In my two most recent articles reviewing Broke, USA, Gary Rivlin's book on the alternative finance industry, I have written about what are probably the best-known threats to the industry: regulation and corporate misbehavior. I believe that many of those who refuse to invest in the alternative finance industry refuse because of those risks. They fear that government regulation, such as interest rate caps, will end the industry's high returns. They are unnerved by the industry's risk of misbehavior. Such misbehavior includes not only obviously illegal activities, such as fraud and illegal collections practices, but also questionable if legal activities, such as lending in ways that encourage borrowers to enter a debt spiral.
However, I believe that it is often not the obvious risks that are the most important to an investor's returns, but rather the ones that people are unaware of. As I wrote in my article about regulation, alternative finance companies have consistently found ways to work around regulation. Even persistent accusations of misbehavior have not kept companies in the industry from outperforming the overall stock market year after year.
Rather, I believe it is the risk of competition, one that I feel many investors have failed to consider, which may be the most dangerous to the alternative finance industry's returns. I knew about the industry's problems with regulation and misconduct before reading Broke, USA. However, I had never realized the risk of competition to the industry. Competition is particularly pernicious because it results from the very competitive advantages that make the alternative finance industry such a good investment. Such virtues, as I mentioned in my first article about Rivlin's book, include high returns on investment, pricing power, and growth prospects.
And yet, despite the many fears about competition expressed by industry executives in Rivlin's book, it is possible that such fears are partially unwarranted. Despite significant competition, the alternative finance industry, particularly the largest integrated companies, still earns strong returns. Nevertheless, given the many comments about competition in the book, such complaints are worth investigating. This is particularly because such complaints tie in with the industry's risk from misbehavior. As Rivlin's book shows, the industry's competitive impulses are a major source of misbehavior.
In contrast, one risk, which does not seem worth worrying about is a fall in the price of gold. The falling price of gold has impacted the stock prices of a number of alternative finance companies, but Broke, USA is silent on this risk. Instead, the book implies that the price of gold is not as serious a risk as some might think.
The Perils of Competition…
Like in every industry, there has always been competition in the alternative finance industry. In Broke, USA, Gary Rivlin tells a funny story about competition in the early days of the industry. He describes how payday lending magnate Steve "Toby" McKenzie, who, at the time, was running a chain of rent-to-own stores, faced a particularly vicious competitor across the street from one of his stores. In Rivlin's words, "the warring between them seemed particularly fierce, with banners that said things like 'Don't be ripped off across the street!'" A friend of McKenzie relates how when he expressed his sympathies about this, "[McKenzie looked] at [him] with this big ol' grin on his face…and he [said], 'Joe, I own 'em both. The type of person who goes to a store like mine, they get all pissed off because you repossess, they get back at you by crossing the street. I'm just givin' 'em a place to go!'"
This anecdote is humorous, but the risk of competition in the alternative finance industry is no laughing matter. In Rivlin's words, everyone expected McKenzie's neighbor to be a genuine rival because of how profitable his business was. As McKenzie put it, if you "buy a television in a store…you might pay a 20 or 30 percent markup over the proprietor's price. But rent out that same TV by the week and you make several times what you paid for it." As a result, Broke, USA notes that "competition was inevitable in a business that lucrative."
Such competition has eroded much of the once lucrative returns in the alternative finance industry. As Rivlin describes it, because of competition and regulation, "the days of 20 percent or more profit margins are over…[payday lender] Advance America, for instance, reported a profit margin of 8 percent in 2008."
Looking at Advance America's (NYSE:AEA) results, it is indeed possible to see the decline in profits that Rivlin alludes to:
As one can see, both margins and returns on assets peaked around 2004 before declining inexorably.
The margins and returns of other alternative finance companies have also fallen, particularly those of other payday lenders. Perhaps the best comparison for Advance America is QC Holdings (NASDAQ:QCCO), another company almost purely devoted to payday lending. As shown below, the company's returns also peaked around 2004 and began declining steadily. Moreover, the actual decline was worse than that shown below. The company's 2013 numbers shown have been adjusted upward to take into account a large writeoff of intangible assets. This allows for an easier comparison with previous years. However, it is worth noting that the company's net income margin and return on assets would have been significantly negative without this adjustment.
Perhaps unsurprisingly, shortly after both Advance America and QC Holdings earned their highest margins and returns on assets, the number of payday lending stores in the US also reached its highest point.
