Sahm Adrangi is the portfolio manager of Kerrisdale Capital Management, a New York-based investment manager of client funds via both limited partnerships and separately managed accounts. Prior to founding Kerrisdale, he was an analyst with Longacre Fund Management, a distressed debt hedge fund in New York.
If you could only hold one stock position in your portfolio (long or short), what would it be?
Cash Store Australia (GM:CSAHF). It mainly trades on the Toronto Venture Exchange under the ticker AUC.
Tell us more about the company behind the stock.
Cash Store Australia is a start-up payday lender in Australia with 44 branches as of Dec. 31. Regulatory risks notwithstanding, it's a fast-growing, well-run business with high returns on invested capital and an ability to generate substantial amounts of free cash flow on a per-store basis. As well, its rapid growth trajectory is occurring in a virtually untapped market for payday lenders. Already, at 44 branches, it’s the leading payday lender in Australia. The sky is the limit, if the regulatory landscape turns out favorable.
The company is run by the same management team that founded and operates Cash Store Financial (CSFS) in Canada. Since opening doors in 2001, CSF's payday lending stores have grown to 469, with 99 of those stores coming through an acquisition of competitor Instaloan Financial Solutions in April 2005. As of Dec. 31, the business generated C$160 million of sales, C$36 million of EBITDA, and C$23 million of free cash flow. By my estimates, aside from the Instaloan acquisition, which cost C$35 million and was funded largely through an equity raise, the company has raised less than C$15 million to grow its organic business into the company it is now. Its return on invested capital is approximately 30%, an impressive statistic. Capex has been relatively light throughout the Cash Store Financial's history.
This management team is on track to do the same thing with Cash Store Australia. With Cash Store Australia, I’m investing in the early stages of a business with strong long-term growth potential alongside a management team that is taking a proven business model and replicating it in a country where there is little current competition. I’ve written blog posts on Cash Store Australia, Cash Store Financial and the payday lending sector in general.
Let's talk about the sector overall. How much is your selection based on the industry, as opposed to a pure bottom-up pick?
Payday lending is a nice business if regulations are not too strict and the competitive landscape is underpenetrated. Lenders lend small amounts of money on a very short-term basis to low-income borrowers with poor credit histories at very high interest rates. Default rates are almost a nonissue for well-managed payday lenders, and Cash Store Financial has never experienced unpredictable default rates, unless caused by changes in payday lending regulations. The durations are too short, the loan sizes too small and the number of borrowers too large for credit risk to be a material problem.
In an unsaturated market like Australia, a well-run payday lender can grow fast and with high returns on capital. The company’s position within the industry landscape is a central reason as to why I’m bullish on the company.
How is Cash Store Australia positioned with regard to competitors?
The competitive environment is very favorable to Cash Store Australia. Despite launching operations in 2004, it's already the leading payday lender with 44 stores. With no other major competitor aggressively trying to develop a dominant national footprint, the growth opportunity seems exceptional.
Does Kerrisdale have any forecasts for store, revenue and profit growth over the next several years?
Yes. Because Cash Store Australia is largely following the growth trajectory of the Canadian operations in the early 2000s, we’ve been able to model Cash Store Australia on a store-by-store basis. We’ve essentially taken store-by-store economics, using data from both the Canadian operations’ and Australian operations’ public disclosures, as well as speaking with management, and have modeled what revenue and profit growth should be based on the company’s stated store expansion plans.
For fiscal 2010, 2011 and 2012, we’re forecasting a store base of 61, 115 and 176 stores. We are forecasting revenue of C$12 million, C$25 million and C$43 million; and EBITDA of C$0.6 million, C$1.3 million and C$3.8 million. But the more relevant statistics to look at are Cash Store Australia’s financial statistics when the company has matured.
We’ve modeled store-by-store growth out into 2018. By 2016, we’re estimating 460 stores, C$173 million in revenue and C$35 million in EBITDA. Profit growth really begins ramping up quickly from 2013 to 2015, as EBITDA margins increase from 13% to 18% based on our forecasts, due to the maturation of new stores. That’s what we saw in the growth trajectory of the Canadian stores.
How does the stock's valuation compare to its competitors?
Because Cash Store Australia is still in start-up mode, you have to value it based on how much profit you think it will generate once the company has matured. Based on the store-by-store model available on my blog, I am forecasting C$35 million of EBITDA in 2016. Using an 8x EBITDA multiple (a reasonable multiple for the industry, assuming that regulatory risks are not on the horizon), we get to an implied stock price of C$18 in 2016. Discounting that back to today at a 15% discount rate gets to a C$7.50 stock price. Therefore, in my base case, I think that the current stock price of around C$3.00 is quite undervalued.
How does your view compare to consensus sentiment?
There is no real discernible sentiment – this is an underfollowed stock with no research coverage and minimal visibility.
Does the company's management play a role in your selection?
