Forget Banks - Buy These Hugely Undervalued Financials Instead

Includes: BAC, C, EZPW, FCFS, GS
by: Larry Meyers

I'm all for grabbing distressed stocks when they are distressed for the right reasons. In the case of financial stocks, there is still so much uncertainty in the sector that I am very leery of getting involved with most of them. That's why the big money is not to be made in big financial stocks, but in financial stocks that are off everyone's radar and are not exposed to any of their peers' threats. These stocks just reported blockbuster earnings yet inexplicably sold off, and are vastly undervalued.

Why stay away from the big boys? There is a huge threat facing banks as the Consumer Financial Protection Bureau (CFPB) is investigating overdraft fees. Most people don't understand how critical overdraft fees are to the banks. In 2008, the consulting firm Bretton Woods did a study regarding overdraft programs. The results showed that without overdraft fees, banks would essentially have no net income. In fact, they'd face huge losses.

Bank of America (NYSE:BAC) is one of the firms being investigated. On top of this, the company has to deal with court challenges to its recent settlement regarding its takeover of Merrill Lynch. Revenue fell by $4.5 billion and net income by $1.4 billion, plus the dividend of 0.5% demonstrates that the bank's capital position and business still isn't what it used to be.

Goldman Sachs (NYSE:GS) would normally be a no-brainer for me. You never want to be on the other side of a trade from it. However, there are wholesale changes going on in the entire financial services industry and Goldman is feeling it. Quarterly earnings were down 23%, and there's a lot of angry sentiment being directed at the company.

I suppose you can go with Citigroup (NYSE:C) if you want to be on board with Bill Ackman, who has loaded up on shares of the company as it separates its toxic assets out from the rest of the bank. The company also just got handed a embarrassing defeat when shareholders rejected the CEO's compensation package. On top of that, the Fed decided the bank wasn't solid enough to initiate an $8 billion stock buyback.

So why bother getting involved in these financial stocks when there are others that are experiencing exploding growth, don't have complex financial statements, have gobs of cash to fund organic growth, and aren't facing the same kind of regulatory scrutiny?

Instead, go with First Cash Financial Services (NASDAQ:FCFS). The company operates several hundred pawnshops both domestically and in Mexico, as well as payday loan stores primarily in Texas. The company cut back its payday exposure significantly to focus on pawnshop expansion in Mexico, where there is no usury cap and 80% of the population is a potential pawn customer (vs. 20% in the U.S.). Total first-quarter revenue was up 16%, driven by an incredible 33% increase in Mexican pawn fees and a strong increase of 10% in Mexican same-store sales.

First Cash is generating net margins of 21%. Why would you bother with Bank of America's 2% margins? Even the vaunted Goldman only manages 14% margins. Free cash flow was $49 million, up 50% over the previous year. First Cash is the leader in large-format pawnshops in Mexico at this point. It raised earnings expectations to $2.72 for this year, up 20% year over year -- the same growth level the company has been experiencing for several years, and will continue to experience going forward. So you'd think the stock would be up around $54.

Instead, it's at $39 when you include its net cash. That's a 30% discount.

EZCorp (NASDAQ:EZPW) is in a similar position. Net income for the year rose 17% over the previous year on a 20% increase in revenues and a 9% same-store increase in pawn fees. Its Latin America segment saw revenues more than double as it expands aggressively into the region. The big development for the company was the purchase of a 60% share of Crediamigo, a payroll deduction loan company. This is a brilliant acquisition. The ability to directly debit paychecks for repayment of principal (and fees) will mean dramatically lower default rates, which translates to much higher margins.

EZCorp is looking for $2.92 in earnings this year, an increase of 13% over last year. Analysts are looking for 17% growth after that. I would put a 15 times multiple on this year's earnings, giving a fair value of $45. The stock inexplicably sold off to $26.21, making it more than 40% undervalued.

Both of these companies are screaming buys. Much of their revenue is generated in Mexico, relieving them of regulatory threats here in the U.S. On the pawn side, there is also little to fear from the CFPB in the U.S. The companies are angling for federal charters for their pawn businesses, which means they'll be subject to one set of federal regulations that are likely to be looser than ones at the state and local levels. That will increase revenues and margins.

While traditional financial stocks flounder and have impossible-to-decipher financial statements, First Cash and EZCorp couldn't be easier to understand -- they're exploding.

Disclosure: I am long FCFS, EZPW.