One can imagine the reason for this. Once people saw how profitable the payday lending business was, they rushed to open new locations, creating competition for existing companies in the sector. This massive increase in locations saturated the market, driving down returns for everyone. Broke, USA illustrates this through the story of Chris Browning, a branch manager for payday lender Check 'n Go who became an industry critic after being fired in 2007. Browning's career reflects the trajectory of payday lending in the 90s and the 2000s. She became one of Check 'n Go's first branch managers in Ohio in the mid 90s, posting well above average numbers in her first year in business. In Rivlin's words, "[a] well-run store in a choice location back then might bring in $150,000 or $170,000 in fees each year; a strong store maybe $200,000. Browning, managing a store in a remote outpost two hours from the nearest big city, generated $247,000 in fees her first full year on the job and $251,000 in her second." However, "[by] 2000, she was no longer clearing $250,000 in fees per year, but revenue was in the $210,000 to $220,000 range through 2003, and edged back up to $235,000 in 2004." Probably not coincidentally, "[where] there had been five [payday lending] stores in town in 1999, there would be twelve by 2001," and by 2004, "there were twenty payday loan stores in town…[ultimately], this modest-sized working class enclave would become home to twenty-seven shops offering payday advances."
Broke, USA describes how such competition made business difficult. Through 2004, "[rivals] could keep opening new stores but revenues at the existing establishments would remain fairly steady." However, by then, "[the] battle was no longer a race to see who could secure a prime location but a war of dueling rewards programs and rival marketing campaigns." As a result, "corporate hounded [Browning] and the other managers to find new customers to replace the old ones whom they would invariably lose." Rivlin attributes Browning's souring towards the payday lending industry in part to this increased competition and the way it affected returns, which he believes also influenced her firing. In his words, "as her attitude toward payday soured and the competition grew more heated, Check 'n Go decided it had little use for a store manager with the fighting spirit of a longshoreman posting only average numbers." Such numbers were, of course, influenced by the fact that "whereas once [Browning's] had been the only store in her stretch of Mansfield, by 2006 three competitors had opened outlets only steps from her own."
Broke, USA offers additional anecdotes about the upsurge of competition in payday lending in the mid-2000s. In Rivlin's words, "[the] big payday chains even started to spawn their own competition. [Check Into Cash CEO Allan] Jones would grumble about the midlevel managers who gave notice 'thinking that making it was as easy as figuring out what kind of plane they was gonna buy.' [Advance America CEO] Billy Webster voiced the same complaint." Competition was also coming from people outside the industry. Rivlin describes "Erich Simpson, a former DuPont factory worker who opened his first of three payday shops in a rural stretch of South Carolina in 2004," the year of highest returns for the payday lending business. In Rivlin's words, "[the] numbers Advance America was posting naturally attracted even more wannabe moguls to the business."
Moreover, it was the very strengths of the payday lending business, which made possible this competition and the subsequent decline in returns. As I mentioned in my first article on Broke, USA, one of payday lending's most attractive characteristics is its high return on investment. Because payday lending locations generally have extremely limited capital requirements, they can earn high returns on that capital. Rivlin's book illustrates this by describing the early days of payday lender Check Into Cash. In Rivlin's words, "[by] 1998, a Check Into Cash team could open a new store in less than two weeks at a cost of $20,000. The new look conjured up something like a bank branch, though one outfitted at the local Office Depot."
Not only was very little investment required to open new locations, but such locations were almost immediately profitable. Again, Rivlin describes this, noting that "[on] average a new store would start showing a profit less than five months after opening. By its ninth month, it had typically generated enough cash to cover the initial start-up costs." In other words, new payday lending locations could generally earn a return on invested capital, or ROIC, of over 100%!
Given such high rates of return and the ease with which payday lenders could open new locations, it is unsurprising that they began to saturate their markets. As Broke, USA describes it, "[it] wasn't uncommon for Check Into Cash to open one store in an area and then open a bunch more, even if it meant opening branches no more than a few miles apart." One reason for such saturation tactics was the centralized nature of the payday lending business. The managers of payday lending locations are closely controlled by their superiors. In Rivlin's words, "they were given a policy manual that they were instructed to treat as if it were the word of God handed down from the mountain top. The manual spelled out in intricate detail the most mundane of tasks…[and] there were daily business reports that were to be faxed to the company headquarters at the end of each day." In this context, clustering stores together to fill a good area was a good strategy because "[clustering] meant better oversight and a more efficient use of marketing dollars."
Moreover, saturation was also a logical result of the way the payday lenders systematized their strategy of finding good locations for their businesses. In Rivlin's words, Check Into Cash, "would seek out a town's name-brand grocery stores and discount retailers. The Holy Grail was a shopping center anchored by a Walmart (NYSE:WMT), but a shop close to a Kmart (NASDAQ:SHLD) or a Kroger (NYSE:KR) was also pretty much a guaranteed winner." If every payday lending chain made similar calculations, they would all go to the same high quality locations, and thus begin stealing business from one another.
Of course, it is not difficult to see how such a strategy would cause a decline in returns. Indeed, Rivlin describes how because of this saturation, "Billy Webster was worried he was witnessing his own doom…[as] a reference point, he harked back to his decade in the fried chicken business. 'You'd never have a Popeyes and a KFC on the same corner as a Bojangles….but that's what you have now [with payday lending stores]. So you end up…with saturation problems from a business perspective.'" Rivlin also quotes Ted Saunders, a private equity executive focused on the alternative finance industry, who "tried explaining that the industry was approaching a saturation point" to various alternative finance industry owners. Unfortunately, for Saunders, "it was like the Wild West out there among the payday lenders and check cashers and pawnbrokers. These are people who have no fear and never had any fear." Of course, it is worth noting that Saunders said these things to try to convince those owners to sell their companies to him. However, it seems unlikely that he would make such a pitch about saturation in the industry if there wasn't at least a kernel of truth to it.
