EZCORP Has Been Treading Water While Improving

| About: EZCORP, Inc. (EZPW)
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EZCORP terminated an expensive and unnecessary advisory agreement with a firm controlled by its controlling shareholder, saving $0.09 to $0.10/share a year in expenses, and named a new chairman.

I don't like the company's decision to reallocate gold jewelry to retail (from scrapping), but the company's Mexican lending operation is leveraged to improving employment and consumer confidence.

By almost any metric EZCORP seems too cheap unless you believe it can no longer generate double-digit margins and/or asset turnover in excess of 1.0.

Eight months ago, I wrote that while EZCORP (NASDAQ:EZPW) had some interesting turnaround potential, I really didn't like the company's operating/ownership structure, nor its operating model. Prior to an announcement in May that I believe is transformative for the company, the shares were tracking down around 5% and the quarterly results were still showing some pressure. While the company is likely to see ongoing pressure in scrapping, comps should start getting easier later in calendar 2014 and the company's valuation is undemanding.

Fixing A Large Problem

One of the things I really disliked about EZCORP was the "advisory agreement" between Madison Park and the company. EZCORP paid over $7 million a year in fees and expenses for this agreement, and it wasn't just coincidence that Madison Park is owned by the controlling shareholder of EZCORP (Phillip Cohen).

Rehashing all of this is moot now, but in my opinion this was little more than a way for Mr. Cohen to enrich himself at the expense of EZCORP shareholders. Madison Park supposedly offered services like "identifying, evaluating, and negotiating potential acquisitions," but the company's investment in Albermarle & Bond has been a disaster (written down to zero) and its overall overseas acquisitions/expansion have left much to be desired.

To the board's credit, it has taken action - terminating the advisory agreement as of June 19, 2014. The board has also elected a non-executive chairman (William Love) and created an independent governance committee. Prior to this move, the former chairman (Sterling Brinkley) was making over $1 million a year for his services ($1.3 million in 2013).

With these moves, I wonder if Phillip Cohen is reconsidering his involvement with the company. He owns all of the Class B voting stock, giving him virtually complete control over the board and company. These shares could be converted to Class A shares and sold and once all of the Class B shares are so converted, the Class A shares become voting shares.

Core Operations Still Under Stress

As of the company's last quarterly report, there's still meaningful stress in the operations. Retail same-store sales were up 4% in the first quarter, which is a pretty solid result compared to First Cash (NASDAQ:FCFS) (up 3%) and Cash America (NYSE:CSH) (negative). Scrapping is still quite weak (sales down 39%) and I still do not agree with the company's decision to forgo scrapping in favor of diverting gold jewelry to retail sales. This slows the inventory turnover and, in my opinion, simply stretches out the pain as opposed to taking First Cash's approach and just taking the hit from weaker scrap results.

The loan business is also still off its pace. Loan fees were up 7% in the first quarter and U.S. balances were up 17% on strong growth in auto title and installment lending, but bad debts are still 20% of fees - better than the fiscal fourth quarter results in 2013, but still elevated. Mexico is doing better - balances were up 23% in the payroll withholding loan business and bad debts are only 3% of fees. That growth compares nicely to the 6% growth in Mexican lending that First Cash saw, and I would think it is due in part to increasing competition in pawn lending (bad for First Cash) and improving consumer confidence/employment in Mexico (good for EZCORP).

Multiple Avenues For Better Performance

I believe EZCORP can credibly expect growth in both its U.S. and Mexican operations in the coming years.

The U.S. pawn market is still largely unconsolidated and First Cash has been moving more aggressively recently to build scale in attractive markets (EZCORP's U.S. store count is more than three times as large). I'm a little skeptical that EZCORP is going to significantly improve its growth prospects with greater use of online selling channels, but this has grown to about 8% of sales without any real margin impairment, so it is at worst a "push" at this point. Looking down the road, EZCORP's operating scale should become increasingly valuable in terms of optimizing pricing and pawn terms and should allow the company to participate in a consolidating industry where regulatory changes are making life more difficult for smaller players.

In Mexico, the company still has a smaller footprint than First Cash (about half as many stores), but a different business mix. Unlike First Cash, which is heavily focused on merchandise-based pawn lending, EZCORP continues to expand its payroll withholding lending operations. While there have been indications that the Mexican government might move to tighten up regulations for this type of lending, the reality is that Mexico is significantly under-banked and lending options like payroll withholding are an important source of credit for Mexican consumers. As pawn lending is predicated upon having valuable items that customers can do without (at least while it serves as loan collateral), payroll witholding lending is more leveraged to job growth and consumer confidence and perhaps a better play on the nascent economic recovery in Mexico.

Expectations Seem Quite Low

EZCORP isn't particularly well followed on the Street, and perhaps that explains why the valuation looks as it does. I don't think 7% to 8% annual growth (on average) over the next decade is a particularly bold projection as the company gets past these scrapping challenges, and likewise I don't think that projecting a return to FCF margins in the neighborhood of 10% is aggressive. Yet, discounting those cash flows back suggests a fair value of almost $23 with an elevated discount rate. Even if I cut the revenue growth to 5% a year, I come up with a fair value above $19.

EV/EBITDA and excess return models likewise suggest undervaluation. Just 6x forward EBITDA estimates can support a $14 fair value and if EZCORP's long-term ROE is 15% (versus a simple 10-year trailing average of 16.5%) that supports a fair value of around $19. To work back to today's price, you have to use a 10% long-term ROE and that basically means a net margin of 10% going forward and no improvement in asset turnover (which is currently the worst it has been in a decade).

The Bottom Line

Unless I'm missing something big, I can't reconcile why this stock shouldn't trade closer to $15 (and I think there's a credible argument to make for $19-plus). I understand that the scrapping environment is still poor and I don't like how the company is handling scrapping, but I think that has to be weighed against the growing Mexican lending operation and the significant shareholder-friendly moves in terminating the advisory agreement and naming a non-executive chairman. I'm not going to sell my First Cash shares in favor of owning EZCORP, but these shares seem to be really cheap today even without a huge turnaround in the business.

Disclosure: The author is long FCFS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.