The history of pawn shop operator First Cash Financial (FCFS) has always been marked by pullbacks and retracements, and those have often been good times to reload on what has been an excellent decade-long growth story. Although concerns about the health of the Mexican operating environment and the direction of gold have pulled this stock back from its highs, First Cash remains a high-growth/high-return play with a big international kicker.
A Dose Of Reality To End The Year
Although First Cash had enjoyed a pretty good run for much of 2011, the stock has weakened lately on worries about the health of the company's Mexico operations. Supplying over half of the company's revenue and a lot of the growth, conditions in Mexico have weakened in part due to violence in Northern Mexico, some reduction in loan demand as the economy softens, and lower loan-to-value ratios as the company works to maintain margins and pricing discipline. Making matters a little worse, a weakening peso is a threat to earnings as well.
U.S. operations, too, have come under a bit more scrutiny. In particular, the price of gold is a relevant worry to this company as roughly 40% of the inventory is gold. While the company does take care to protect itself with hedges, the reality is that lower gold costs do impact the company's profits from scrapping pawned gold jewelry.
None of these are major long-term worries for the company. Instead, it is more of a situation where the stock ran too far too fast, got ahead of the fundamentals, and became vulnerable to profit-taking and valuation-based downgrades.
A Mexican Consumer Stock In Disguise
With so much of the company's current business and future growth tied to Mexico, First Cash is in many respects a Mexican consumer/finance stock. That's relevant not only from the perspective that Mexico still offers some solid growth prospects, but also from the relative scarcity of liquid stocks on U.S. exchanges to play that theme -- Walmex (WMMVY.PK) and FEMSA (FMX) being two of the rare exceptions.
First Cash currently has more than 440 stores across 22 states in Mexico, and management believes that the country can support at least 300 more. Given the current rate of new store growth, that suggests roughly four more years of new store growth before saturation becomes an issue. Given how significantly under-banked Mexico is, though, investors should not assume that the end of new store growth will mean the end of growth in Mexico.
In the meantime, management is beginning to consider what comes next and may launch a test entry into a new country in 2012. Given that Central American countries are small and Brazil is difficult from a regulatory perspective, Argentina or Chile may make the most sense.
Are Regulatory Risks Overstated?
It's impossible to talk about First Cash, nor its peers and rivals like Advance America (AEA), Cash America (CSH), EZCORP (EZPW), without mentioning regulatory risk. It is true that consumer advocacy groups, state legislatures, and even the federal government under the Obama administration have tightened the screws and aggressively pursued so-called “predatory lenders.”
The distinction, though, is between payday lending and pawn lending. Payday lending has been the target of most of this activity, and remains a real risk to Advance America, DFC Global (DLLR), and World Acceptance (WRLD). First Cash, though, has largely pulled out of payday lending, getting about 10% of revenue (and 13% of EBITDA) from these operations. Moreover, the company operates mostly just in Texas – generally a pretty benign operating climate.
Pawn lending, in contrast, is grudgingly tolerated – perhaps because the need to present physical collateral limits the opportunity of a downward debt spiral, to some extent. Although there is certainly a risk that states will change the rules on pawn lending, this tends to be a more regulated industry and First Cash has a competitive advantage with its scale and strong internal systems.
The Bottom Line
Despite a few “bad hair days,” First Cash has built a reputation for beat-and-raise performance and prudent expansion. While a share buyback may dent liquidity a bit, the company has more than enough cash to meet its near-term growth needs and generates not only good cash flow but strong returns on capital.
Assuming double-digit revenue growth and gradually improving free cash margins over the next five years, First Cash looks undervalued by nearly 20%. That's not a tremendous bargain in today's market, and some investors may worry that economic recovery will limit its near-term growth potential in the U.S. That said, as a quality growth name, First Cash is still worth a look on pullbacks like this.
Disclosure: I am long FCFS, FMX.