DFC GLOBAL CORP DLLR
August 28, 2012 - 1:58pm EST by
Saltaire
2012 2013
Price: 18.51 EPS $0.00 $0.00
Shares Out. (in M): 44 P/E 0.0x 0.0x
Market Cap (in $M): 815 P/FCF 0.0x 0.0x
Net Debt (in $M): 789 EBIT 0 0
TEV ($): 1,604 TEV/EBIT 0.0x 0.0x

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  • Financial services
  • Europe
  • North America
  • Lending
  • Levered Equity

Description

 

Investment Recommendation:


Buy the common stock of DFC Global (DLLR) at $18.47 per share (close as of August 24th, 2012).
 

Business Description:


DLLR is a leading diversified financial services company serving primarily unbanked and under-banked consumers who purchase some or all of their financial services from DLLR rather than from banks and other financial institutions. DLLR has over 1,300 retail storefront locations, in three geographies including Europe (8 countries), Canada, and the US. Over the last 12 months ending March 31st, 2012 DLLR reported revenue of $1.028B, of which 54% was from Europe, 33% was from Canada, and 13% was from the US. Additionally, 60% of revenue was from consumer lending, 14% check cashing, and 8% pawn lending, with the remainder coming from other services such as money transfer fees and gold sales. Through acquisitions in the UK and Scandinavia, DLLR now has a fast growing internet lending platform that now accounts for 24.9% of total revenue.
 

Company History:


DFC Global Corp. was organized in 1979, purchased by Bear Stearns & Co. in 1990, taken private in a management buyout in 1992, and then went public with an IPO in 2004. The company was originally a roll-up of check-cashing businesses and today is a diversified financial services company that services underbanked and unbanked consumers. As regulation has tightened in the US, DLLR has shifted operations abroad, no longer investing in the US, and now seeks most of its growth in Europe which is a largely underpenetrated and growing market. Canada shows more modest growth prospects, but is more mature from a regulatory standpoint.
 

Investment Thesis:


1. Diversified product channel and geographic mix – DLLR is the most diversified player in its peer group with large product, channel, and geographic mix that limits its exposure to regulatory risk. DLLR also has a limited footprint in the United States (13.5% of revenue) where the regulation is most restrictive, competition is strongest, and operating expenses are highest. DLLR’s diversity of product and channel allows it to focus resources on areas and products that show the most growth potential.

2. Market leader in underserved markets - DLLR is the market leader in terms of revenue in Canada, the UK, and Scandinavia. DLLR also has the largest pawn book in Europe and the third largest pawn book worldwide. As the market leader DLLR enjoys economies of scale, strong house brands, and a solid real estate portfolio which creates barriers to entry.

Europe –According to the British Casher’s Association, DLLR is the largest player in the UK and controls approximately 30% of the market. The UK is still largely fragmented and underpenetrated. The United States has approximately 166% more pay-day stores per person than the UK. While DLLR does not break out margins by product, DLLR’s blended margin is significantly higher than its two largest competitors in the UK.

Canada– Canada, albeit to a lesser extent, is also underserved as the US has 60% more pay-day stores per person than Canada. DLLR’s Canadian segment also enjoys significantly higher margin than its largest competitor in Canada, Cash Store Financial Services. MoneyMart (DLLR’s Canadian subsidiary) and Cash Store Financial Services both charge province-max rates with similar other fees and late charges. The margin advantage is due to its operating performance at the store level rather than higher price points.
 
3. Lower than average regulatory risk – I believe that there is an overhang on DLLR’s valuation due to higher-than-actual perceived regulatory risk. As previously mentioned, DLLR has only 13.5% of revenue coming from the US where regulatory risk is highest.

