The nonprime consumer credit industry is going through some turbulent times. There are both opportunities and pitfalls in some of the stocks in this sector. Today I'm going to examine a company I've been following for almost ten years, First Cash Financial Services (FCFS), which presents a great long-term buying opportunity.
The Nonprime Consumer
Before we jump into fundamentals on FCFS stock, it's essential to understand the products the company offers and, more importantly, the behavior of the nonprime consumer. This demographic has not built good credit, and as such, does not have access to traditional credit sources such as banks or credit cards. A Georgetown University McDonough School of Business Study identified this demographic with the following traits:
• Majority earn between $25,000 and $50,000
• 90 percent have a high school diploma or better
• 54 percent have some college or degree
• 53 percent are under 45 years old (only 9 percent are 65 or older)
• Majority of customers are married
• 63 percent have children in household
• 32 percent own homes
• 54 percent have major credit cards
• 100 percent have steady incomes
• 100 percent have checking accounts
This demographic lives paycheck-to-paycheck, so if an emergency expense arises, they will find themselves in need of short-term credit. The options, along with the cost per hundred borrowed, are:
Borrowing from a friend ($0).
Credit card advance ($1).
Installment loan ($3-$8).
Auto title loan ($8-10).
Payday loan ($15-23).
Online payday loan ($25-30).
Utility Reconnect Fees ($42).
Bank overdraft fees ($60).
Loan shark (no maximum).
Each carries some kind of risk upon default. The most serious being losing a life or limb using a loan shark. However, the loss of a personal relationship is nothing to sneeze at. Default on a title loan may cost you a vehicle. You'll forfeit the item you've pawned if you don't redeem it. With a payday loan, however, the worse case scenario is you get sent to a collection agency. You are NOT reported to credit bureaus.
First Cash's Business
First Cash had been both a payday lender and pawnshop operator, but in recent years, the company has dramatically scaled back its payday loan presence. It now only has stores in Texas, the least-regulated state for the product. It has instead concentrated on its pawn operation, and was the pioneer in developing US-based pawn operations in Mexico.
Pawnshops generate retail sales from the merchandise acquired through collateral forfeitures, and from over-the-counter purchases from customers, though not things like rare muskets that you see on "Pawn Stars." Pawnshops are also a source for short-term consumer loans. Items like jewelry, consumer electronics, tools, sporting goods and musical instruments are pledged as collateral.
There's a significant difference between US and Mexican pawn operations, as well as between the pawn demographic in these countries. The pawn industry in the United States is well established, with the highest concentration of pawnshops located in the Southeast, Midwest and Southwest regions of the country. The operation of pawnshops is governed primarily by state laws, and accordingly, states that maintain pawn laws most conducive to profitable operations have historically seen the greatest concentration of pawnshops. The U.S. pawn industry is mature, but it is also highly fragmented, with the three public pawnshop companies only operating some 2,200 of the 15,000 U.S. pawnshops. Pawn is truly a mom-and-pop business. Most of them are 1-5 store operations.
Mexico is a different story. Whereas the U.S. has large format stores with full-service, Mexico only has about 6,000 stores, almost all of which are small and only deal with jewelry. They don't really handle retail goods. First Cash saw an opportunity to bring their large-format stores to Mexico, establishing a solid footprint, and offering full service - loans, accepting retail goods and jewelry as collateral, selling retail products, and offering cash advances. The company believes there's room for 20,000 such stores….and so far they've opened a mere 597.
There is a long, long way to go in Mexico. Even better, no other competitor - including US-based companies - have made any dent in Mexico. One public company tried, and focused too much on jewelry. They have since had to scale back operations as the price of gold fell. Another had to shut down all their stores because all they did was buy and sell gold. It's First Cash's market, they own it, and there's nobody that can stop them. In the U.S., the company has 227 pawnshops, and 92 payday loan stores (in TX only).
First Cash just reported its FY13 numbers. There are some good things happening, and some headwinds, but I believe these are short-term bumps. Let's look at the number and interpret what they mean.