Moreover, once the payday lenders filled all of the same high quality locations, they began moving into more marginal areas in which they earned weaker returns. This can be seen in the "branch economics" table of QC Holdings' 2011 annual report:
Source: QC Holdings' 2011 Annual Report
As one can see, the later a branch was opened, the worse its economics were. This effect persists even more than a decade after a branch was opened - in 2011, the company's pre-1999 branches still brought in nearly twice as much in average per branch revenues as its branches opened in 2001, even though both groups of branches had been open for at least a decade. This means that newer payday lending branches did not have lower average branch revenues because they had not had time to mature. Rather, it appears that once QC Holdings had opened branches in all of the best possible locations, the company continued expanding into ever more marginal locations, earning weaker and weaker revenues per branch as it did so. One can imagine why the company would have done this - such locations might have offered weaker returns, but management may have hoped that they would also have less competition.
This tendency in the alternative finance industry towards saturation and expansion into marginal locations appears abroad as well. In one of my recent articles, which discussed UK pawnbroker Albemarle & Bond's (OTC:ABMLF) bankruptcy, I quoted John Nichols, the CEO of Albemarle & Bond competitor H&T Group (OTC:HTZZF). Nichols describes the UK pawnbroking industry similarly to Billy Webster, saying "[we've] been in business since 1897. Usually, there was just one competitor [on a street]. Now you'll have eight or nine." A Financial Times article puts numbers on this increase, noting that "[while there] were fewer than 600 pawnbrokers across the UK in 2007…[, in October 2013], there [were] more than 2,150." As I showed in my article, this rise in competition coincided with a major decline in Albemarle & Bond's core business. Many measures of the company's performance, such as inventory turnover and asset turnover, fell by up to 35%. Thus, I argued that Albemarle & Bond's slide into administration was not caused merely by overexpansion and the effects of the collapse in gold prices on its foray into gold buying, as has been reported in the media. Rather, the underlying reason was the decline in its historical pawnbroking business caused by competition.
The threat of such competition can also be seen, again, in the results of QC Holdings. That company's stock price has fallen by nearly 90% since the company's IPO in 2004, near the industry's peak.
Source: Yahoo! Finance
I believe competition has been particularly challenging for QC Holdings because it is one of the least diversified alternative finance companies. QC Holdings draws almost all of its revenues from payday lending. This is despite the fact that in Rivlin's words, "[diversification] has been the watchword of the forward-looking fringe financier in recent years." He describes how the various payday loan companies he profiled, including Advance America and Check 'n Go, had begun offering services such as check cashing, wire transfers, and even title loans. He quotes Allan Jones as explaining this diversification by saying "'Before we were just focused on taking care of our customer…[now] we're trying to survive.'" In other words,, it appears that many companies in the alternative finance industry equate diversification with survival in the face of competition.
...Drive Diversification, Which Brings Its Own Perils
And yet, diversification brings its own challenges. In my first article on Broke, USA, I described diversification as one of the great growth opportunities for the alternative finance industry. Not only can larger, diversified alternative finance companies take market share from smaller pure-plays, but such diversification may allow the larger companies to operate more cheaply. After all, payday lenders charge triple digit interest rates in large part because they have high fixed expenses relative to their volume of business. As a result, they need to charge high rates to cover operating costs such as rent and salaries. However, a payday lender that is part of a larger operation, such as a pawnshop, can serve as a source of additional revenues without creating many new expenses. Such a lender can therefore win market share by charging lower rates.
However, diversification also poses many problems, both for the diversifiers and for the companies already operating in the areas into which companies diversify. One such area is the tax preparation business. Traditionally, tax preparation companies such as Jackson Hewitt and H&R Block (NYSE:HRB) have served many of the same customers as the alternative finance industry. One reason for this is because such companies could offer loans against borrowers' tax refunds. Though this practice was largely banned by 2012, in the interim, many alternative finance companies had expanded into the tax preparation business. In Rivlin's words, "Almost every enterprise that's part of the fringe economy takes a stab at the tax return business. That's something that [Instant Tax Service CEO] Fesum Ogbazion griped about…all those pawnshops and check casher operations and even used car lots encroaching on his turf."
This sort of competition is another example of competition resulting from one of the industry's virtues. In this case, the virtue of diversification into new lines of business results in the vice of increased competition for companies already in those lines of business.
The difficulties created by this sort of competition are obvious; however, another, less obvious problem is the threat of diversification to the diversifiers themselves. A company's attempts to diversify itself either geographically or into new lines of business can create new sets of risks. A company trying to diversify itself geographically might take on too much debt to do so. Alternatively, it might execute badly in trying to expand into new business lines. Finally, those business lines might create new weaknesses for the company.
