A recent and passionate investor pastime has been raking through the carnage of sub-prime for long and short opportunities. The sub-prime issues facing the market are complex and have impacted investors' outlooks on many sectors with the natural outcome that significant valuation disparities now exist.
We highlight the pawn broking sector as an example of an industry whose valuations have recently been punished and argue that it has, in fact, not at all been affected by the sub-prime meltdown; rather, the sector has traded down in sympathy and is now valued at extremely compelling levels. In addition, we propose a specific recommendation, EZCorp (EZPW), which, in our opinion, is a value investment with significant long-term growth potential trading at a very cheap valuation with considerable near-term upside.
Pawn broking is an age-old industry whose legal standing has been well established. Pawnbrokers make loans based purely on the value of the collateral offered in exchange for the loan. Checking the customer's credit history, (and in fact, if the borrowing party even has a credit history), is not necessary because only the value of the item being pawned is relevant. If the loan, or at least the interest, is not paid off during the specified term, the pledged item is forfeited and may be resold by the broker. Typically, the majority of items pledged are jewelry made of precious metals, primarily gold, that have readily ascertainable values and are highly marketable in pledged form or as melted-down bullion.
The pawn broking industry often evokes images of dimly lit rooms with opportunistic lenders taking advantage of those pressed for cash. In fact, the industry is well-regulated and reports high levels of customer satisfaction. The pawn brokerage customer is reported as finding the value proposition offered by the lender to be much better than available alternatives and hence compelling. The industry is modern and many industry players articulate customer-focused strategies that involve treating borrowers with courtesy and respect.
As the industry has evolved, many new services with significant incremental earnings potential have been offered by pawnbrokers. They were unlikely to suffer from any additional reputation risk and they already had the lending methods and infrastructure to be successful with new product offerings. These include check cashing, payday loans, and other specialty finance products. Much of the growth in the "sub sub-prime" industry is driven by these new product offerings.
A huge area of opportunity for the industry has been the payday loan which emerged in the early 1990s. A payday loan is the unsecured lending of a small sum of money, typically $500 or less, for short periods of time, typically two weeks (i.e., "until the next payday"). The borrower is charged a fee, usually amounting to 15% to 20% of the advance amount, rather than an interest rate and, even if the advance is not paid when due, interest does not accrue. The relatively large fee and short-term nature of the loan imply a very high annual percentage rate, which may be equivalent to 200% to 400%. Permissible fees and loan durations are regulated and vary according to state law.
The payday loan segment grew as a result of a number of factors. Firstly, the cost of loans was compelling compared to the cost of bounced checks, late payment penalties, and the lack of availability of alternative credit products. Secondly, enabling legislation was adopted in many states providing guidelines and consumer protections under which the industry would operate.
The industry is currently estimated to have more than 22,000 payday advance locations across the US and to extend about $40 billion in short-term credit to millions of Americans that experience cash-flow shortfalls between paydays. There are many private and public companies operating in the space including EZCorp (EZPW), Cash America (CSH), and First Cash Financial Services (FCFS).
From no enabling state legislation in 1990, more than half of the US states have enacted specific enabling legislation for the payday advance industry. A large proportion of the industry's store base is located in Texas. The Texas legislature sits every two years. In the recent session, the only bill relating to the industry was one regarding information disclosure and it was returned to committee, meaning there will be no possibility of regulatory change at the state level in Texas until the next session in 2009.
How Have Pawn Brokerage and Payday Loans Been Affected by the Sub-Prime Crisis?
We do not see evidence that the sub-prime crisis has had any impact on the profitability of the pawn broking or payday loan segments.
The pawn brokerage segment is considered recession-resilient and has performed well in economic downturns. When contemplating the potential impact of sub-prime issues on the pawn industry, we note that each loan is collateralized, (with a significant margin of safety), by highly liquid physical assets. As a result, there is no loan loss experience. Regarding volumes, while we do not have statistical evidence, it seems intuitively logical that stress amongst sub-prime consumers may even benefit the pawn brokerage through increased demand for products. Conversations with executives and analysts lead us to believe that this could well be the case.
In the payday lending operations, the potential impact of sub-prime, if any, would manifest in one or more of the following three ways: a decline in the number of loans, an increase in loan losses, or a squeeze of available funding to underwrite the loans. We address each risk individually:
Regarding loan volumes, we apply the same logic to the payday lending segment as we do to the pawn brokerage segment; whereas, stress amongst sub-prime consumers may even benefit the payday loan industry through increased demand for products.