Diluted EPS was $2.86 compared to $2.72 in FY12. This wasn't entirely unexpected, given the damage done to margins from the falling price of gold. Indeed, the entire industry suffered. FY13 scrap gold production was down 22%. Gross profit from wholesale scrap jewelry fell 64%. This was due to the average selling price of gold liquidated during the quarter being $1,213 per ounce (with gross profit margins of 10%), as compared to FY12 price and margin of $1,723 and 27%, respectively. Scrap jewelry accounted for only 2% of fourth quarter and 3% of full year net revenue. Quite a difference, and it created a $0.34 per share drag on EPS.
Here's the good news. Consolidated revenue from pawn sales and loan fees increased 25%. Consolidated retail merchandise sales increased 28%, of which the U.S. increased 34% and 24% in Mexico. Pawn loan fees increased 19%, of which U.S. pawn loan fees increased 25% and 15% in Mexico.
These are terrific numbers. It demonstrates that people in both countries consider pawn to be a truly viable option for credit, and that people not only wander into pawn shops to actually buy stuff, but they are buying a lot of stuff.
Payday loan revenue fell 14%, but now only comprises less than 7% of total revenue. First Cash has virtually eliminated its reliance on payday. There are two reasons for this decline, but also reasons why I believe it will increase in the future.
First, internet lending continued to soar and has been cannibalizing storefront, to the point where internet lending owned 35% market share. I use the past tense ("owned") because the federal government cracked down on internet lenders by choking off their payment processors. That means a large portion of market share lost to the internet will return to the stores.
Second, several large cities in Texas passed ordinances that have limited payday lending, causing material declines in revenue across all the companies. However, there are lawsuits making their way through the courts and they will eventually succeed. State law trumps local ordinances, and there is both a 5th Circuit Court and AG Opinion that support the lenders' argument regarding the supremacy of state law. That will boost demand and revenue again in Texas, and that will show up in FCFS' earnings.
Consolidated pawn loans increased 12%, of which U.S. pawn loans increased 19% and Mexico pawn loans grew 3%. It's important to note that the absolute number of loans increased by 29% in the U.S. and 8% in Mexico, but growth in the value of pawn loans fell due to 8% and 5% decreases, respectively, in average loan sizes, primarily on loans secured by gold jewelry. With falling gold prices came falling loan-to-value ratios.
The value of loans is going to ratchet back up, as gold jewelry inventory becomes less valuable to lend against. Already in Mexico, 87% of pawn loans are collateralized with hard goods, and only 13% were collateralized with jewelry. Indeed, loans collateralized with hard good items increased 8% in Mexico. Fees were also lower than what was expected because there was higher payoff of pawn loans in Mexico of 20%, compared to 14%. This will also send revenue higher when it reverses.
Despite the various headwinds, pawn remains strong and so does the company. Free cash flow for fiscal 2013 increased 60% to $80 million, compared to $50 million in FY12.
Action to Take
FCFS gave FY14 guidance in a range of $3.00 to $3.15. That's only a 5% - 10% EPS increase. However, as mentioned above, I believe a number of trends will reverse course in FY14. I think management is being conservative, but we'll take their guidance at face value. With the stock trading at $50, a 10x estimate on $3.15 in earnings yields a value of only $31.50. So here are my thoughts.
If you hold FCFS, but do not have a long term horizon, you might want to sell here. I don't think the stock will move much in the next 6 months and if it does, it's more likely to go down than up.
If you hold FCFS, and have a long term horizon, I would hold your position. Over the long-term, there is simply no other competition in Mexico. FCFS will rule the world in pawn in Mexico, and they will be expanding there for a very long time. They will see 15% long term growth in EPS once through this tough period, and $50 will seem cheap.
Do you buy FCFS here? I think a better move, if you have a long term horizon but don't own the stock yet, is to sell some naked puts a few months out. The June 50 Puts are trading in the $3 - $4 range. That's a good premium. If the stock gets put to you, be glad to take it at an effective price of $45 or so. If not, you've made money while you wait, and you can sell more puts out a few months.