Canada– From conversations with trade organizations and DFC’s competitors I believe that Canada is fairly mature from a regulatory perspective. In 2007, the Canadian Parliament amended the federal usury law to permit each province to assume jurisdiction over the development of laws and regulations regarding the payday lending industry. Since then 6 provinces have passed legislation regulating the payday loan industry, setting rate caps, and preventing "rolling-over" loan balances. It seems that regulations have since stabilized and harmonized across provinces. From the beginning of the regulatory overhaul, DLLR made an effort to be out in front of the legislative changes working through a trade organization to assist the legislative process. Since these regulatory changes were implemented in 2009 and 2010, the industry has consolidated somewhat as smaller operations struggled without economies of scale and more consumer friendly regulations. Please refer to the Appendix for a more detailed regulatory overview of Canada including rate caps by province.

UK & Europe– The UK is less mature from a regulatory perspective than Canada or the US, however the uncertainty in the UK has abated somewhat recently. There are neither rate caps, nor restrictions on "rolling-over" loans in the UK but in early 2012 an amendment to the Financial Services Bill was proposed which would have added unspecified caps on short-term lending. It was voted down by the House of Commons in May of 2012, and it is unlikely that similar legislation is passed in the near-term. Through conversations with trade associations and the OFT, which currently regulates the payday lending industry, it is clear that industry self-regulation is the favored approach over legislation. DLLR, as they did in Canada, is working through trade organizations to influence policy and just participated in the release of a Codes of Practice that pledges more transparent marketing and other business practices. In 2014 a new governing body, the Financial Conduct Authority, will take over take over regulation authority from the OFT. Please refer to the Appendix for a more detailed regulatory overview.

4. Proven management with effective acquisition and integration process – Management has well-defined practices of acquiring small competitors and buying back franchises. Currently approximately 40% of revenue is derived from acquisitions made over the last three years. DLLR also has centralized underwriting and collections for each major market which creates economies of scale and a sophisticated approach to credit analysis. Centralized underwriting has been successful in reducing defaults over the past several years through strategic analysis across different geographies by aggregating data. In Q3 2009 DLLR created a Global Credit Analytics Group which was successful in reducing total credit losses as a percentage of lending revenue from 17.8% to 13.1% in Q4 2010 despite a challenging macroeconomic environment. Since Q4 2010 losses have risen as DLLR has grown rapidly in new markets and entered the internet lending business which carries higher losses.

5. Strong start in high-growth internet lending market – DLLR has had a strong start in the internet lending business in the UK and also begun operations in Canada, Poland, Finland, and Sweden. Through its acquisitions of MEM, the UK’s leading internet lender, in April of 2011 and Risicum, the leading provider of internet and mobile lending in Finland and Sweden, DLLR is well positioned for future growth. As of Q3 2012 Internet-based lending accounted for 24.9% of total revenue which is up from 7% one year earlier. Store based loan losses typically range between 10% and 20% as a percentage of revenue while internet loans have losses to date range between 30% and 35%. Even at these elevated loss levels, management has stated that it expects internet lending to carry higher margins than store-based lending, due to lower operating costs. While internet lending naturally carries higher losses, part of the elevated loss rate through the internet channel is due to the large percentage of new customers. I expect that internet losses will come down as a higher percentage of internet customers become repeat customers. Additionally to date, DLLR has been able to charge a higher fee through the internet channel than through store-based channels. Below I have provided a theoretical comparison of in-store versus online lending based on company data and Credit Suisse estimates.

6. Attractive Valuation – DLLR trades below most of its peers despite a limited US footprint, market leader status in Europe and Canada, and the most diverse set of products and geographies. See below for further discussion on valuation.

7. Strong Track Record of Growth – For the past three years DLLR has achieved an EBITDA CAGR of 29.2% and has achieved an EBITDA CAGR excluding material acquisitions (MEM, Risicum, and Sefina acquisitions) of 18.4%. DLLR is now positioned in wide-open markets in Europe to continue this level of growth. DLLR entered the UK in FY 2010 with a small acquisition of 9 stores. Since then DLLR has grown rapidly in the UK both through acquisition and de novo store builds to a point where the UK generates 48.6% of total revenue and is home to 515 stores. In March of 2012 DLLR employed a similar strategy when entering Spain with an acquisition of 8 pawn stores. DLLR plans to open 20 de novo stores in Spain in the coming year and sees Spain as a market that could ultimately support 500 stores. DLLR is replicating this successful growth strategy all over Europe including Poland, Sweden, and Finland.

Current Valuation:


DLLR currently has 44.5M shares outstanding on a fully-diluted basis which at $18.47 per share translates to a market capitalization of $839.2M. DLLR has $1012.6M of outstanding debt and cash balances of $224M resulting in an implied enterprise value (EV) of $1.627B. On an enterprise value basis, DLLR trades at 5.1x LTM EBITDA and 5.5x LTM EBITDA less maintenance Capex. On an equity value basis, DLLR trades at 10.4x LTM adjusted EPS.

Despite DLLR’s diverse product and geography, limited exposure to the US, market leader status, and strong growth prospects in Europe, Canada, and internet lending DLLR still trades below most of its peers. I believe DLLR is trading at such a discount for the following reasons:

1. Regulatory overhang associated with payday lending businesses Many of DLLR’s publicly traded peers generate most of their revenue from pawn lending which is associated with lower regulatory risk. From a revenue perspective, EZCORP is 80% pawn, First Cash Financial Services is 88% pawn, Cash America is 61% pawn, and World Acceptance is 100% longer term consumer lending. Pawn lending is a much more mature industry globally and as such comes with a more mature regulatory environment. Payday lending is associated with high regulatory risk, especially in the US, with a considerable amount of attention being paid to the Consumer Financial Protection Bureau (CFPB) in the US and potential upcoming regulatory changes. Given DLLR’s international focus (only 13.5% of DLLR’s revenue is generated in the US) I see any actions by the CFPB as fairly insignificant to DLLR’s business model. The important geographies for DLLR are Canada and Europe, most notably the UK. For reasons stated above I feel the regulatory risk abroad is low.

2. Concerns about large debt load With $737.3 of net debt, a debt/EBITDA ratio of 3.1x, a net debt/capitalization ratio of .51x, and a debt/equity ratio of 1.9x, it’s a possibility that leverage could be a concern to some investors. DLLR has no near-term principal maturities with the closest maturity a CAD 600M in 2016. DLLR comfortably meets its obligations with a 3.2x EBITDA/Interest coverage ratio. Additionally management is comfortable with this capital structure and has a history of carrying a similar debt load for years. DLLR’s leverage ratios are comfortably in line with covenants established in credit agreements.Loan covenants require that debt/EBITDA must be less than 4.755x, that secured debt/EBITDA must be less than 2.0x, that EBITDA/interest expense must exceed 2.0x, and that (EBITDA-capex + lease expense)/(interest expense + lease expense) must exceed 1.4x. DLLR comfortably clears all of these covenants. After performing a stress test, the first covenant that would be tripped should EBITDA fall would be (EBITDA-capex + lease expense)/(interest expense + lease expense). Currently DLLR’s (EBITDA-capex + lease expense)/(interest expense + lease expense) ratio is 1.98x. DLLR had $95.7M of EBITDA or 29.3% of cushion over this covenant in FY 2012.

3. Small float and small average daily trading volume With a float of only 44M shares and an average daily volume of 314K shares traded daily I believe DLLR is somewhat overlooked.

 

Price Target:

In arriving at a price target I have assumed a conservative CAGR Revenue growth over FY’13 and FY ’14 of 12.7% (organic revenue CAGR for the last three years has been 17.6%) which factors in a continued decline in check cashing revenues. I have also assumed a slight EBITDA margin compression from 30.3% to 27.5% as the provision for loan losses continues to inch upwards as DLLR acquires new customers in new markets. While we believe earnings have been depressed by new store opening costs, we haven't gotten a good number for the actual costs. We also assume they will continue, albeit at a decreasing rate over time. Consequently we have not made any adjustments. These assumptions yield an organic EBITDA CAGR of 7.2% (organic EBITDA CAGR was 18.4% over the last three years). Lastly I have used an EV/EBITDA range of 5.5x - 6.5x. As you can see above DLLR trades below all its peers except Cash America International from an EV/EBITDA perspective. I believe that DLLR should be trading at a premium to its peer group rather than at a discount. Accordingly, I have applied a modest multiple expansion to my EBITDA estimates to arrive at a price target of $35.9 at a 6.0x multiple and $40.1 at a 6.5x multiple.              

