OMF) trade at 6.5x and RM at 7x.

So, a low $40’s PT is not out of the question.

As the call progressed, we felt we changed his mind for a few reasons:

• He is comping WLRD to OMF (which is 7x levered vs 1x for WRLD), and RM (which is

more levered and earns half the ROE’s WRLD does).

• He stated that WRLD management does not return his calls given the sell rating he has

on the stock; therefore, he is not able to be fully up to date on their thinking and

planning.

• He is worried about CECL and the debt covenants, but as per the cash generation in the

recent Q4 results and managements comments, this will not be an issue.

• While he has a spike in charge off’s in his forecasts, we believe charge off’s will either

remain flat or come down.

He did not dispute our thesis that the business could easily return to prior profitability levels,

and if that is the case, $25/share is achievable. We agreed on several things:

• The company has now underwritten profitably for decades.

• WRLD is a countercyclical business, which is something great to own if you are worried

about a recession.

• The business has not fundamentally changed, which means it should be able to return to

historical margins.

• WRLD’s regulatory issues should stay contained to a state by state basis, and that WRLD

primarily operates in Republican states, and therefore should not have significant

regulatory issues unless a Democrat wins in office and the Senate, which most observers

believe has a low probability of occurring.

Reversion To Mean Levels Of Profitability & ROE, Combined With Share Buybacks, Will Drive

A Rebound In Earnings:

As illustrated in the following table, WRLD is a company with a 20+ year proven business model

as well as a track record of growth and delivering strong earnings, cash flow and financial

returns. During the 10-year thru-the-cycle period between FY05-FY15 WRLD recorded a

revenue CAGR of 11.2%, EPS growth of 21.2%, FCF growth of 19.1% and a 13.4% growth in book

value/share. A critical part of our investment thesis on the stock is that WRLD’s business has

not significantly changed from a structural perspective relative to the past, and that following a

period of a couple of years where the company has dealt with a number of temporary issues,

the financial model will mean revert back to prior historical levels.

As discussed, the recent increase in charge-offs is mostly tied to the growth in new customers,

which we believe will continue and help drive revenue growth in the 6%-8% range over the next

few years. Revenue growth should be split between 2-3% branch growth and 4-5% SSS growth

per branch. As recent vintages of new customers acquired over the last few years begin to

season and help offset new customer growth, we believe overall charge-offs will peak during

the current fiscal year. Thus, profitability and ROE should begin to mean revert closer to more

normalized levels in the next 18-24 months. The improvement in margins combined with

continued aggressive share repurchases should result in a ~$25+ EPS CAGR in GAAP earnings

over roughly the next 5 years. Again, this estimate is directional in nature and not meant

to be specific in the time period.

Once the mix normalizes, 0-6 month & 0-12 month customers will become a smaller portion of

the portfolio and loss rates and delinquencies will drop dramatically resulting in higher

revenues and less provisioning. When that turn happens, EPS will grow rapidly.

The below analysis highlights the major assumptions to achieve management’s target of

$25/share in EPS in 5 years. As illustrated, they do not make any heroic assumptions, and are

even below historic levels.

Absolute & Relative Valuation Disparity With Significant Upside Share Potential:

Today, WRLD is trading around $54/share, or 5.1x normalized EPS. While there are few real

comparable companies to compare WRLD, we think Credit Acceptance (CACC) - a sub-prime

auto lender is the best comp. Prescott’s Scott Vasaluzzo is on the board of both companies, and

we believe he intends to advise both companies similarly. CACC has averaged ~14.5x earnings

over the past 5 years. Using CACC as a comp leads us to a price target of $150/share today on

normalized EPS. If management hits its 5-year target of $25/share, WRLD should be valued in

the $250-$300 range in 5 years. However, to be more conservative, we looked back historically

as to the multiple that WRLD traded at in the 15-year period prior to when the company began

to experience some of its recent issues beginning in FY16. As illustrated below, during this

period WRLD’s forward P/E multiple averaged 10-12x.