Such risks can be seen in the story of Albemarle & Bond, the UK alternative finance company I alluded to earlier that went into administration. Albemarle & Bond diversified heavily before its bankruptcy. The company moved into the new business line of gold buying, opening dozens of locations solely devoted to that business. It also diversified geographically by opening large numbers of new locations. In the popular account, such diversification was later blamed for the company's slide into administration. Media reports described the company's bankruptcy as being caused by the large amounts of debt taken on to open those new locations. Those reports also blame the bankruptcy on the company's gold buying business. The gold buying business made Albemarle & Bond vulnerable to fluctuations in the price of gold, and when that price fell, so did the company's profits, causing it to violate the earnings covenants on its debt.
In my article, I argued that the popular account ignores the underlying reason for the bankruptcy, which was deterioration in the company's core business due to competition. However, it is true that the direct cause of Albemarle & Bond's fall was the one found in the popular account. Indeed, one can say that Albemarle & Bond succumbed to problems directly caused by its attempts to diversify its business.
This theme of problems caused by diversification can also be seen in the story of DFC Global, whose June 2014 buyout by Lone Star Funds was the subject of my most recent article. In my first article about Broke, USA, I described how Europe is the new hope for many alternative finance companies. Rivlin's book describes Allan Jones as saying "Europe makes him nostalgic for the United States in the mid-1990s, when most of the country was still virgin territory."
One company that took this to heart was DFC Global, whose major expansion into Canada, the UK, and continental Europe I described in that first article about Broke, USA. That article used the company as an example of how some companies in the alternative finance industry are trying to escape competition through geographic diversification.
However, DFC Global also illustrates the perils brought by diversification, particularly those brought by debt-driven expansion. In my article about the DFC Global acquisition, I described how the company was chronically highly indebted due to its constant geographic expansion. It consistently maintained a ratio of Debt to EBITDA, or earnings before interest, taxes, depreciation, and amortization, of over 4. It also earned on average only 1.7 times the EBIT, or earnings before interest and taxes, necessary to pay its interest costs.
This became a problem when the company ran into temporary trouble in 2012 and 2013 due to regulatory changes in the UK payday lending market, a major source of revenues for the company. As DFC Global's earnings fell, the company's bankers imposed onerous covenants on the company out of fear that it might not be able to service its debts. As a result, the company was forced to sell itself at a bargain price to private equity firm Lone Star Funds. It did so out of concern that its continuing troubles might cause it to violate those covenants, which mandated a certain level of earnings and fixed expense coverage for the company. If such a violation had occurred, the company might have gone down the path of Albemarle & Bond.
DFC Global's fate was different from that of Albemarle & Bond because its core business had not lost the ability to earn high returns. However, DFC Global's fall does illustrate an indirect risk of competition to the alternative lending industry. The company diversified rapidly into Europe to take advantage of a market without major competition. In doing so, the company took on excessive debt. That turned a temporary business problem into a permanent investment loss when most of the company's investors were forced to sell their shares to Lone Star below the price at which they bought them.
Thus, it is true that the managers of alternative finance firms can at least partially protect their companies from competition by expanding into new markets and new business lines. However, such diversification also creates the risk that those managers will execute badly on their expansion plans, such as by going into excessive debt, thus destroying shareholder value. Because the rationale given for such diversification is often competition, such destruction of shareholder value is often an indirect result of competition.
Broke, USA offers additional anecdotes about the risk that unwise expansion will destroy shareholder value in the alternative finance industry. As I mentioned above, Allan Jones described to Rivlin the alternative finance industry's many opportunities in Europe. However, instead of expanding into Europe, Jones instead chose to expand into Texas. In Jones' words, he thought, "Why go to Europe if you haven't been to Texas yet?" As it turned out, this decision proved to be a major mistake. "Texas has been a consistent money loser" for Jones, who told Rivlin, "I can't tell you how many times I kicked myself for that decision." This account shows the execution risk taken on by alternative finance companies trying to diversify into new regions. There is always the possibility that they will make some sort of mistake, such as picking the wrong place to diversify to.
Similarly, there is also the risk of diversifying into the wrong line of business. Broke, USA illustrates this through another story about Allan Jones. In Rivlin's words, with criticism of and regulatory attention on payday lending increasing, "Allan Jones decided it was time to hedge his bets. He knew nothing about selling cars but he certainly knew the poverty industry, and so in 2005 he took the plunge into the used car business."
As Rivlin describes it, this venture into used car sales has been a disaster:
Jones told me he hated the used car business…it only brought headaches from day one. "It's really the collections business," Jones said. "A lot of these people have weekly payments so you need to be on them after every paycheck." It's even more labor intensive than payday, he said. "These people, they don't send in their checks, they stop by the lot on their way someplace," Jones said. "So you have to stop whatever you're doing, call up the file, and mark their payments." Under Tennessee law, he can charge an interest rate of 21 percent, but that's too low, he complained, given the customers he deals with. He estimated that one in four loans were past due, and invariably a portion of those were going to be written off as losses.
