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In this article I want to detail what is happening in the Payday Loan industry and detail what is happening with the companies that operate in this segment. I think that this industry is under-followed and due to several risks explained below, the stocks in this segment are trading at inexpensive valuations. Despite several risks, I continue to see value in the underbanked group. Let's start summarizing what is happening in the industry and then check if the market has already discounted all the bad news and valued the stocks from this segment attractively.

Higher disposable Incomes could mean lower demand for Payday loans

According to a recent speech by San Francisco Fed President Janet Yellen, a 50 cent [per-gallon] decline in gas prices leads to a 0.5% boost to household disposable income. As the average price of regular unleaded down 60 cents from a peak of $3.93 in early April, I think that the underbanked consumers have likely experienced a boost in disposable incomes, limiting demand for loan products while improving credit metrics. I think that the higher disposable income trend will not stop in the foreseeable future. This could be a challenge for Payday lenders.

Risks from increased regulation

Federal regulators are moving to curb or eliminate high-interest, short-term lending that may ensnare consumers in a cycle of debt as they draw one loan to repay another.

The Consumer Financial Protection Bureau, following a study that focused on repeat usage of so-called payday loans made by storefront lenders and deposit advance products offered by banks, said it will consider imposing waiting times between loans. In fact, in a recent interview with Bloomberg, Sam Olens, the attorney general of Georgia, said the he would welcome federal action to limit the ability of lenders to affiliate with Native American tribes. "This is an area where Congress should tighten the laws," Olens said in an interview.

If the downtrend in Gold prices persists, it could hurt Payday margins

Rising gold prices over the past few years created a window of opportunity for customers to generate short-term windfall by liquidating broken and unwanted gold jewelry at a time when the gold rally was a hot topic on the evening news. According to Cash America's CEO, that window of opportunity was open during 2010 and '11 when the spot price almost doubled from $1,000 per ounce to a high of $1,900 an ounce.

Pawn brokers and independent gold buyers were all the beneficiaries of a momentary spike in consumer gold liquidation during 2010, throughout 2011, and early 2012, enjoying unusual spikes in purchases of customer jewelry and gold during this period. The spike in volume fell back to earth in the third quarter of last year, which is when payday lenders' year-over-year comparison for commercial profit began to really get tough.

Payday lenders have room to expand both locally and internationally

Payday lenders have room to expand their current store count. For example, EZCorp has operations in Mexico and Canada, and has strategic partnerships with a pawn operator in the U.K. and another with operations in Australia, South Africa, France and other countries. Cash America operates in Mexico, and through Enova Financial, its online subsidiary, operates in Canada, the U.K. and Australia. (Source: Barron's - Payday Loans, Pawn Stores Feel the Pinch).

With all these concepts in mind, let's analyze the most important stocks in this segment:

The indisputable leader

Cash America (NYSE:CSH) is a business that should generate EPS growth of 15% per year for the next 5 years as the company advances in the turnaround of its key Mexican operations and expands internationally. In addition, the company has room to grow its profitable online operation.

In the last quarter, Cash America reported a significant improvement related to the performance of its pawnshop business in Mexico as a result of reorganization activities started in the fourth quarter of last year. While not yet profitable, due to the immaturity of the retained locations, Cash America's business in Mexico reduced its operating loss from approximately $4.6 million in the first quarter of 2012 to $1.25 million in the first quarter of this year and is expected to become profitable next year.

Cash America has been applying a strong diversification strategy, expanding the company's product offering and geographic footprint. This mitigates a potential regulatory risk, as the company's total portfolio of U.S. single-payment payday loan products represents only 27% of consolidated gross consumer loan balances at the end of the quarter.

The stock is cheap, trading at just 8.62x forward earnings. If I take the lowest earnings estimate for 2014 (EPS of $5.10 vs. average of $5.47) we get a forward P/E of 9.3x. It is important to remember that the stock found strong support every time it traded at 8x earnings in the past 5 years.

The market has discounted all the risks in this stock

EzCorporation (NASDAQ:EZPW) or EzCorp is the second leader in this highly fragmented segment. While this company faces more risks than other lenders, the market has already discounted all the negatives.

In a recent report, FBR Capital lowered EZPW price target from $19 to $17 with a negative view given EzCorp greater proportion of revenues in the U.S., weak corporate governance, heavy exposure to gold, aggressive payday lending expansion in the U.S., and revenue exposure to buy/sell retailing (a lower margin business).

While I agree on the risks that FBR mentions, I think that EzCorp has room to expand in both its local store count and in its online segment. In fact, in the last Analyst day presentation, management told investors that it plans to get to 5000 stores in the next 5 years from the current 1000 store count.

This company has a strong track record of 17% top line CAGR growth in the past 10 years while deploying significant capital with 20% returns on equity. The shares are extremely cheap at only 7x trailing P/E and a 6.6x forward multiple.

A solid International play

First Cash (NASDAQ:FCFS) is a company that has grown from 200 U.S. stores in 2009 to a current 277 store count. But the real growth comes from its Mexican operations: the company went from 329 stores in 2009 to 559 in Q1 2013. More than half of revenues are generated in Mexico.

I like the fact that it has the smallest percentage of payday revenues in the peer group, which reduces the regulatory risk that investors could face. First Cash has a store operating profit margin of 29% and an effective monthly yield on pawn receivables of 14%.

I think it is interesting that 95% of the gross profit comes from retail sales and lending activity with limited contribution from jewelry or gold scrap sales. This reduced the risk of a further downturn in gold prices, a risk that Cash America and EzCorp could experience.

First Cash trades at a forward P/E of just 14x, a multiple that is the lowest in the past 5 years. This company shows strong metrics that should deserve a premium valuation over peers and could translate in a multiple expansion: for example 19% increase in EPS last year, strong growth from pawn receivables (up 21% in Mexico and 34% in the U.S.) and strong revenue growth from core earnings stream pawn fees are some of the positives from the First Cash model. In addition, First Cash maintained a strong retail margin at 41%, which is better than peers.

Source: Payday Lenders Analysis: Which Is The Best ?