Using the midpoint of this historical multiple suggests the shares should be valued at

~$120/share on normalized EPS. Moreover, looking out to the future, should management

deliver on its 5-year $25/share EPS target (which could be delayed somewhat due to COVID-19),

the shares could trade in the $250-$300/share range compared with the current ~$54/share

stock price. As per our 5-year financial model, this price target is not intended to imply

precision, but to directional illustrate what we believe is the significant upside potential as

well as the margin of safety in the shares due to the current mis-pricing associated with

investor misunderstanding of charge-off’s and the company’s growth potential. The point we

are trying to illustrate is that if management comes anywhere close to delivering on its 5-year

earning target the shares could be up many multiples of the current stock price.

COVID-19; A Temporary Pause Similar To Others, But Structurally Nothing Has Changed:

Commenting on the impact of COVID-19 on its business during the March investor call WRLDS

management noted the following:

• originations were healthy, growing +5-10% until about March13th when they began to

see the COVID-19 impact on their business,

• thereafter management proactively halted marketing and tightened underwriting

criteria,

• the company saw a decline of about 50%-60% in their business in the second half of

March and in April saw the business drop ~80% from new customers and ~50% in

refinancing activity,

• the company has seen very few charge-offs related to COVID, with most related to the

growth in new customers over the prior 12 months,

• to date WRLD has not seen a dramatic shift in the quality of applicants coming in,

• management stated that there is a lot of headroom on their debt covenants.

Thus, there appears to have been a temporary pause in the business due to COVID-19, but

structurally nothing appears to have changed. The company appear ready to reaccelerate its

growth when states begin to re-open and the crisis begins to abate. Thus, the next two quarters

will likely be temporarily depressed from a growth/earnings perspective due to the virus, but

we believe WRLD will be back on its growth path to achieving its long-term EPS goal later in the

year.

Helpful to WRLD’s recovery is the fact that many of the states in which the company has its

largest concentration of branches have or will shortly lift stay-in-place restrictions. The map

below illustrates the states which have lifted stay-in-place restrictions. The four states in which

WRLD has the largest number of branches (Texas, Georgia, Tennessee and South Carolina),

which combined account for about 50% of all branches, are open as of May 12

th. In total about 75% of WRLD’s branches are in states who have already lifted these restrictions as of this date.

WRLD Has A Heavy Concentration Of Branches in States

That Have Lifted Stay-In-Place Restrictions

We believe the impact of COVID-19 on its business will be about consistent with that of other

sub-prime lenders. In general, comments from other sub-prime lenders suggest that the impact

of the virus began in the second half of March and somewhat temporarily froze the market for

a period relative to new originations. In response to the crisis and early sign of an increase in

delinquencies, most sub-prime lenders significantly tightened lending standards. The result of

these two actions has led to a significant drop in new originations. However, indications are

that initially delinquency rates rose modestly but importantly, despite the sharp increase in

unemployment levels, have leveled off. Also, with the passing of the CARES Act and the payroll

protection program, it appears that many sub-prime customers who missed payments have

begun to now make some payments. Noteworthy in this regard are the April 28

the comments from Enova’s CEO David Fisher:

“In terms of the April [credit]performance, I think the most interesting thing is we haven’t seen

deterioration, we haven’t seen a part of improvement necessarily with the stimulus, but we

haven’t seen the deterioration we would have expected with the high levels of unemployment.

It's actually been much steadier, certainly in terms of the default rate than we would have

guessed and the improvement we've seen is in the deferral modification rates coming down

over time.”

As well as the April 28th comments from One Main Financials’ CEO Doug Shulman and CFO

Micah Conrad:

“Our delinquencies for the quarter were running in line with expectations until the second half of

March. Consistent with other consumer lenders, we did experience a moderate increase in 30- to

89-day delinquencies by about 32 basis points year-over-year at the end of March. However,

this trend appears to be somewhat moderating in April. We believe this improved performance

in April is attributable to enhanced Borrower's Assistance as well as the government stimulus

payments. And we've seen a very healthy payment trend over the last couple of weeks.”