Regarding loan losses, recent earnings announcements in October and November by companies with payday activities indicated bad debt provisions were consistent with prior experience. Various management teams stated that they were also anticipating projected loan losses to be consistent with historical levels. Industry players have indicated to us that less than 15% of their payday client bases also have a mortgage. In addition, studies indicate that payday customers are likely to honor their payday loans before other obligations.
Regarding underwriting, pawn brokerage and payday loan providers are not dependent on the credit markets for funding – in fact many are debt free - and in any event are not particularly interest rate sensitive given the very high annual percentage rate compared to their cost of debt.
The Long Case for EZCorp (EZPW)
EZPW is, in our view, one of the best run operators in the specialty finance industry and is currently trading at an extremely cheap valuation. The company is a multi-line operator whose traditional business was pawn shops but which has expanded in to payday loans and other debt products. The payday segment is the growth engine of the company's business; however, revenues and profits are currently generated predominantly from the pawn brokerage segment. Profitability in the pawn segment is impacted by the price of gold and some consider it to be partially a long play on that commodity. With that said, the industry advances at different rates per ounce of gold depending on prevailing prices. The company added payday lending to some of its pawn stores as well as built new, stand-alone payday storefronts. As of September 30, 2007, the company has over 600 stores in the US and recently expanded into the highly prospective Mexico market. EZPW's store base has been rapidly increasing with 99 new stores added in the current fiscal year ended September 30, 2007 and the anticipation of an additional 100 stores to be opened in FY 2008.
At a share price of around $13.00, EZPW has a market capitalization of approximately $540 million and is debt free. EZPW has aggressively expanded its product offerings and store base and has grown sales at double-digit rates for over five years. Margins have consistently improved over this period. We look at the company as having a predictable revenue model with strong cash flow generation and very attractive after-tax free cash flow yields.
Separately from management guidance, how do we get comfortable with forward earnings? The company generated $0.88 per share for the year ended September 30, 2007. Management has a long history of meeting or exceeding guidance. In the most recent earnings call on November 8, management provided guidance of $1.12 per share for the year ending September 30, 2008. (Management guidance assumed a gold price of $750 per ounce and prices in excess of this amount provide significant upside.) The company's store base is rather immature with 40% of stores under two years old. If history is a guide, stores typically take four years to mature. For example, data released by the company shows that the portfolio of loans (i.e., income generating assets) from a store can increase 25% from year 1 to year 2. On a prior earnings call management stated that stores that were over two years old at the last anniversary had grown their loan portfolios by more than 20% year-over-year. Therefore, there is strong visibility into the considerable growth within the existing store base.
In addition, the company has been aggressively expanding its payday lending store base, an endeavor that has been more than fully funded by internally generated cash flow. We expect the company to grow rapidly over the next three to five years without the risk of reaching saturation According to recent industry research, a conservative population to support a profitable payday lending store is ~5,000. The number of payday lending stores in Texas implies a population per store of 14,250, signifying that Texas has room for an additional 3,000 stores. With EZPW's current number of payday lending stores in Texas of approximately 250, even in the face of increased competition, there is still significant room for growth.
To calculate the implied multiples we need to take into account "hidden assets" on the company's balance sheet. These include a minority interest in a UK publicly-traded pawn operator which has a market value in excess of the value it is carried on the company's balance sheet worth around $1.25 per share. In addition, we estimate that of the $22.5 million of cash at September 30, 2007 only $10 million is needed for working capital. We estimate these "hidden assets" to be worth in excess of $1.50 per share at September 30, 2007.
Taking into account these "hidden assets," EZPW trades at a forward P/E multiple of around 10.3x. The company's projected earnings growth rate is 15-20% per year over three to five years hence the implied PEG ratio is very attractive at around 0.5 to 0.7. A more typical PEG ratio would imply a near-term price of $17 to $20.
Our view is that the current valuation is extremely cheap, which has been caused by the market's temporary misunderstanding of EZPW's exposure to sub-prime contagion and that the prevailing prices represent a very attractive entry point.
Discosure: Funds affiliated with the author are long shares of EZPW and FCFS. The opinions expressed are those of the author and should not be relied upon.