Description

EZ Pawn has been written up three times (on VIC) in the last decade, and has performed exceptionally. If there was ever an industry in the US that is part of the Wild West it is “Alternate Financial Services”. EZPW provides an excellent example of a great business, that 10 years ago had an amateur management team. Under the leadership of then CEO Joe Rotunda they brought process and focus to the business fixing the near term issues that the company had, while implementing a strategy for domestic growth, and most recently a strategy for revenue diversification.

The company is a leader in a space that is highly fragmented in the US, and is just beginning its international growth trajectory. Frankly the growth opportunities remind me of Starbucks 15-20 years ago.

The stock is down almost 50% over the last year, and dropped almost 20% from its recent earnings call. The whole sell side has gone negative. I think this is a classic run for the hills on a growth/momentum stock that both has dropped its multiple and earnings in the short-term but offers an excellent and safe 2-3X if you are willing to wait out the storm.

We think the stock is down for three fundamental reasons

1)      Growth has slowed

2)      Revenue and earnings were guided down to flat for next year as the company makes investments for future growth

3)      Democrats and Elizabeth Warren did well in the election, creating an uncertain regulatory back drop.

We think that not only has the market over reacted to these issues but they are transient in nature, creating a classic value play.

The business:

I can point you to the previous write-ups (or presentation below) to get a general flavor but as the company describes it they help consumers do 3 things

1)      Sell . You have merchandise that you want to convert into cash. They will give you a bid on it. Lots of reality TV shows on the History channel if you want to get an idea of how pawn shops work. But generally they have only a few categories of merchandise. Jewelry, musical instruments, Tools, DVD/Video games, and TV’s and other common electronic equipment. The common theme, is through eBay and other channels all these items have a pretty predictable resale value. They bid 25-50% of that.

2)      Buy. Like a classic market maker they let consumers buy merchandise they place into inventory from the above category. They also place inventory from forfeited collateral from loans (below)

3)      Borrow: Everyone needs credit, especially low income folks. When you are thin file with no credit file your options are limited. EZ provides this demographics with options for unsecured credit, and secured credit by pledging their cars, and also items (Pawn Loans). These carry high fees, and high returns on capital, with relatively low risk. If folks default they repossess the collateral and move to monetize. Since they have conservative LTV ratios the rarely lose a lot of money in the aggregate.

They have grown quickly in the US by both acquisition and de novo growth. The industry is still highly fragmented with over 15,000 outlets. So plenty of consolidation opportunities in the US. But the company has been very smart and if you think the US is wild and virgin then wait until you get to Mexico where credit is even more limited. The company has moved into establishing a beach head in Canada and Mexico, and has acquired meaningful stakes of publically traded operators in the UK and Australia. They own 30% of the leading Pawn shop in the UK. All said and done now 20% of their business comes from outside of the US. The Mexican market alone offers even higher ROIC (30%) than the US, and we think has at least 10-15 years of unabated growth.

What we like:

• It is highly unlikely that banks and the formal financial sector will move into this territory. For one there is reputation and regulatory headaches they don’t want to deal with. Second, they don’t know how to effectively operate with this demographic.
• The industry is dominated by mom and pop shops/clusters in the US (and abroad). Which make the value of a large professional platform stand-out. Tech, training, compliance all scale in this industry. The flip side is that as one of the few operators these guys are targets if the regulatory hammer comes down.
• High Returns on capital with trivial recourse leverage The Company has demonstrated 20% ish ROIC capability without levering the balance sheet. So little in terms of the kind of surprises we often see with ‘safe’ money center banks. We feel there is both margin of safety on the B/S and the high APR, secured loans they originate to customers.
• Room for capital structure improvement. With a 1B dollar company you can do things you can’t do as a small cluster of stores. They have done a securitization in Mexico for example that has lowered the borrowing rate from 19% to 11% in a few months and are renegotiated other loan facilities. These businesses have been traditionally equity funded but given the scale, some B/S optimization can go a long way.
• The management team has heavy retail, operational and PE backgrounds. We think they are disciplined on running and growing the business, but most important on capital deployment they are an ROIC driven shop. This discipline has led to consistently higher EPS over time, and they have on average outperformed the S&P 500 by a huge margin over the last decade.
• Interestingly we like the fact that the space will get more regulated. It will drive smaller players out (or into the arms of EZ and like operators). It will also clarify regulator expectations which we think will lead to higher multiples in the space (remove uncertainty), and we think regulators are smart enough to know they need this industry to survive since no one else is willing to provide credit to this demographic. You can’t simply cut them off. In fact we think regulators would put these guys on life support if they had to same as they did to the main street banks.

The numbers:

Let’s look at the balance sheet:

Not much to note here except it is trading close to book (when including goodwill), and about 2X tangible book.  More importantly is only 75 mm of net recourse leverage here. The long-term debt of 90 mm is recourse only to the Mexican Sub. Even still it would be low leverage. This is an earning and operating scale, growth story not a balance sheet one. But its good to see a safe capital structure so they can execute on the operating side with plenty of runway.

Income statement:

2012 Revenue $992 mm

Net Income: $143.7mm

EPS for the year was $2.81

ROIC 19%

For 2013 they project range of EPS $2.55-$2.90 which is obviously flat to down which no one liked, but it is driven by the fact that they intend to triple the de novo store openings worldwide which we should see come through in 2014 earnings or even the back half of 2013.

Valuation:

Let’s assume the low end of their range $2.55. They have historically guided very conservatively.

On a 2013 forward basis they trade at

2013 P/E $17.80/2.55 = 7X

On 2012 numbers it is even cheaper

2012 P/E $17.80/2.81 = 6.3X

I think a business with these kinds of returns and growth opportunities deserves at least a 12X multiple which in$ 3.00 of earning 18-24 months out is a double. With some upside on both earning and multiple over that time you could easily see more than 2X return.

Summary:

Investing in EZPW gives you a low-risk way to get a 2-3X return over the next 3-5+ years. You get to invest in an excellent business (20%+ ROIC). Managed by an excellent team, with a history of positive shareholder stewardship (for the most part). And you get the growth in the business for “free”, all with a balance sheet free from recourse obligations.

It is rare to be able to invest in a great business, at a reasonable valuation that has the opportunity to re-deploy capital into the business at the same or better ROIC for extended periods of time.

Check out an old preso here. Really worth looking at. Check out slide 11

https://dl.dropbox.com/u/4497140/EZCORP%2006-01-2012%20Investor%20Presentation.pdf

What we don’t like/risk:

• Some really creepy related party stuff, that makes you want to vomit, but the business is soooo good, and the results over the last decade speak for themselves that we are willing to look the other way. They have a dual voting class too. But as I said cheap enough makes you hold your nose. I think this is a legacy issue that has nothing to do with the current team.
• Politician that want to use the company as a Piñata.

Catalyst