Of course, it's hard to tell if these difficulties are because of inherent problems with the used auto business, or because of execution problems. Either way, Rivlin's account illustrates how the way competition drives diversification can cause problems for shareholders in the alternative finance industry. When competition spurs alternative finance managers to diversify their companies, they might pick the wrong place or wrong business line to diversify into. Even if they avoid doing so, the manager may still execute poorly in building its new business. Regardless, if such problems occur at a publicly traded company, shareholders will suffer.
Thus, diversification is a major opportunity for companies in the alternative finance industry to grow, but when such companies diversify into other areas of the industry, they create competition for the companies already in those areas. Moreover, when alternative finance companies are driven to diversify, they encounter new threats, such as going into excessive debt, and new risks, such as the execution risk of trying to operate in new regions or lines of business.
As an aside, there is also the possibility that competition might cause alternative finance lenders to begin relaxing their standards. Though my reviews of Rivlin's Broke, USA have largely focused on tax preparers, pawnshops, and payday lenders, Rivlin actually spends much of his book focusing on the subprime mortgage industry. As many know, competition between subprime mortgage lenders in the 2000s drove many of them to lower their lending standards, helping precipitate the financial crisis of 2007-2009. More recently, I noted in my article about Albemarle & Bond that the quality of the company's borrowers declined as the company lost more and more business to new entrants to the pawnbroking industry. Fortunately, we don't appear to have seen that sort of decline in borrower quality in the American alternative finance industry, but it is yet another potential threat driven by competition.
…May Drive Misconduct
Of course, lending to poor quality borrowers is not the only type of questionable behavior in the alternative finance industry that might be encouraged by competition. In my recent article about misbehavior in the alternative finance industry as illustrated by Broke, USA, I described a number of unethical, even illegal lending practices, such as making loans that encourage borrowers to enter a debt spiral and making inappropriate threats while trying to collect on a loan. One threat is that the pressure of competition may drive alternative finance companies towards this sort of behavior.
The reason this might happen is because competition threatens the key to an alternative finance location's performance-loan volume. Because the majority of costs for a payday lender are fixed, any increase in revenues flows almost entirely to profits. Revenues in turn are driven almost directly by loan volume because most alternative finance lenders charge similar interest rates. This sort of operating leverage is great if loan volume is increasing, but any decrease in loan volume is a serious problem because even a small decrease in revenues can cause a major fall in profits for a branch.
Broke, USA describes loan volume's importance to a payday lending location through the story of the aforementioned Chris Browning. Rivlin describes how Browning received an "actual Check 'n Go directive informing store managers that they were to loan 'to anyone getting social security who had at least one dime to their name.'" Similarly, the book notes that "Check 'n Go programmed its computers to spit out lists of customers who had gone sixty days without taking out a new loan…Browning said '[they] were supposed to call every person on that list and then also send them a letter. And that person kept showing up on your reports until they came back in.'"
Such behavior was designed to increase loan volume, even if it was questionable based on the standards of the payday lending industry itself. As I have noted in several of my articles, the industry's lobbying association, the Community Financial Services Association of America, or CFSA, describes payday loans on its website as "short-term financial assistance… intended to cover small, often unexpected, expenses." That organization also describes them as a "financial taxi" and notes that just as "[a] taxi service…is not economical for long-distance travel…a payday advance is inappropriate when used as a long-term credit solution for ongoing budget management." A strict reading of this description makes Check 'n Go management's directives seem rather odd-after all, it's not as if taxi companies regularly mail former customers to convince them to take additional taxi rides.
Rivlin interviewed Jared Davis, the head of Check 'n Go, to see how he explained such actions. Davis said that "with increased competition, [everyone in the industry does] what [they] can to find an edge." In his words, "payday lending isn't like it used to be where you just open a store and make money…you have to keep your brand out there in front of people." In other words, the rise of competition has driven payday lending companies to be increasingly aggressive in marketing themselves to potential borrowers.
This is hardly surprising when you think of how competition threatens an alternative finance lender's loan volumes. We have already seen how revenues at Chris Browning's payday location fell as competitors opened branches nearby, taking away business. However, such behavior is concerning because this sort of aggressive marketing may reflect aggressive behavior in other areas as well. In July 2014, the Consumer Financial Protection Bureau fined payday lender ACE Cash Express $10 million for a variety of practices. In the description of the fine, the CFPB noted that:
ACE would encourage overdue borrowers to temporarily pay off their loans and then quickly re-borrow from ACE. Even after consumers explained to ACE that they could not afford to repay the loan, ACE would continue to pressure them into taking on more debt. Borrowers would pay new fees each time they took out another payday loan from ACE.
