|Shares Out. (in M):||55||P/E||10||0|
|Market Cap (in $M):||530||P/FCF||7||0|
|Net Debt (in $M):||107||EBIT||65||0|
Full disclosure - I have to submit a writeup this week, and I don’t have any original ideas. What I can do is try to provide more clarity on risks and potential upside on something that’s been written up many times before but is still ridiculously cheap.
That company is EZCorp - a counter-cyclical, cash generative business in a fragmented industry with fairly high ROIC moving forward. It has low fundamental downside and attractive upside.
It is selling for less than 10x FCF, a significant discount to past takeout multiples, and below NAV. There are clear risks here which deserve a discount but not this big of a discount. Meanwhile, those risks and corporate governance are getting better.
EZ Corp has been written up 9 times on VIC, so what’s different this time? Well for one, I’d like to point out that the majority of these writeups have returned greater than 2x over the next 2 or 3 year timeframe. To explain why I believe now to be one of those times, I’d like to go over the history.
EZCorp went public in 1991 with 66 stores. EZCorp’s pawn business back then was not refined like it is today. There was no inventory management system or loan analysis, and most collateral was gold or silver jewelry. In short, it wasn’t a great business and only worked well in times of economic downturns or high gold prices. Using the proceeds from the IPO and a secondary offering, they expanded to 297 stores by 2000. However, results were very inconsistent. Over this decade, there were multiple large inventory write-offs, merchandise margin fluctuated wildly, and PLO (pawn loans outstanding) growth was heavily reliant on the economy. Share price declined from $3.25 (split adjusted) at IPO to a range of $.50-1.50 in 2000.
In 2000, Joe Rotunda took over as CEO and turned around the store level operations of EZCorp. He set up new inventory control procedures and cut down on store level expenses. For the decade moving forward, EZCorp saw higher PLO per store growth (even through times of booming economy), higher inventory turnover, more stable/lower inventory per store, less aged inventory, and more stable gross margins. They went from:
2000 - 300 stores producing $10mm CFFO, share price ranged from $.30-$1.75
2010 - 1000 stores producing $124mm CFFO, share price ranged from $10-23
Depending on your basis, EZCorp was anywhere between a 5x to a 75x over this decade. Granted, these results must be taken with a grain of salt. During this decade, not only did the price of gold skyrocket, but EZCorp also experienced massive growth in their new payday loan segment (which no longer exists).
In 2010, Joe Rotunda left and the new management took the company in a much different direction. Instead of focusing on lending in pawn, they began focusing on retail. They tried developing an online marketplace of pawned goods similar to EBAY. They entered adjacent businesses that wound up destroying capital. Store level expenses ballooned, PLO began to suffer, and inventory management went out the window. In short, they quit focusing on their core competency, which was pawn lending. By 2014, CFFO had fallen to $74mm while debt had grown to over $400mm (from $15mm in 2010) and a high percentage of their inventory needed to be written down as it couldn’t be moved.
This shouldn’t be super revelatory… but when pawn shops are working at the store level, they have high returns on capital and are great businesses/investments. When they’re unfocused or inefficient at the store level, the opposite is true. One need only look at EZCorp’s results in the early 2000’s or First Cash’s results for the past 20 years to fully appreciate the compounding potential of a company in this industry.
I think current management has proven that they’re very good operators at the store level. Although they seem to be struggling with capital structure and aligning with shareholders, they’re trying to improve. Since current management took over in 2014/2015, PLO per store has grown steadily faster than competitors. Store level and corporate expenses have come down. Their inventory management has been good ever since the firesale of aged inventory in 2015 due to previous management’s blunders. Most importantly, they are once again 100% focused on pawn lending. Most of the mistakes in the past stemmed from capital pissed away on worthless ventures. That doesn’t seem to be a problem currently.
Store Level Operations
So what makes a good store operator? It’s all about a combination of managing inventory and driving PLO. Obviously driving PLO is going to be the main influencer in whether or not a given store does well. PLO’s are the earning assets. It’s either translated into pawn service charges or into inventory which is then sold for a profit. So any increase in same store PLO has extremely high incremental net margins. Driving PLO can come from a few places - mainly by manipulating loan to value (and therefore inventory gross margins) or by driving foot traffic through the store.
LTV has a large impact on PLO growth. You see LTV come through the financial statements via the gross margins of retail goods. Too high of a gross margin means you’re appraising pawn collateral too conservatively and short changing yourself on possible pawn loans. Too low of a gross margin means you’re valuing collateral at too high a price and missing out on merchandise profitability. It’s a delicate balance, and EZCorp’s management has learned that the most ideal GM range is between 35-38%. They are consistently within this range. Poorly run pawn shops often times utilize lower LTVs to drive gross margin for retail. This pushes potential loan customers to competitors as customers want as much money as possible for their collateral. Using the ideal LTV ensures capturing customers while also remaining profitable in retail.
Foot traffic is also important in driving PLO growth. Historically, pawn shops have focused on jewelry (gold mostly) as collateral. This limits not only potential loan customers, but also retail foot traffic. EZCorp has improved mix away from pure jewelry towards general merchandise, especially in newly acquired stores (I’ll talk more about this later). You can get a really good idea of the physical change seen in stores on slides 34/35 in EZCorps 2018 investor day presentation. Not only is the presentation much more inviting, the presence of general merchandise is successful in capturing foot traffic (especially in latin america).
Lastly, you have store level incentives. This is very relevant due to EZCorp’s recent history. Before the management shakeup in 2014, store level incentives were based on net revenue. This incentivized low LTVs and high gross margins for retail. There’s no incentive to move old inventory, or even to filter loans based on inventory that can be moved. This causes old/unmovable inventory to build up, which is a hidden expense. This was the cause of the big EBITDA hit EZCorp took in 2015, as they liquidated old inventory. Pawn shops can operate for years looking profitable while stockpiling old and unmovable inventory, but this will eventually lead to large inventory write downs. EZCorp has since implemented a new store level incentive system that focuses on store level profitability instead of net revenue. On top of that, EZCorp has introduced new analytics designed to track inventory. This should allow them to move inventory before it depreciates.
The combination of better aligned incentives, analytics, ideal LTV, better inventory mix, and more appealing storefronts combine to make EZCorp well run at the store level. And I’m not just saying this, it shows up in the numbers. Following are charts of EZCorp’s US and Latin American PLO growth, merchandise margin, and aged inventory over the past 5 years.
Latin American PLO Growth Versus First Cash Over Past 13 Quarters: