Paired Trade: Buy EZCORP, Sell Aaron's Rents

This is the 5th in a series of articles that attempt to identify relative value discrepancies between two closely related securities. So far, the first four have been modestly successful in aggregate, though it's a little early to be drawing conclusions:

• 3/14: Buy Met-Pro (MPR), Sell Nalco Holding (NLC)
• 4/18: Buy Johnson & Johnson (JNJ), Sell Allergan (AGN)
• 5/3: Buy Columbia Sportswear (COLM), Sell UnderArmour (UA)
• 5/10: Buy C.R. Bard (BCR), Sell Intuitive Surgical (ISRG)

In this trade, I am looking at two companies that deal with credit-impaired or low-income consumers generally. In the case of Aaron's (AAN), which just changed its ticker from RNT, the company "leases" appliances, televisions, computers, etc. to anyone without doing a credit check. Not surprisingly, its sales have been strong lately. My thesis is that it's easy to sell to someone with bad credit, but harder to collect when the economy is struggling. It's not a bad business in a strong economy, but it's very risky in a weak one.

EZCORP (EZPW), on the other hand, is a pawn shop and payday lender, though it is moving into other areas such as auto titles. When it sells used merchandise, it is a final sale, unlike AAN, which may have to repossess if the "buyer" doesn't keep up his payments. While the payday lending is at risk, the low valuation of EZPW tells me that investors are paying very little for that business. According to management (twice publicly to me on their conference call), the exit costs are minimal should the business become uneconomic. Here's the tape (click to enlarge):

EZPW is much cheaper on a PE basis, and it has a very strong balance sheet. AAN has a high EBITDA margin, but its D&A is huge. AAN has also been boosting its sales by buying in franchises. I don't know management at AAN as well, but I can say that EZPW management is very strong. I believe that EZPW will trade towards 18 this year as the strength of its pawn business supports earnings growth, while AAN is likely to pull back towards 24. (click on chart to enlarge)

Disclosure: Long EZPW

Comments

[Roger Knights:]

Buy silver, sell gold?

Jun 06 08:03 PM

[Ricard:]

Alan,

Yet another interesting comparison. I'm currently looking for a screaming sell, so I wanted to check out AAN for myself.

I look more at operating cash flow, and it's been consistent for a good couple years now. Although the other numbers are interesting, I'm not sure this is a 'sure thing'.

The story is compelling. I really like how you compared not only the financials, but the business models as well to tell a fascinating tale.

Perhaps in the future, if this stock continues to rise and its business conditions do not merit such, then it may just fit into my portfolio...but not yet.

Jun 07 02:58 PM

[Alan Brochs...:]

Don't be fooled by the operating cashflow - it's fake in my opinion. The company reinvests in new merchandise on an on-going basis. It's like Hertz. Yes, there is large depreciation, but the "profits" are all plowed into new cars there. It's not "CapEx" at AAN (or HTZ). In simple terms, at least the way I look at it, the business grows and profits grow but the risk grows too as the portfolio grows.

I see a lot of "screaming sells". Some of my favorites are PSS and HOT

Jun 07 10:28 PM

[Ricard:]

Thanks for the reply. I'll look at it more closely, along with your other recommendations. Good luck!


On Jun 07 10:28 PM Alan Brochstein wrote:

> Don't be fooled by the operating cashflow - it's fake in my opinion.
> The company reinvests in new merchandise on an on-going basis. It's
> like Hertz. Yes, there is large depreciation, but the "profits"
> are all plowed into new cars there. It's not "CapEx" at AAN (or
> HTZ). In simple terms, at least the way I look at it, the business
> grows and profits grow but the risk grows too as the portfolio grows.
>
>
> I see a lot of "screaming sells". Some of my favorites are PSS and
> HOT

Jun 08 08:53 PM

[User 430417:]

Well EZPW is certainly tanking now. Reduced earmings estimates. AAN is really odd - since I've been watching it, it tends to do the opposite of the DJIA - this morning, after failing to participate in any market gains this week (indeed doing the opposite), it was up until the market turned north - now AAN is into negative territory. But I got out of EZPW with a $100 loss and am glad I did.

Jun 12 11:28 AM

[Bud H:]

In weaker economies companies like Aaron's draw customers "down" from retail credit buying - they still have income, still have needs, but fear debt and obligation (not to mention liking free repairs). In strengthening economies customers who have overloaded or maxed out their credit come to Aaron's while newly employed consumers who've never had credit go to Aaron's with new paychecks. How can it go wrong? Collections? History of the industry proves that 94% of all customers pay their bills without much prodding and with no "gorilla" tactics on part of company. Real cost center is the delivery, pickup, refurbishment, repair, replacement and distribution of goods with higher salaries paid to those who do it because the job is three times more complex than traditional retail.

Jun 12 10:07 PM

[Alan Brochs...:]

Surprising and very disappointing... I still think AAN is an accident waiting to happen - and much worse than the slack demand at EZPW.


On Jun 12 11:28 AM User 430417 wrote:

> Well EZPW is certainly tanking now. Reduced earmings estimates. AAN
> is really odd - since I've been watching it, it tends to do the opposite
> of the DJIA - this morning, after failing to participate in any market
> gains this week (indeed doing the opposite), it was up until the
> market turned north - now AAN is into negative territory. But I got
> out of EZPW with a $100 loss and am glad I did.

Jun 14 10:00 PM

[Alan Brochs...:]

Thanks for your comments. Yes, history would indicate, but these aren't exactly "normal" times. My thesis is that AAN's is getting some customers that might never have gone in there before, but they can't use credit cards like they have in the past.


On Jun 12 10:07 PM Bud H wrote:

> In weaker economies companies like Aaron's draw customers "down"
> from retail credit buying - they still have income, still have needs,
> but fear debt and obligation (not to mention liking free repairs).
> In strengthening economies customers who have overloaded or maxed
> out their credit come to Aaron's while newly employed consumers who've
> never had credit go to Aaron's with new paychecks. How can it go
> wrong? Collections? History of the industry proves that 94% of all
> customers pay their bills without much prodding and with no "gorilla"
> tactics on part of company. Real cost center is the delivery, pickup,
> refurbishment, repair, replacement and distribution of goods with
> higher salaries paid to those who do it because the job is three
> times more complex than traditional retail.

Jun 14 10:01 PM

[thefullclev...:]

Alan,

Aaron's consumes cash because it is growing. You want free cash flow buy Rent-a-Center. They're not growing and throwing off loads of cash. Aaron's could do the same thing, but they are choosing to grow and are doing so profitably. I'm not sure what risk you see as they depreciate their inventory fairly aggressively and have a relatively unlevered balance sheet. Fact is, customers are credit constrained and Aaron's may be their only solution. I understand that business is pretty brisk.

Jul 10 04:45 PM

[Alan Brochs...:]

Maybe they won't be left holding Herman, but the growth isn't sustainable if their customers can't meet the payments. No evidence yet, that's for sure. If one believes the numbers, then the stock isn't the devil I predict - who can argue with 13X 2010? They had a surge in the last recession followed by a quick pullback, but that wasn't a consumer recession. I think that there are going to be too many competitive sources out there - pawn shops, craigslist, etc.

I have some serious egg on my face on the EZPW side and a hole in my pocket too!

Jul 10 06:54 PM