The CFPB's fine was not primarily targeted towards ACE Cash Express' marketing efforts, but rather its collections tactics. However, in a way, those collections tactics were actually a type of marketing effort, if an overly aggressive one. According to the Bureau, ACE's collectors falsely threatened individuals that they would be subject to lawsuits or criminal prosecution for not paying their debts. The company also harassed delinquent borrowers. Such tactics were, interestingly, not focused on trying to get borrowers to pay off their loans. Rather, they were intended to urge them to take out new ones. In other words, even though such tactics were in theory part of the company's collections efforts, they were designed to support the company's marketing goal of generating additional loan volume.
The CFPB describes such a strategy of urging borrowers to take out new loans to pay off old ones as abusive. However, Broke, USA shows the importance to the payday lending industry of loan volume from this sort of repeat borrowing. In Chris Browning's words, "repeat borrowers are the payday loan institution's bread and butter." Browning also describes how many of her borrowers were paying off old loans with new ones, often doing so at multiple payday lenders.
In that context, it is unsurprising that store employees would try to create more repeat borrowers by taking advantage of the captive audience created by delinquent borrowers. After all, such borrowers are already subject to collections phone calls, so it makes sense that managers would try to use those phone calls to drive additional loan volume, even through deceptive collections practices. This connection between the quest for loan volume and misbehavior is even made explicitly in Rivlin's book by a former payday lending manager named Tom Kirk, who blamed employee misbehavior on the fact "that employee bonuses were based largely on volume."
Such practices appear to occur at other types of alternative finance companies as well. In May 2013, Paul Kiel of the investigative journalism organization ProPublica wrote an article detailing the practices of subprime installment lender World Acceptance Corporation (NASDAQ:WRLD). The article described how the company aggressively urged borrowers to renew their loans. In Kiel's words, "[the] goal of…calls and visits [to delinquent borrowers] is only partly to prod the customer to make a payment. Frequently, it's also to persuade them to renew the loan." Though in theory a borrower had to make a payment towards his or her loan to renew that loan, the payments needed to renew a loan could often be very small. Kiel describes payments of only a single dollar to renew a loan of thousands of dollars, or in some cases, no payment at all. The goal of such actions can only be, of course, an attempt to drive loan volume. And, like with the payday lending industry, World Acceptance Corporation has become associated with not just aggressive marketing, but also other complaints of improper behavior, including problematic collections practices. The ProPublica article describes delinquent borrowers who were threatened with confiscation of their furniture and who received harassment at their workplaces, despite such behavior being either illegal or highly questionable under Federal Trade Commission and CFPB rules. Perhaps because of such behaviors, the company is now under investigation by the CFPB.
Thus, what drives much of the misbehavior in the alternative finance industry is the desire for additional loan volume. In turn, competition indirectly causes this misbehavior because it threatens loan volumes. When volumes fall, not only are alternative finance lenders tempted to market aggressively - perhaps too aggressively - but they are also tempted to push the borrowers they already have to take out additional loans. In doing so, lenders sometimes cross the line into overt illegality, which threatens shareholder returns. After all, not only does illegality bring fines and reputational damage, but it threatens the possibility of more serious regulatory damage that could shut down entire businesses. For example, because of what it sees as excesses in the payday lending industry, the UK's Financial Conduct Authority has outlined new regulations which are likely to shut down 99% of payday lending firms in that country, according to the Financial Times. Similarly, Seeking Alpha contributor Abdalla Al-ayrot described World Acceptance Corporation in a February 2014 article as being "likely to be bankrupt in 2014" due to its actions.
Such threats offer a reminder of how the drive for loan volume can cause misbehavior in the alternative finance industry. This drive for loan volume is in turn spurred by competition. Thus, I do not think it is unreasonable to say that at least some misbehavior is a direct result of competition in the alternative finance sector.
…Are Perhaps Exaggerated?
Given all that I have written in this article about Broke, USA's description of the threat of competition to the alternative finance industry, it is perhaps ironic that competition might not be the threat that the industry describes it to be. Rivlin seems to allude to this through such anecdotes as his interview with Tim Thomas, the owner of Daddy's Money, a pawnshop in Wichita, Kansas. In Rivlin's words:
Daddy's Money faces stiff competition. A partial list of rivals within the Wichita city limits includes A-OK Pawn, the Pawn Shop, King's Pawn, Cash Inn, Money Town, A Loan at Last, Aces' Pawn, Air Capital Pawn Shop, Cash Inn Pawn, C&C Pawn Shop, Country Pawn, Easy Money Pawn Shop, Mr. Pawn, and Sheldon's Pawnshop. But apparently even in the country's fifty-first most populous city, with 350,000 residents, there's more than enough business to go around. Daddy's Money, Thomas acknowledged, turns a handsome profit.
