goeasy: Their Competitors Are Leaving The Market
- goeasy has a strong market runway as payday loan lenders are regulated out of the market.
- Minimum wage changes improve their clients' ability to pay back their loans.
- Trading cheaply based on quickly growing earnings.
goeasy (OTCPK:EHMEF) [TSX:GSY] operates in two business segments – leasing and financial. These are related businesses, as they operate out of many of the same locations and cater to the same customers. The leasing business is the legacy operation, and requires more space. The company sells and leases furniture, appliances, and electronics. Leasing with weekly or monthly payments is their primary business, and has much higher margins than a standard furniture store. Of course, because the company is leasing goods, they inevitably get a material portion of them back. That means that even though a standard white coil top range and stove (estimated retail value ~$500) would cost a total of $2808 through EasyHome, they are fairly likely to get it back before the end of the three year term. Effectively, this business is a mix of hard goods retailer and subprime lender.
Their newer and faster growing business is EasyFinancial, which skips the retail portion of the business and simply makes subprime loans. This expands the potential size of their market, because it allows them to provide funds for subprime clients for any reason, not just because they want a new couch or Xbox. These loans have terms from 9 months to 5 years with sizes of $500 to $15,000 available. There are a number of advantages to both the consumer and the company of this model as compared to the payday loans that are their major competitor.
The first is that it reduces the handling costs of making the loan. Payday loans are for short terms with high fees, which are necessary to cover the fact that interest (even at very high rates) is a nominal amount of money over short timeframes. These very high origination fees are necessary to cover the high amount of customer interaction/cost per dollar of loan value. Because goeasy has longer loan amortizations (at lower but still very high interest rates) it can reduce the fee burden because it is more efficiently deploying capital than payday lenders. The increased efficiency from reducing the number of origination transactions to deploy the same capital can be shared between customers and the company.
The company’s business has been and should continue to benefit dramatically because of recent changes to government legislation in Ontario, which is Canada’s biggest market by far. The government has restricted payday lenders by legislating their maximum fee. It decreased from an initial $21 per $100 of loan amount to $18 per $100, and has changed again on January 1st, 2018, down to $15 per $100 of loan advance. This is effectively another 20% price decrease mandated by the government on the payday loan industry, which is likely to significantly impact their ability to operate. Alberta has recently enacted similar legislation that caps payday loan charges at $15 per $100 borrowed.
The Ontario legislation also mandates that payday lenders will be forced to convert loans to installment loans with a maximum duration of 2 months on the third renewal of a loan. That will disrupt some of the most profitable business payday lenders have, which is from customers who continually renew the same payday loan over and over again, paying only the interest and fees each time. These forced installment loans (and their relatively large mandated payments) will likely push people to replace payday loans with longer term loans such as those provided by goeasy.
These changes have reduced the competition faced by goeasy substantially as payday lenders have been steadily exiting the market. This includes the exit by well-funded foreign players who were operating online only, which is the most efficient end of the payday loan spectrum. As just one example, the market leader from the UK expanded into Canada, but closed its Canadian operations in 2016.
The scale of the changes is material, with nearly 30% of licensed payday loan locations in Alberta closing in the 21 months since the Alberta Government tightened its rules. This leaves a much larger space for term loan competitors, and gives goeasy a natural tailwind.
Another external factor that will provide a big boost for the company is legislated changes to minimum wage. In Canada, minimum wage is a provincial responsibility, and the provinces have been raising the minimum wage dramatically. Every province in Canada had an increase of at least inflation in the minimum wage in 2017, and some of the increases were much more material than that. As a couple of examples from the bigger provinces where goeasy operates, Alberta changed its minimum wage from $12.20 to $13.60 as of October 2017, and it will go to $15.00 in October 2018, a 23% increase in total. Ontario also has had a big increase, with minimum wage going from $11.60 to $14.00 on January 1st, 2018, and another increase to $15.00 on January 1st, 2018. These increases provide a materially improved ability to pay for those at the bottom of the economic spectrum. Also, an increased minimum wage tends to boost wages at the lower end of the wage spectrum even among those who weren’t previously making minimum wage, as the fast food supervisor probably will always make a few dollars per hour more than the workers they manage, as just one example.
Ontario and Alberta are the company’s two biggest jurisdictions, with a combined 48% of leases and 56% of loans as of their most recent financials, the 2017 Annual Report, so improving wages in those provinces should continue to improve their bad debt expenses, which have been trending downward as a percentage of the portfolio recently.
The other big potential concern for the company is the economic expansion, which is getting long in the tooth. In some ways, the company would potentially benefit from an economic decline, as people in some sort of financial distress are its bread and butter clients. On the other hand, I suspect that most of its clients are already in financial distress (that’s why they need a high interest loan in the first place). This is usually the case for non-macroeconomic reasons, as most loans are taken out for debt consolidation, car repairs, medical bills, and other similar reasons, by people who don’t have the financial flexibility to cover issues that have come up in their lives. That makes their customers highly exposed to job loss, as they are already financially stressed.
