Description

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Overview

WRLD is the largest publicly traded subprime small dollar installment lender in the US, with a 59-year history. It operates over a thousand stores in primarily small rural towns in the US and provides emergency funds for low-income borrowers who otherwise have very limited options. Its loans carry high interest rates but are unsecured and fully amortizing with terms generally between 3 to 16 months. The company has an outstanding long-term track record – it sustained double digit annual growth and double digit return on assets for multiple decades. It has been able to achieve this by developing a deep understanding of the local market and by establishing decades of relationships within those communities. This results in the company’s ability to derive a large portion of its originations from referrals and repeat customers, which help improve the average cost of acquisition. More importantly, the person-to-person relationships at the branch level allow the company to underwrite and collect more effectively. When borrowers personally know the employees at the branches, they are more likely to perform on their loans. WRLD’s multi-decades long track record of elevated returns is a testament to their outlier strength in this domain.

Since 2015, with the rise of fintech competitors and heightened regulatory scrutiny, WRLD went through a period of stagnation and high management turnover. After several years of turmoil, the company promoted Chad Prashad to CEO in 2018. Since then, WRLD has embarked on several new expansion strategies and successfully reignited the growth of the business. Though the lifetime value of new customers is high, rapid growth negatively impacts short-term profitability as losses are higher in this cohort. As a result, net charge-off rates have spiked recently. This caused the stock to sell off in H2 2019 with bears positing that the credit performance represented a permanent reset rather than a shift in mix. More recently, COVID has slowed the customer growth trajectory due to a reduction in store traffic and abundant government funding. While this hurt the business in the short term, credit performance reverted to historical levels, demonstrating that underwriting and loan profitability likely have not fundamentally changed. The stock has rebounded somewhat since the trough; however, we believe this remains a compelling long with ~50% upside from today’s prices.

Overall, the existing portfolio and customer base should remain highly profitable for the foreseeable future. The shares currently trade at 11x LTM adjusted earnings, which leaves a wide margin of safety should the company’s ambitious expansion strategies falter. At an industry-level, the addressable market is growing (absent major changes in the regulatory regime), and there remains low-hanging fruits that should be attainable by a competent management team. We believe it is reasonable for the company to grow loans organically at 5% p.a. (roughly the rate of growth over the last couple of years excluding acquisitions).

As alluded to above, the major risk associated with the investment is its exposure to regulatory and compliance issues. The risk here is two-fold – company-specific deficiencies versus industry-wide reforms. On the former, WRLD’s track record appears to be checkered at first glance. Closer examination reveals that most of these issues have been remedied and the company has undergone a multi-year CFPB investigation during Richard Cordray’s tenure that ultimately found no wrongdoing. With regards to industry-wide reforms, the small dollar lending sector is always at risk of state and federal level changes. At the state level, usury rates have been tightening slowly over time since the deregulations in 1970s-1980s. Changes in the future will depend on the longer-term evolution of sociopolitical views across the country. Tactically speaking, the bulk of the company’s business comes from deep red states that have largely been stable from a usury perspective and are expected to remain so in the foreseeable future. Federal level legislative changes are possible (and there are regular bills in Congress related to interest rate caps), but improbable even with the Democratic sweep. Studies by international agencies and bipartisan research groups have found that interest rate caps alone do not materially improve borrower outcome as they typically push consumers to less safe/transparent forms of credit. In our opinion, the best solution should policymakers choose to eliminate high-cost lending would be to provide this population with government-sponsored aid. We believe this strategy is unlikely to gain traction beyond the progressive left, given its political and financial implications.

Background information

• 1.2K stores in the US, growing footprint at 6% p.a. since FY2000 (and 2% p.a. since FY2017)

• Average APR of ~60%

• Net loans receivable growth of 10% p.a. over the last 20 years

• Average gross loan balance (including principal and interest) of $1.3K, growing at an average 5% p.a. over the last 20 years  (and 2% p.a. since 2017)

• Average ROA of 11% over the last 20 years

• Consistently returned excess capital to shareholders through buybacks - bought back over $1.1B of its own stock from FY2000 to FY2020, reducing its share count from 19M to 8M over the same period

• Serves an estimated mid-single digit percent of borrowers who take out a small dollar credit product each year