Daddy's Money is not unique in this. Earlier, I mentioned how Broke, USA uses the example of Advance America's falling profit margins to illustrate how competition has worn away at the alternative finance industry's returns. That has certainly happened, but if one considers the company's net margins from 2005 onwards, one sees essentially stable and fairly high margins. By incorporating the results from Grupo Elektra's US operations in 2012 and 2013 - which consist solely of Advance America locations - it is possible to see that this trend continued after its 2011 acquisition.
Indeed, Rivlin's book acknowledges this continuing strength in the face of competition by noting that "despite the increased competition and greater regulatory prescriptions, Advance America's profit margin [reported in 2008] would place it ahead of more than 60 percent of the companies in the Fortune 500." Likewise, QC Holdings' net income margin, adjusted for one-time expenses, stayed strongly positive between 2005 and 2013, despite its troubles:
Similar results can be seen for the major integrated alternative finance companies, such as Cash America International (NYSE:CSH):
And similarly with First Cash Financial Services (NASDAQ:FCFS):
This stability of margins between 2005 and 2013 is particularly remarkable because those years not only saw the financial crisis, but also the establishment of much payday lending regulation and the creation of the CFPB. Moreover, they have also seen the rise of online lending, another major source of competition.
I believe this bodes well for the industry. It implies that despite strong competition, the industry will still be able to earn high returns. One reason for this, I believe, is the rise of large, diversified alternative finance companies to dominate the industry in the US. Despite the risks of diversification, the largest US alternative finance chains have successfully become "one-stop shops" offering pawn and payday lending, check cashing, debit cards, and other services. Rivlin describes this process in Broke, USA:
"There may have been a time when the poverty industry wasn't a single entity so much as splintered, competing interests fighting over the same clusters of customers. But the pawnbrokers became check cashers and the check cashers ventured into payday, as did rent-to-own. And more recently the payday lenders started getting into check cashing, money orders, refund anticipation tax loans, and any other business that might bring in additional revenues. They all learned the same tricks for maximizing revenues from the same sources, each category of business grew plump with profits due to the same set of broader economic factors"
When I read this passage, I sense the possibility that competition will not be the threat that many of those quoted in Broke, USA seem to imply that it is. It is true that Ted Saunders, the private equity executive I mentioned earlier, has argued that these "better-funded, better-managed companies [will] crush the smaller players." However, public investors will benefit from this scenario. After all, the better funded companies that Saunders describes will likely also be the publicly traded companies that investors can buy shares in. Moreover, as we have seen elsewhere, mature, diversified companies like those Saunders describes can often compete aggressively with one another while still delivering high shareholder returns. For example, Coca-Cola (NYSE:KO), Pepsi (NYSE:PEP), and Dr. Pepper Snapple (NYSE:DPS) are vigorous competitors in the US beverage market, but that has not kept them from delivering high returns for investors.
Thus, I believe there is evidence in Broke, USA that the US alternative finance industry will be dominated by a small number of major diversified operators. Such operators would compete vigorously with one another, but all of them would earn healthy returns, if not returns as high as they might have once earned. If such a scenario comes to pass, it is likely to be a good one for public investors in the industry.
What Isn't a Risk: Falling Gold Prices
If Gary Rivlin's Broke, USA offers much evidence - if somewhat contradictory evidence - about the risk of competition to the alternative finance industry, it is silent on one threat to the industry, which has been in the news - falling gold prices.
That's somewhat ironic, given that when I was reading the book in 2013, the news was filled with accounts of how falling gold prices were affecting the share prices of alternative finance companies. A July 2013 Wall Street Journal article described how "First the Gold Bugs Got Stung, Now the Pawn Shops." An October 2013 article from The Motley Fool attributed fluctuations in the share prices of EZCorp (NASDAQ:EZPW) and Cash America International to falling gold prices. In July 2013, NPR even asked rhetorically in a broadcast whether falling gold prices would drive pawnshops out of business in the same way that falling housing prices drove banks out of business. That question was answered with a firm "no" by a pawnshop owner, though only a couple of months later Albemarle & Bond would announce that falling profits from gold sales meant that it was having trouble with its loan covenants. That announcement, of course, presaged the company's eventual slide into administration.
There are several reasons why Broke, USA never mentions the threat from the price of gold. First, there is the obvious issue that the book was written before gold prices crashed in 2012 and 2013. Also, it focuses primarily on the payday lending and subprime mortgage businesses, whereas gold price movements primarily impact the pawnbroking industry.
However, I believe the book's silence about the threat of gold prices shifts also reflects a deeper lesson - that fluctuations in the price of gold should not frighten investors in the industry.
I believe this implicit lesson can be found in what Rivlin does write about the economics of pawn lending. Broke, USA describes a conversation he had on the subject with the aforementioned Allan Jones:
"The rule of thumb with pawn is you pledge three times collateral," [Jones] said. So if one of his clerks thinks they can sell a flat-screen TV for $300, they will loan that person $100. That borrower pays a little more than $20 a month in interest on that $100 (Tennessee allows pawnshops to charge a 256 percent APR); meanwhile, the pawned item remains in the shop's back room as long as that customer keeps current with his or her loan. If that customer can't repay the loan or decides not to, the shop puts the item up for sale. "I make money if they can pay off the loan," Jones said. "I make money if they can't pay off the loan."
