The appointment of Richard Cordray as Director of the Consumer Financial Protection Bureau has caused concern among investors in the payday loan sector. My analysis of the legal and regulatory landscape, however, suggests that there is nothing for payday investors to be concerned about. Indeed, the industry has begun another growth cycle and virtually every stock is undervalued with significant upside remaining.
Regarding Mr. Cordray, there are certain things he should do. This includes codifying the Community Financial Services Association's Best Practices into federal regulation. This set of guidelines must be followed by any company that wishes to be a member of CFSA, and it includes all public companies. These same practices are essentially equivalent to state statutes that already are in existence by which all responsible payday lenders must comply. With these practices as federal standards, it will chase out the bad apples that exist in the marketplace. In turn, the good players will then move into vacuum created by those who have exited. That is exactly the kind of protections that are useful to consumers that do not restrict their access to credit, nor are unfair to payday lenders.
Beyond this, I would suggest that Mr. Cordray step lightly. There is no need to overreach because, as already mentioned, the states are governing the product just fine. States that have banned these loans have seen consumers suffer, as well as seen people lose their jobs, and the economy suffer. One thing which did not get mentioned much at the field hearing in Alabama is that when payday loans are taken away from the consumer, they are forced into getting that credit somewhere else since demand does not just vanish. That other choice is almost always writing a bad check, which results in bounced check and merchant fees that are vastly in excess of a payday loan fee.
As to my reading of the Dodd-Frank bill, there are numerous portions that make it quite clear what the Bureau can and can't do. One portion reads:
(B) Objectives- The Bureau is authorized to exercise its authorities under Federal consumer financial law for the purposes of ensuring that, with respect to consumer financial products and services--
(1) consumers are provided with timely and understandable information to make responsible decisions about financial transactions; (2) consumers are protected from unfair, deceptive, or abusive acts and practices and from discrimination; (3) outdated, unnecessary, or unduly burdensome regulations are regularly identified and addressed in order to reduce unwarranted regulatory burdens; (4) Federal consumer financial law is enforced consistently, without regard to the status of a person as a depository institution, in order to promote fair competition; and 5) markets for consumer financial products and services operate transparently and efficiently to facilitate access and innovation.
Any reasonable interpretation of this section would result in a clear conclusion -- public payday lenders are already operating in a manner consistent with this section. Furthermore, any unreasonable limitation on payday lenders that do not also include banking overdraft fees are in direct contradiction to the above edict. If banking overdraft fees are limited, then banks would literally go out of business, according to a recent study by Bretton Woods.
The other part of the statute that may worry some folks is that the Bureau has the authority to act against unfair, abusive or deceptive practices. Again, under the concept of reasonable interpretation, any payday lender that is acting in accordance with CFSA's Best Practices do not even come close to fitting the definitions of "abusive, unfair, or deceptive". In particular, one portion of the statute reads that:
(D) Abusive- The Bureau shall have no authority under this section to declare an act or practice abusive in connection with the provision of a consumer financial product or service, unless the act or practice--
(1) materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service; or (2) takes unreasonable advantage of--
(A) a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service; the inability of the consumer to protect the interests of the consumer in selecting or using a consumer financial product or service; or (C) the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.
Again, responsible payday lenders and those belonging to CFSA have nothing to fear. Any attempt by Mr. Cordray to unreasonably interpret the language in these statutes simply will not fly. The short-term advance industry would, in my estimation, litigate as necessary to protect their ability to simply stay in business and do so fairly and in full compliance with applicable laws and regulations. Given the legal and political cloud under which Mr. Cordray was appointed, I am hard-pressed to believe that he would pick a fight.
Finally, for those who may still be worried, should the GOP re-take the White House in the fall -- and especially if they re-take Congress -- say goodbye to the CFPB. So with all this in mind, with regard to the stocks, I'm bullish on just about every one. Here are my feelings on three of them.