There are a couple of factors that I think largely mitigate these risks for goeasy. The first is the type of economic downturn that is likely to occur. Economic downturns are often led by the segment that was most extended prior to the downturn, and in Canada that is pretty clearly the housing markets in the larger cities, with Toronto and Vancouver being the main issues. I suspect that any coming economic storm would likely fall less hard on goeasy’s clientele, simply because the vast majority of them are unlikely to be homeowners. The rise in minimum wage rates should also help many of them play through an economic storm. Of course, if minimum wage rates combine with a downturn to reduce demand for lower economic status labour to the point that their customers lose their jobs and can’t replace them, that would be an issue. However, the service economy in Canada has become relatively resilient, with retail jobs in Calgary being largely available even during the lowest depths of the recent oil price crash as just one example.
Competition is a definite risk here, and is in many ways the one I most worry about. The company is not the only one to have noticed the gap left by payday lenders exiting the space, and many smaller and/or private operators have entered the business. goeasy has what may be a structural competitive advantage in the space, as they are the only large public player that has access to institutional financing. Their large size and long history in this market has provided them with an edge on the cost of funds against other non-bank players.
Where the company wouldn’t have an edge, however, would be against banks or credit unions entering the market. While Canadian banks have historically not chosen to play in the personal unsecured loan business, if the banks ever decide to take over this business, their cost of funds and distribution through branch advantages would mean they could probably kill goeasy. Of course, there are reputational and risk reasons why they haven’t entered this business in the past, and I think those reasons remain.
The other player that is a risk (at least regionally) is credit unions. They have historically had more of a client focus than the big banks, which has sometimes made them more willing to take credit risks. They have a similar cost of funds advantage because they can raise money through provincially insured deposits. As just one example local to me, First Calgary (the city’s largest credit union) is offering 19% rates on unsecured term loans with requirements similar to goeasy. I found this advertised when I was doing a Google search on a payday loan related term for my research into this article, which is something I suspect many of goeasy’s customers would do. I do wonder how sustainable 19% interest rates will be for them, but in the meantime, it is definitely a risk.
Finally, the company is facing online competitors in the same space. Online competitors have a potentially lower cost structure, although the speed a storefront lender can approve an application may be attractive to a number of customers. Online competitors don’t have to pay rent, but will need to attract customers with advertising, and loans generally need human interaction at some level anyway (especially the ‘text me a screenshot of your bank statement’ variety), so I doubt the overall cost difference is material.
Ultimately, these competitors have been around for some time (the earliest reference to First Calgary’s product I could find is nearly two years ago in this article), and goeasy has been growing very quickly (as you can see in the graphic below). Therefore, it appears the hole left by the payday lenders exiting is big enough (for now) for everyone who wants a piece of the market. Going further back, US players have also exited the market after the global financial crisis to repatriate capital. The most significant of these was Wells Fargo, which closed 120 stores focused on subprime credit in 2010.
Source: goeasy Investor Presentation (pdf)
Finally, the biggest way the company could mitigate competition would be to acquire its own bank licence. While this would materially lower its cost of funds as they could take deposits, it would also open them up to significant regulatory oversight and probably require them to diversify into some less risky assets as well. However, the cost of funds change would be material, and would allow them to compete with anybody. Becoming a bank in Canada isn’t easy. I was once a shareholder of what became Homequity Bank, and it took them years to get a banking licence even though they already made mortgage loans in Canada. goeasy would be further down the financial respectability spectrum, so I suspect the regulator would make it more difficult. Nonetheless, if they could pull it off it would cement their business more or less permanently. For an interesting piece on the process to become a bank in Canada, see here.
On the risk side of the ledger, there were a few items in the most recent quarter that slowed their stock price gains. An $8.2 MM charge in the fourth quarter related to the refinancing of their debt. This relates to prepayment penalties as well as a write-off of the deferred financing costs related to getting the loan in the first place. This is a bit unfortunate, but the new facility is materially larger than the facility it replaces, with $529 MM of new money replacing $300 MM in previous financing.
The new financing comprises a $110 MM bank loan at prime plus 350 basis points or bankers acceptances plus 450 basis points, with the rest being notes offered in the US, and swapped to a 7.84% interest rate. With prime at 3.20% and bankers acceptances at 1.49%, that puts the weighted average cost of the money at 7.5%. This will be a slight saving on the rate, as they were paying slightly in excess of 8% on their previous facility.
The other headline risk in the short term is the adoption of IFRS 9 starting in 2018. The company will need to change how it calculates its allowance for loan losses, and has estimated allowances will increase from their current 6.1% by an additional 2.5%-3.5%. The company has been proactive on communicating this with the market, which should help reduce the impact given these are non-cash changes. The bigger risk is if this change coincides with a drop in their actual performance, as if loan loss allowances went from 6% to 11% or 12% in a year that would probably have a material impact on their stock price, even if much of the change is a non-cash charge for a calculation methodology difference.
