While most pawn shops globally have seen significant share price declines in 2013, First Cash Financial Services (NASDAQ:FCFS) has seen its shares rise 15% YTD and they now trade at 20x 2013 estimated earnings, a 100%+ premium to fellow pawn operators EZ Pawn (NASDAQ:EZPW) and Cash America (NYSE:CSH) which trade at 8 and 10.5 times 2013 estimated earnings. Further, while First Cash has benefited from the rapid growth and relative stability of its Mexican operations, a recent disappointment from Wal-Mart's (NYSE:WMT) Mexican division, commonly called Wal-Mex, suggest that its growth engine may be slowing down. A less optimistic appraisal of the prospects for this business could cause shares to fall to the mid-30s, implying downside of 30% or more.
First Cash has experienced strong growth over the past several years as it has rapidly expanded its Mexican pawn lending business, growing stores nearly six-fold since 2004 to almost 600 today. Similarly, it has grown its US pawn lending business as well - almost doubling stores during the same time period. The light-speed growth of the Mexican business over this timeframe has allowed it to become the company's largest segment, representing 55% of revenue.
The second quarter saw First Cash report essentially flat EPS year over year after adding back exceptional costs. This represents a marked deceleration in earnings growth from past years. However, these results benefited from a stronger Mexican peso. Looking at the third quarter, the tailwind from the Mexican peso will be greatly reduced given the weakening that has occurred since mid-year. Further, while the Mexican business is not too dependent on gold prices (most collateral is items other than jewelry), jewelry and gold represent 61% of the US business's collateral. Recall the US still represents 45% of total revenue for the group. Declining gold prices have been a huge headwind for other publicly traded pawn shops (both in the US as well as internationally - see UK operators H&T Group and Ablemarle and Bond's recent results/guidance) as it has all but eliminated scrap profits, has crushed gross margins, and causes lower interest income as loan size is reduced (because collateral value has fallen). Given these headwinds, we will need a heroic performance from the Mexican business for the company to meet its earnings guidance.
While Mexico has been a bright spot thus far for First Cash, there is evidence that consumer spending in the region could be slowing. As in the US, Wal-Mart is considered a barometer of consumer health in Mexico. Last week, Wal-Mex reported a -4.7% decline in same-store sales. 4.7% would be significant for a teen retailer ,which is subject to the whims of fashion; it is a huge decline for a purveyor of daily necessities. Consider that Mexico is a market with a young population (it is an outlier for having a large population of people aged 15-35 this group tends to be the largest consumer of personal products like cosmetics, toiletries, snack foods, beer, etc) with low penetration of formal retail. When factoring in these dynamics, a 4.7% decline is rather shocking -- it was the biggest drop Wal-Mex has seen since 1999. Further, this is Wal-Mex's 5th same store sales decline in the past 6 months.
While there are many resilient characteristics to the pawn business, a drop of this magnitude at Wal-Mex suggests a decline in the purchasing appetite of customers which could negatively impact First Cash a couple of different ways. First, this would mean a reduced demand for loans as customers decide to cut back rather to borrow to spend. Wal-Mex's numbers seem to suggest people are cutting back on necessities, not just indulgences. Secondly, this could make it more difficult for First Cash to sell its large stock of second hand goods, most of which are durable goods like TVs, tools, etc. This could depress gross margins for retail disposition and make the company more hesitant to grant loans should collateral values decline. Aside from COGS, the pawn business has high fixed costs and limited variable costs, which means that a slowdown or decline in the top line would feed straight through to profits.
Given the headwinds faced by both the US and Mexican businesses, I think that a 20x multiple is far too aggressive. While I agree that the multiples at which EZ Pawn and Cash America trade at are too low (even though 25% of EZ Pawn's earnings come from Mexico and its US business is very similar to First Cash), I think that a 13-15x multiple is more appropriate. Similarly, I expect that First Cash will be hard pressed to grow earnings much (we didn't see any growth in second quarter EPS and I expect the third and fourth quarters will be even more difficult) and actually expect EPS will be -5% YoY for the third and fourth quarters (vs. company guidance of flat to up). Using EPS of $2.73 (flat with last year) and a multiple of 14x, I get to a fair value of $38.22/share, which is 32% lower than where it is trading today. I am short shares of First Cash Financial and look forward to its earnings release later this month.