Addressing key issues

1)     Loan performance

Loan performance has meaningfully worsened since 2018 up until mid-2020, with significant deterioration in H2 2019 – this has caused the stock to fall precipitously leading up to 2020. Bears believe that the deterioration is a result of undisciplined underwriting in pursue of growth. We believe that it is the temporary output of the accelerated growth, and that over time as growth rates revert to historical levels so too will credit performance. New customers have over 2x higher charge-off rates than existing customers. This is because the company has the least amount of information on the consumer at the time of onboarding, and over time, continues lending to only the subset that demonstrates a pattern of adequate repayment, improving the portfolio’s credit performance. As the company shifted into an expansionary phase, the ratio of new borrowers to existing borrowers shifted in concert, temporarily depressing the credit performance at the portfolio level. The question that remains outstanding is whether the current group of new borrowers will yield a similar ratio of profitable long-term customers, in line with historical averages. COVID has introduced noise to the data (i.e. credit performance has been particularly strong during this period due to a variety of reasons, including the government stimulus checks), however early indications suggest that new loans acquired during the expansionary period have performed in line with historical levels.

Note: the spike in March 2016 is due to the stopping of all in-person visits as of Dec 18, 2015

Performance through crises

During the GFC, the company experienced some elevation in NCOs due to customers’ reduced ability to repay. The magnitude on a percentage basis however was materially milder than lenders higher up the credit spectrum. Extrapolating from this, if this crisis ends up mirroring a more traditional recession, we should expect performance to worsen across the portfolio, followed by a reasonably speedy recovery.

2)     Growth

Over the last 20 years, loans grew at a 10% p.a., with roughly half of the impact from loan count and the other half from loan size. The company went through a period of stagnation in FY2014 and FY2017 before resuming growth at roughly historical levels from FY2018 onwards, up until COVID in FY2021. The stagnation came primarily from a rapid increase in competition from fintech players (more below), combined with the lack of innovation from WRLD. Since then, the company has promoted a new CEO who is focused on modernizing operations. The company returned to growth through both acquisitions of small competitors and improvements in marketing, with the impact roughly split evenly between organic/inorganic. In 2020, the company went through a significant contraction at the onset of COVID followed by gradual recovery in subsequent quarters. We expect growth figures to return to pre-COVID levels as the pandemic fades.

Beyond its recent progress, the company should have additional levers to improve sales and marketing, due to the low starting point of its existing operations. A simple example is the fact that the company has only started online originations in May 2020, even for borrowers with prior accounts. Brick and mortar lenders as a group have been slow to adopt new technology, but COVID has accelerated multi-channel initiatives.

Disruption from new entrants

WRLD competes against all lenders that provide borrowers with small dollar loans including installment lenders, payday/pawn/auto title lenders, banks, credit unions, as well as the various fintechs. The subprime space has historically been difficult for new entrants to disrupt at scale because knowledge of the local community, experienced underwriting and brand are essential to success, and any misstep could result in significant losses. In recent years, fintech players have been gaining meaningful share in the small dollar unsecured installment lending space, and we expect that they will continue to do so going forward. Their share of the nonprime ( CFPB’s findings of payday installment loan performance (similar in structure to regular installment loans, except lenders typically have direct access to bank accounts) across storefront versus online lenders:

Note: The CFPB analyzed the default rates of 2 million payday installment loans made by 7 different lenders that charged interest from 197% to 369% with a median of 249%.

Fintech players have combated this issue by charging higher rates, however most in the deep subprime market continue to struggle with profitability. While we expect fintech players to continue to grow at above-market rates, longer term, we expect the two camps to converge with players ultimately carrying multi-channel capabilities. The brick-and-mortar players with scale are well-positioned to exist in that world as they continue to make progress towards digitalization.

3)     Regulatory risks

There are various regulatory risks associated with the business given the nature of its at-risk customers. Current areas of heightened risk are the following:

• Elevated APR and rate caps

• CFPB and the Payday Lending Rule

Elevated APR and interest rate caps

States vary widely in their usury limits with some as low as less than 30% while others carry no boundaries. Over time, states have been generally tightening usury rates, however the speed of change has been gradual. WRLD relies on a few key states for its operations, which are generally politically conservative, have high/no interest rate caps, and are relatively stable from a regulatory perspective. WRLD’s smaller states that are more at risk of regulatory changes are potentially replaceable with new states should they undergo tightening. There are still states with sufficiently high usury limits that are untapped (some of the expansion over the last 10 years can be attributed to expansion into these states, often through acquisitions of existing stores).