“We saw some payments softening in the second half of March, just as our customers became

dislocated from the sort of emergence of the pandemic, and the initial job was claimed. What

we've seen in April to date through the 24, which was last Friday, we've seen an improvement in

our payment rates. And that has contributed in part to the delinquency improvement you see on

the page. So, situation, as I think everyone knows, but we're somewhat encouraged by just what

we're seeing in the early parts of April in terms of those payment rates.”

Another factor that will help sub-prime lenders like WRLD during the current period is that high

level of customers that take credit insurance with their loans. Given the expected short

duration of the current crisis and the growing availability of federal stimulus funds available to

consumers, this should help provide a mitigating benefit to future delinquency and charge-off’s.

It’s also important to note, that a majority of WRLD’s customers would actually see an increase

in their incomes with the new unemployment benefits if they were laid off. This would give

them time to paydown their loans instead of defaulting. We therefore think it is possible that

WLRD actually sees a decline in charge-offs with time.

We suspect that with parts of the economy beginning to gradually open up, originations will

rise commensurately. Also, consistent with historical pattens, we believe delinquencies will

moderate back to prior levels.

The Sub-Prime Segment Is The Most Stable During Economic Shocks:

Importantly despite the view of many investors that the sub-prime sector is the riskiest sector

of the lending market, data suggest the opposite is true. As illustrated in the following charts,

data from the Federal Reserve Bank of Philadelphia shows that sub-prime consumer credit

losses are less volatile in an economic downturn than other sectors.

Source: Enova

Likewise, data from TransUnion shows that during periods of economic stress delinquency rates

for the sub-prime sector are more stable than other sectors of the lending market.

Source: TransUnion

Noteworthy on this point, are additional comments from Enova’s CEO David Fisher on the Q1

FY20 earnings call discussing the reason for the stability of sub-prime customers:

"Yes, but part of that could also be the stimulus, but certainly we're not chalking up the overall

performance of the portfolio being better than we would have expected six weeks ago to

stimulus because of its actually been more stable…..So I think we chalked it up more to some of

the comments I made around the recession worthiness of our customers being very familiar with

living paycheck, to paycheck having to manage variability and cash flow and so being somewhat

familiar with how to operate in an environment like this".

Looking back at WRLD’s overall financial track record and specifically the company’s

performance during the 2008/09 financial crisis (see previous Financial History table) bears this

point out. WRLD’s 15-year track record shows an overall consistent pattern of growth during

the FY05-FY15 period before facing with a number of issues that are now behind the company -

a Consumer Financial Protection Bureau (CFPB”) regulatory investigation, the divestiture of its

troubled Mexican operations, a CEO transition and a slowing in branch expansion. Importantly,

during the 2008/09 financial crisis WRLD was able to grow its revenues through the period and

recorded an increase in its profit margins, especially during the recovery phase. These data

points give us confidence that any impact to WRLD’s business from COVID-19 will be

temporary.

Conclusion:

We believe WRLD is an attractive contrarian investment for long-term oriented investors with

significant upside. As WRLD’s mix of new customers moderate, driving a decline in charge-offs

and earnings mean revert to more normalized historical levels the short thesis on the shares

will dissolve leading to a short squeeze and as management’s 5-year $25/share EPS target

becomes more tangible and the multiple re-rates closer to comp’s, we believe there is the

potential for a 5x or more increase in the share price over the next 5 years.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Continued strong growth in originations
The loan book becoming more seasoned resulting in lower charge-offs
EPS exceeding sell-side consensus expectations
A short squeeze

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			2020	2021
Price:	54.38	EPS	0	0
Shares Out. (in M):	7	P/E	0	0
Market Cap (in $M):	383	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0