Indeed, this quote fits with the conclusion presented in the NPR broadcast. In the words of corresponded Lisa Chow:
…pawnbrokers have always been more conservative. Of the ones I spoke to, nobody said they lent amounts greater than 70 percent of gold's value. That's like the entire banking industry demanding a 30 percent down payment on every house. Pawnshops, they don't want you to default.
In light of this, it is interesting that Chow notes that "During the recession, when gold prices started rising, default rates went up because people could borrow so much more money with their gold." That seems almost to imply that rising gold prices are bad for pawnbrokers. Of course, an increase in the price of gold also increases the size of the loans that can be made using that gold as collateral, thus increasing loan volume and loan revenues for a pawnbroker. However, it is interesting that Chow's words about the conservatism of the pawnbroking industry correspond with Rivlin's in Broke, USA.
Similarly, I have also argued that the Albemarle & Bond bankruptcy was not fundamentally a result of falling gold prices, even if that was the immediate cause. As I have argued, the underlying reason why the company went into administration was actually because of deterioration in its fundamental operations.
Indeed, if one looks at the very stock prices that some have cited in describing the effect of gold prices on pawnbrokers, one can see how operating results are what matter, not gold prices:
Source: Yahoo! Finance
As one can see, the share prices of several major US alternative finance companies have diverged drastically in the past several years even though all of them have been affected by fluctuating gold prices. EZCorp's shares have plunged due to operating problems - including the Albemarle & Bond bankruptcy. In contrast, those of Cash America International and First Cash Financial Services have gone up significantly. I believe this is because the latter companies have not had similar operating problems. Gold prices, as we know, have fallen moderately.
Even if one fears the effects of falling gold prices on the alternative finance industry, it is worth noting that falling gold prices are by their very nature a temporary risk. After all, a sharp decline in the price of gold cannot occur every quarter or even every year. Moreover, gold prices have a natural floor in their cost of production. The price of gold cannot stay below the cost of production for long, because if it does, production will decline and prices will go back up.
Given that fact, it is interesting to consider the current situation in the gold mining industry. Seeking Alpha contributor Hebba Investments noted in a recent article that "all-in cost to mine gold of many miners is above the current gold price." Bloomberg reported the same in a November article, while a September 2014 Reuters article takes the issue to its logical conclusion by saying that "[the] price of gold…is approaching the tipping point where the mining industry would see a spike in the number of producers reducing output or even shutting down operations." Of course, there are those who disagree with this theory, such as a study cited in Bullion News that notes reasons why a price of gold below the cost of production would not necessarily mean gold prices have to rise. However, overall, I think it's reasonable to believe that a serious decline in the price of gold is unlikely in the future.
Thus, I do not believe that falls in the price of gold are a serious threat to the alternative finance industry. Broke, USA persuasively describes the strength of the pawnbroking model, a strength confirmed by outside sources. Moreover, a collapse in gold prices is by its very nature a temporary event that will only permanently affect a pawnbroker such as Albemarle & Bond that is overleveraged and/or already experiencing other problems. Finally, it seems unlikely that a sharp decline in the price of gold will occur anytime soon unless gold prices spike again first, given the current state of the gold mining industry.
In conclusion, competition is the "dark side" of the advantages that make the alternative finance industry such an attractive investment. Key advantages of the industry are its high returns on capital and low capital expenditures required for growth. However, these advantages also make it easy for rivals to enter the space. Once those rivals appear, they compete away the high margins and returns that made the industry so appealing in the first place. Moreover, competition is a serious threat because it can affect perhaps the most important metric for an alternative finance company - per store loan volumes, and by extension, per store revenues.
In addition, the efforts that companies take to avoid competition, particularly diversification into new areas of business and new regions, can also create new risks for investors in the form of excessive debt and execution risk. Similarly, the threat of competition can drive employee misconduct, particularly in marketing and collections. One can see the effect of competition in the decline of QC Holdings, in the bankruptcy of Albemarle & Bond and sale of DFC Global, and in the fines leveled on any number of alternative finance companies for questionable practices designed to drive loan volume.
That said, that does not mean that competition will make it impossible for investors in the industry to earn high returns in the long run. In my mind, the alternative finance industry is different from, say, the airline and shipping industries, where competition erodes away almost all shareholder returns. Instead, I believe many businesses in the alternative finance industry will thrive, even in the face of competition. Moreover, those businesses will probably be the largest companies, and thus the ones that public investors are most likely to own shares in. As with most industries, it is merely up to the enterprising investor to find those companies, and to invest in them.
Some concluding thoughts about Broke, USA and the alternative finance industry will be the subject of my final article in this book review series, "Understanding The Alternative Finance Sector Through Gary Rivlin's Broke, USA, Pt. 5: Final Thoughts."
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