The merits of a federal level interest rate cap is an ongoing topic and is popular amongst voters, however its support from policymakers thus far has been highly partisan. There remains meaningful dissent within even the democratic party as moderates are wary of the impact of an interest rate cap on credit access while progressives do not believe a 36% rate cap is sufficiently low. We believe finding a middle ground is highly unlikely in the near to medium term.

Importantly, others (e.g. RM and OMF) industry players have demonstrated a profitable path with a lower APR book, albeit at a lower rate of return on capital. As of FY2020, 30% of WRLD’s receivables had APRs that are equal or less than 36%. The company should be able to sustain a large portion of its existing book above 36% under a lower rate (since it already has significant experience with these borrowers). While a federal interest rate cap will meaningfully impact WRLD’s profitability, it is not as binary as many believe.

CFPB and the Payday Lending Rule

The small dollar loan industry took a break from intense regulatory scrutiny under the Trump administration following a period of heightened oversight after the enactment of the Dodd-Frank Act in 2010. The new CFPB under the incoming director Rohit Chopra will likely bring back Cordray-style enforcement actions and may reinstate some version of the original payday rule.

This has several implications for the WRLD. In terms of oversight of its operations, the company has gone through an extensive CFPB investigation that spanned approximately four years (from March 2014 to January 2018). The company ultimately walked away without any action from the CFPB after Mulvaney took office, but internal conversations that were subsequently released to the public suggest the final decision was made during Cordray’s tenure. Based on the clean bill of health, we believe it is clear that WRLD’s products are legal and compliant under existing regulations. Returning to prior levels of scrutiny should not pose material risk to the company.

The other implication from a Chopra-led CFPB is new legislation, which includes the potential reinstatement of the original payday rule that was “defanged” by Trump’s more conservative CFPB. This rule in its 2017 form would not have material impact on WRLD’s existing business, as its products are unsecured (i.e. the company does not have access to bank accounts, vehicle titles or other collateral) and fully amortizing. Depending on the scope, we believe the return of the original rule may improve the competitive positioning of the company, as fewer competitors with substitute products may be allowed to operate. There is however also the risk that the new rule could expand to impact WRLD, but for a variety of reasons (including the cost/benefit of the products, the resources and time deployed to construct the initial payday rule, and the urgency of other high priority issues at the agency) we believe the probability of such legislation is low in the current environment. Importantly, rulemaking takes time even under progressive/democratic leadership as the Payday Law’s history shows.

Valuation

WRLD currently trades at 11x LTM adjusted earnings. Conservative assumptions below suggest that the equity is worth roughly ~$200/share, which represents ~50% upside from current share price.

We assume that the company will experience another year of decline in FY2022, followed by recovery to FY2020 levels the year after. We expect that loan growth long term will normalize around 5% p.a., followed by some recovery in revenue yield (in line with the increase in new customers).

The company has historically spent virtually all its earnings in share repurchases outside of acquisitions. We expect this capital allocation decision to continue (with Prescott as the largest shareholders), which are highly accretive at current levels. 

If shares remain at today’s prices, the company should be able to reach its 2025 EPS target of $25.3 (established in Q3 2020 before COVID; LTM adj EPS of $11.8) with a modest 3% growth p.a. in loan book (assuming performance remains constant).

Summary

Despite the recent turmoil, WRLD runs a highly profitable and stable core portfolio with customers that have a long history with the company. The company’s loan growth strategy is not without risk, however it seems likely to bear some fruit. Assuming the company returns to a moderate rate of growth at historical return levels, the intrinsic value of the business should be ~50% higher than its current share price.

The biggest risk with the business is the potential for broad sweeping regulatory changes. We believe this is unlikely to materially impair the business in the near-mid term. Given the undemanding valuation and rapid cannibalization of share count, regulatory risk is unlikely to impair capital at the current stock price.

Catalyst

Share repurchases

Return to growth