First Cash Financial Services (FCFS) just reported another blockbuster quarter. FY net income up 36%, Q4 up 21%; FY revs up 22%, Q4 up 20%; Same store revenue up 14% in Mexico and 12% in the US; net margins hit 21%, far higher than before the company moved aggressively into Mexico. The company added 61 pawn stores in Mexico and 21 in the US. Free cash flow remained strong and was evenly distributed over capex, buybacks, and pawn store acquisitions. They have no debt outstanding. The company remains a stellar play in the sector and with 20% growth expected in 2012 to $2.65 - $2.70. The company totally deserves a 20 P/E, and that gives us a price target of at least $53, which is more than 30% from here. It's a no-brainer buy, and I've been buying ever since the price fell under $40.
There's even more value in EZCORP (EZPW). Like First Cash, the company has made big inroads into Mexican pawn. Their growth has also been astonishing. Net income was up 43% (after extraordinary charges), revenue up 14%, Mexican same store revenues up 15%, 54 new pawn stores opened in Mexico. The most exciting development is they acquired 60% of Crediamigo, which provide payroll deduction loans, mostly to government employees. This is an area I've been looking at from a private equity standpoint for some time, for what could be better than making a multi-month installment loan where the principal and fee can just be deducted directly from the employee's paycheck? This will mean negligible, if any, default rates and should prove to be extremely profitable for EZ. The entity has a $93 million portfolio. This will be huge for EZ. The company trades at $27, and on 2012 projected earnings of $3.05 (20% growth YOY), this stock should be trading at $60. It absolutely deserves that 20 P/E, given its solid free cash flow and low debt. That's more than a 100% return from this point. I'm long and you should be, too.
Advance America (AEA) has proven to be the most resilient of the domestic payday advance companies. While virtually every other payday company has ceased expansion, or is selling off its stores, Advance America has been diligently consolidating its store base in an oversaturated market, paying down debt, and making strategic acquisitions. One such purchase was last August, when it scooped up 300 stores from CompuCredit (CCRT) for a comparative song. I'd expected exactly such an event and wrote about that possibility last June. Its consolidation phase has paid off, allowing it to trim center operating and occupation expenses, pushing those savings to the bottom line, and doubling net income on flat revenue.
With other big competitors having effectively abandoned any domestic growth, Advance America is well-positioned to move back into states that have closed to payday lending over the past few years. Once the issues with the CFPB are resolved, which I believe will be in less than one year if not sooner, the company can return to those closed states with a lot of ammunition. At that point, Advance America can say, "Hey, the feds didn't ban us. They're overseeing everything. Every other state is fine with us. Why aren't you?"
Given that the New Hampshire legislature introduced a bill to return payday to the state last year after a ban, and the litany of non-partisan studies that have proven consumers are worse off when the payday option is forcibly removed, I consider it very likely that we will see states open up to payday lending. Advance America will lead the new gold rush. First Cash has sold off stores except for Texas and is obviously focused on Mexican pawn. EZ has also been focusing on pawn both foreign and domestic. Cash America (CSH) has been judicious about where it deploys its capital, and has also been focusing on pawn. Dollar Financial Group (DFG) has significantly diversified its revenue stream and has been focusing on Canada, the UK, and Europe. That only leaves QC Holdings (QCCO), which has liquidity issues, and a few large private companies.
With Advance America having sold off from the low $9s down to $7.83 as of Wednesday, with a 3.2% dividend, $35 million in cash and no debt, and over $150MM in TTM FCF, it is also vastly undervalued.
However, if you hold a big bank that was involved in the mortgage nightmare, such as Bank of America (BAC), I'd be plenty concerned. The public hates Bank of America right now. The Countrywide settlement didn't make anyone happy. I also don't care for the bank's liquidity position, which obviously needed help considering Warren Buffett had to pump $5 billion into it. Indeed, the bank is rated the 18th most hated company according to the American Customer Satisfaction Index. Talk about a more deserving target for Mr. Cordray! I'd say sell BofA and buy these 3 payday lenders.
Disclosure: I am long FCFS, EZPW, AEA.