Investment Risks and Mitigants:

 

Economic and Credit Quality Risks – Credit quality deterioration is a significant risk particularly as DLLR enters new markets and channels.  In mature markets I believe that DLLR targets around 10% losses as a percentage of lending revenue.  In the internet channel I believe that DLLR targets around 20%-25% losses.  At these higher loss levels internet operating margins would still be higher than store-based lending margins.  However, currently internet losses as a percentage of lending revenue are approximately 30%-35% as they have been expanding their customer base.  Management has stated that even at these elevated loss levels they are indifferent to online or offline loans given the lower operating costs of internet loans.  In addition to this, given the short-term nature of payday loans (loans turn about 12x per year) if losses were to rise outside of targeted loan loss levels, it is likely that DLLR can simply tighten underwriting standards until losses falls in line with targets.  While more traditional longer term lending carries a certain tail risk as changes in the economy or uncertainty in new geographies can dramatically affect the performance of a loan book, the same is not true for payday loans. 

Alternative financial services companies typically perform well in most economic environments.  DLLR in particular has had considerable success in the past controlling loan losses even in tough economic times.  From Q4 2008 to Q1 2010 DLLR reduced its loan losses from 22% of revenues to 13%.  Losses have since risen again as DLLR has entered the internet lending business and has been growing rapidly in the UK and Europe. 

Regulation Risk – Strict interest rate caps, bans on “rolling-over” loans, and other regulatory changes could significantly affect DLLR’s profitability.  See the appendix for a complete discussion on the regulatory environment in the UK and Canada. 

Competition – Substantial competition exists in DLLR’s major markets from independent pawn shops and payday shops in addition to large publicly traded entities.  Borrowers may also substitute away to more traditional financial institutions and banks.  DLLR is the market leader in both the UK and Canada and has the largest pawn book in Europe.   As a result DLLR enjoys economies of scale, strong house brands, and the benefits of centralized underwriting. 

Check Cashing Secular Decline – While only 13.1% of revenue is generated from check cashing, I assume this business has above corporate average margins and will continue to decline as credit, debit and mobile payments grow.

Roll-up/Integration Risk – While history is full of examples of M&A deals that looked good on paper but ended as failures upon execution and integration, Jeffrey Weiss and his team have an unblemished track record of integrating acquisitions.  DLLR had been able to find very attractive acquisitions available at attractive multiples.  DLLR has made its last 5 major acquisitions at an average EV/EBITDA multiple of 6.6x. 

Foreign Exchange Risk – DLLR’s businesses are mainly based overseas, with only 13.5% of revenues generated in the United States, and reported results are affected by foreign currency fluctuations. The current strengthening of the dollar represents a headwind to earnings. However, the company has indicated that it has little USD-denominated debt to service and no longer has currency-related mismatched Debt/EBITDA covenants. Therefore, as there is little economic risk to DLLR from FX impacts, it does not hedge currency and will generally report more volatile USD earnings. The principal currencies to which DLLLR is exposed include the Canadian dollar, the British pound, the Swedish Krona and the Euro. DLLR has estimated that a 10.0% change in foreign exchange rates by itself would have affected reported pretax earnings from continuing operations by 11% of consolidated foreign pretax earnings for the fiscal year ended June 30, 2011.

Large Debt Load – DLLR has a 3.1x debt/EBITDA ratio, a .54x net debt/capitalization ratio, but no near-term principal maturities and thus is in a manageable position.  

 

Potential Catalysts:

  1. Further clarity on regulation in the UK.
  2. Continued success expanding throughout Europe with strategic acquisitions and organic store build-outs
  3. Continued strong earnings growth
  4. Further stability of internet loan losses

 

Catalyst

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