Absolutely. Cash Store Australia’s management team built Cash Store Financial into the No. 2 payday lender in Canada in eight years, growing profitability with minimal start-up capital. A Canadian divisional vice president, Don Steffanson, was appointed chief operating officer of the Australian operations in March 2009 and is spearheading the expansion.
Prior to moving, Steffanson managed a network of 79 branches in Canada. Many of the other senior and regional managers in Australia are also seasoned executives from the Canadian operations.
What's the difference between the American regulatory environment and the Canadian and Australian regulatory environments?
In the United States, the legislative landscape varies widely by state, and continues to evolve on a state-by-state basis. Fifteen states have effectively banned payday lending, whereas other states like Utah or Nevada have virtually no payday lending regulations.
In Canada, on the other hand, the government has adopted a legalize-and-regulate approach. The federal government transferred legislative jurisdiction over payday loans to the provinces in 2007. In the following two years, most provinces held public hearings; commissioned studies; and otherwise debated how best to regulate the industry. Their conclusions, by and large, were favorable to companies like Cash Store Financial. The final rate caps were largely above the rates that Cash Store Financial was charging, and had negligible impacts on store profitability.
For a variety of reasons, I think that Australia’s regulatory evolution will follow in Canada’s footsteps, not the United States. The Australian demographics, government and regulatory environment is far more similar to Canada than the United States. It's a smaller country with fewer provinces/states. Cash Store Australia is spearheading an industry group that is establishing a code of conduct aimed at self-regulating the industry and at taking a proactive approach towards regulation. The Federal government is taking a more active initial role in regulatory reform than was the case in the United States.
How does industry growth in Australia compare to industry growth in Canada or the United States?
Cash Store Australia management estimates stores per capita in the three countries to be:
U.S.: 10,000 residents per store
Canada: 25,000 residents per store
Australia: 75,000 residents per store
The population demographics of Australia are fairly similar to Canada. As a result, the Australian payday loan market appears quite underpenetrated. With Cash Store Australia already as the leading payday lender with 44 stores, and no major competitor trying to develop a dominant national footprint, the growth opportunity seems exceptional.
What catalysts, near-term or long-term, could move the stock significantly?
There are no real catalysts aside from continued store growth and increased earnings, quarter after quarter.
What could go wrong with your pick?
The main risk with Cash Store Australia is regulatory risk. The company faces a somewhat binary outcome. If payday lending is effectively banned in Australia, all bets are off, to some degree. The company's core business model would be deemed unprofitable and Cash Store Australia would likely halt its growth prospects. It's quite possible that the company would find a way to eke out some sort of profit, but the growth trajectory would likely be materially less than what we estimate in our model. What could Cash Store Australia be worth in such a scenario? Well, the company is currently trading at an enterprise value of approximately C$50 million to C$60 million. In a banned payday lending scenario, a potential estimated enterprise value could be C$30 million. Given the company has no net debt, that implies a stock price downside of about 50%.
What are the chances of payday lending being effectively banned? My take is that there's a 5% chance of sufficiently prohibitive rate caps being passed in Australia to make payday lending effectively unprofitable. While it's possible, I view an outright national effective ban on payday lending as quite improbable.
So our risk-reward scenario looks like this: there's a 95% chance that AUC is reasonably worth materially higher than its current stock price, with my base case being that it's worth 100% higher than the current price. Then there's a 5% chance that AUC is worth 50% lower than its current price. This risk-reward payoff scenario is fairly attractive to me.
In addition to the regulatory risk, it's a very low-volume stock; what sort of liquidity risk are investors in for?
That's right - this has to be a long-term investment, because the liquidity in this stock is very poor. The bid-ask spread is quite large, so an investor should be willing to commit to holding Cash Store Australia over the long term, because the low liquidity will make it relatively difficult to sell out of the stock at a gain if an investor changes his mind shortly after investing.
How does your choice reflect your fund's investment approach?
For our long investments, we focus on valuing companies on the present value of their future discounted cash flows. Our investments include both small-caps and large-caps as well as domestic and international stocks. They inhabit a wide variety of industries. Some have near-term catalysts; others don’t. But generally, the common trait inherent in most of our long investments is that they are cheap relative to the present value of their future discounted cash flows, based on our estimates of those future cash flows.
That’s why we hold a small-cap payday lending operation in Australia. While it doesn’t fit easily into specific sector or industry buckets, it’s nevertheless cheap and the stock should appreciate over the long term.
Our approach is to try to find a variety of stocks that are cheap and where the business fundamentals are somewhat uncorrelated with one another. The biggest risk to Cash Store Australia is Australia’s payday regulations – none of my other holdings feature that same risk, and therefore this is nicely uncorrelated with my other investments.
Thanks, Sahm, for sharing your choice with us.
Disclosure: Kerrisdale Capital has a long position in Cash Store Australia.
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