One other risk that may increase their capital spending over time is the lack of EasyHome locations appropriate to add in-store EasyFinancial kiosk to. New stores will generally now be stand-alone operations, which probably increases their cost, as they will need to find retail locations and pay for new leases. The retail real estate market is not especially strong in Canada right now, although much of the space available is in a larger format than what goeasy would require (ex Sears stores, for example). This is worth mentioning, but probably isn’t a significant risk, especially since the company is offering a sought good, and consumers will likely find them even if they are in B grade locations near the consumer. Their target market of lower income Canadians also probably reduces the cost of acquiring new locations, as there is less demand to market to that demographic. Ultimately, their ROI is such that small increases in their capital costs for physical locations are probably not significant.
The company issued a tranche of convertible debentures [TSX:GSY.DB] in mid 2017. The debentures are convertible at $44.00, compared to a share price of $35.52, and the debentures currently trade for $102.26. The debentures mature in July 2022, and can be redeemed in July 2021, or July 2020 if the share price is more than 25% above the conversion price. These are a mix of debt and equity, and their 5.75% coupon will help reduce the cost of financing for the company in the short run.
With 2 and a quarter years left before the earliest redemption on the debentures, $100 in par value will collect $12.94 in interest. The $102.26 cost of buying $100 in debentures would buy 2.88 common shares, which would collect $5.83 in dividends over the same time period. The graph below shows the financial outcome at various share prices over 2.5 years. It assumes the company doesn’t enter financial distress (and hence the debentures would be worth par) and that the current dividend levels are maintained.
Source: Author’s work
As you can see, the direct share purchase comes out ahead of the debentures at even slight improvements to the current share price. On the other hand, the debentures have much lower downside at any share price point, making them a lower risk, lower reward way to play the same thesis.
Subprime lending at interest rates just below the legal limit (generally 60% in Canada) is something that often makes people ethically squeamish. The company has been the subject of a CBC expose, but ultimately their product is legal and likely to remain so. It also has the material benefit of being much less exploitive than payday lending, and keeps criminal elements mostly out of the loan sharking business. There will always be demand for money from poor credit risks, and keeping that in the formal economy reduces crime and violence, because the lenders can use formal economy means to recover their losses. Loan sharks, on the other hand, who would spring up if the high interest lenders were eliminated, would not be able to use the courts and credit bureaus, which means they inevitably resort to violence to collect their debts. While high interest lending isn’t a business that many people would be proud to tell their grandma about, much like the provision of tobacco products it is better for it to be a legal product. Having this business in a public company also probably improves oversight and legal compliance, as compared to mom and pop operators.
goeasy trades at 2.12 times its most recent book value, which makes it expensive when viewed as a traditional financial institution. That being said, financial institutions in Canada often have higher returns on equity which leads to them trading at high book values, and the Royal Bank of Canada is also trading over 2.1X P/B. There are really no direct comparables to the company, which makes determining the correct multiple more difficult, as they are effectively a new kind of financial company.
goeasy has been reporting ROEs in the high teens range rather consistently (or 20% if adjusted for one time costs related to a potential acquisition and refinancing expenses), which makes its equity worth materially more than book value, as it is earning excess returns. Additionally, the company is in the rather rare situation of having extremely strong reinvestment prospects to actually grow that return on equity over time, as well as grow the absolute size of the business. Their increased level of cheaper debt funding should improve their margins, and they are compounding their existing equity by pairing it with new debt and increasing their loan book.
Given the numerous macro tailwinds, growth in the business, and strong returns on equity, I think it makes more sense to value goeasy by its earnings. During 2017, the company earned $36.1 MM. Their earnings are growing materially, up 16% year over year. However, if you exclude the refinancing cost earnings were up 44% from 2016. There will be a huge earnings tailwind for 2018, because they won't have that charge and are still ramping up loans in many of the stores they have opened. A store opened last year earns interest from all the loans it originated last year plus all the loans from this year, as none are paid off yet. That combination of factors suggests to me that 2018 should be a banner year.
Figuring a business growing by leaps and bounds with macro tailwinds should be worth at least 18X earnings, I’ll suggest a price target of $649.8 MM, or $47.75 per share, or $37.91 USD.
Supporting the valuation is the fact the company has been growing dramatically, with same store revenue growth up over 18% this year. That isn’t a totally fair statistic, because stores open less than 3 years will still be ramping up lending, while their same-store sales include all stores open for more than 15 months.
It is also worth noting the company is slowly converting EasyHome locations to franchise operations. This allows it to redeploy the equity used in those businesses and collect a more capital light return going forward. There is almost no disclosure on how they are being paid by franchisees and what the terms are, so I haven’t added any value to the company for what is likely a higher quality business model embedded in the company. I mention it simply as a note that franchise revenue reduces the company’s risk, because it will be able to collect profits from those stores without putting up its own capital.
goeasy is an alternative lender with a differentiated market position. It has a lower cost of funds than its mom and pop and smaller private competitors, and has a better storefront position and more consumer visibility with low credit score clients than the banks and credit unions. It has an advantaged regulatory position, with payday lenders under significant pressure from governments in its major operating areas. The company will benefit from increases in minimum wage, and the macro environment is conducive to its business model. It trades at an undemanding valuation based on earnings, and those earnings are growing rapidly. The company’s shares represent reasonable value at present, and the likelihood of significant earnings growth in 2018 is a strong catalyst.
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