August 20, 2007 - 5:00pm EST by
2007 2008
Price: 12.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 500 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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The Payday Loan Sector – Sucked Down with Sub-Prime.  The Long Case for EZCorp (EZPW)

 We believe that it is time to aggressively invest in the payday loan space which, in our strong view, has been inappropriately punished with the sub-prime sector.  We outline the Payday Loan Industry below and argue that the sector has not at all been affected by the sub-prime meltdown and now trades at very compelling valuations.  In addition, we propose a specific recommendation, EZCorp (EZPW) which, in our opinion, is trading at an extraordinarily cheap valuation and has 40-70% upside within nine months as well as excellent longer-term prospects.

The Payday Loan Industry

 What is a Payday Loan?  The Payday Loan Industry, sometimes also referred to as the Payday Advance Industry, is a consumer finance segment that involves the unsecured lending of small sums of money, typically $500 or less, for short periods of time, typically two weeks.  The borrower is charged a fee, usually amounting to 15% to 20% of the advance amount, rather than an interest rate and, even if the advance is not paid when due, interest does not accrue.  The relatively large fee and short-term nature of the loan imply a very high annual percentage rate (“APR”), which may be equivalent to 200% to 400%.   Permissible fees and loan durations are regulated and vary according to state law.

 The industry emerged in the early 1990’s and grew as a result of a number of factors.  Firstly, there was strong consumer demand for a service of this type resulting from, amongst other things, a significant increase in the cost of bounced checks, late payment penalties, and the lack of availability of alternative short-term credit products.  Secondly, enabling legislation was adopted in many states providing guidelines and consumer protections under which the industry would operate. Due to the different legislative models payday loans are marketed under a variety of names.  For simplicity, we will use the term “payday loan” to cover all advances of this nature.

 Although the cost of a payday loan appears high, it often represents compelling value to the consumer.  The reason for the strong demand is the cost and convenience of this form of credit related to available alternatives.  For example, a payday advance is cheaper than a bounced check, late fee to a landlord, or utility reconnect. This is a compelling value proposition for certain demographic groups and industry bodies report a remarkably small amount of customer complaints, implying satisfaction is high.

 The industry is currently estimated to have more than 22,000 payday advance locations across the US and to extend about $40 billion in short-term credit to millions of Americans that experience cash-flow shortfalls between paydays. There are many private and public companies operating in the space including EZCorp (EZPW), Cash America (CSH), First Cash Financial Services (FCFS), and QC Holdings (QCCO).  This is a defensible segment in consumer finance as an entirely different and specialized infrastructure, for example compared to banks, is required to profitably operate in this line of businesses.

 Customers can source loans through a variety of payday loan providers.  Firstly, through stand-alone storefront businesses that offer payday advances as their sole product and source of income (also know as mono-line providers).  Secondly, through multi-service providers such as check cashers and pawn shops that offer payday advances as an ancillary line to their other services (also known as multi-line providers). 

 From no enabling state legislation in 1990, more than half of the US states as well as the District of Columbia have enacted specific enabling legislation for the payday advance industry.  A large proportion of the industries store base is located in Texas.  The Texas legislature sits every two years.  In the recent session the only bill relating to the industry was one regarding information disclosure and it was returned to committee meaning there will be no possibility of regulatory change in that state until the next session in 2009.

 The industry has two national lobby groups, The Community Financial Services Association of America (CFSA) and Financial Service Centers of America, Inc. (FiSCA), as well as a number of state organizations. Significant materials on the industry are produced by these national organizations.

How Has the Payday Loan Industry Been Affected by the Sub-Prime Meltdown?

 How has the profitability of the Payday Loan Industry been affected by the sub-prime meltdown?  In short, we do not believe that it has at all. 

 Payday loan customers are known as “under-banked.”  For example, discussions with various executives and analysts have indicated that only an estimated 15% of customers have mortgages and that few, if any, credit alternatives are available to them.  In addition, studies, for example by Experian, indicate that payday customers are likely to honor their payday loans before other obligations.  Our discussions with industry experts have indicated there has not been a down trend in loan losses and that one is not anticipated.

 Payday loan providers are not dependent on the credit markets for funding – in fact many are debt free - and in any event are not particularly interest rate sensitive given the very high APR compared to their cost of debt. 

 While we do not have statistical evidence, it seems intuitively logical that stress amongst sub-prime consumers may even benefit the Payday Loan Industry through increased demand for products.  Conversations with executives and analysts indeed lead us to believe that this could well be the case.

The Long Case for EZCorp (EZPW)

EZPW is, in our view, one of the best run operators in the Payday Loan Industry and currently trading at an extremely cheap valuation.  The company is a multi-line operator whose traditional business was pawn shops.  The company added payday lending to some of its pawn stores as well as built new stand-alone payday store-fronts. As of September 30, 2006, EZPW offered pawn loans from 280 EZPAWN locations and 369 EZMONEY loan stores.  Its store base has been rapidly increasing.

At a share price of around $12.00, EZPW has a market capitalization of approximately $500 million and is debt free.  The company currently generates returns on equity of around 20%.  EZPW has aggressively expanded its product offerings and store base and has grown sales at double-digit rates for over five years.  Margins have consistently improved over this period.  We look at the company as having a predictable, recurring revenue model with strong cash flow generation.

In addition, the company has “hidden assets” including a minority interest in a UK publicly-traded pawn operator as well as excess cash.  The UK pawn operator, Albemarle & Bond (AIM: ABM) is carried on EZPW’s balance sheet at cost (rather than market value).  The difference between the market value and cost of A&B is approximately $45 million (or around $1 per share).  In addition, of the over $30 million of cash reported on the balance sheet at September 30, we estimate that less than $10 million is required for working capital and hence, conservatively, there is around $22 million (or around $0.50 per share) is excess cash.  Hence, total “hidden assets” equated to around $67 million (or over $1.50 per share) at June 30, 2007.  (Since that time, the company participated in a private placement in A&B in the amount of around $13 million which we will ignore as it does not meaningfully impact this analysis.)

 Taking into account these hidden assets, EZPW trades at a current year P/E multiple of less than 12x (year end is September 30), and an estimated FY2008 P/E multiple of less than 10x.  The company generated an after-tax free cash flow yield including growth capex of 7% on an LTM June 30, 2007 basis and in excess of 9% for that same period excluding growth capex.  The company’s projected earnings growth rate is 15-20% per year over three to five years.

 How do we get comfortable with forward earnings?  The company generated $0.70 per share for the year ended September 30, 2006.  While earnings benefited slightly from a spike in the gold price and a small one-time benefit due to the shortening the term of pawn loans, on an overall basis, we believe that this earnings level represents a representative base from which to build up projections.  The company’s store base is rather immature with 40% of stores under two years old.  If history is a guide, stores typically take four years to mature.  For example, data released by the company shows that the portfolio of loans (i.e., income generating assets) from a store can increase 25% from year 1 to year 2.  On the last earnings call management stated that stores that were over two years old at the last anniversary had grown their loan portfolios by more than 20% year-over-year.   So there is strong visibility into the considerable growth within the existing store base.  In addition, the company has been aggressively expanding its store base, an endeavor that has been more than fully funded by internally generated cash flow.  EZPW plans to open nearly 50 stores just in the September 2007 quarter alone.  We expect the company to grow rapidly over the next three to five years.

 The company has guided to $0.88 per share for the year ending September 30, 2007.  EZPW has a history of exceeding guidance and with three quarters of the current fiscal year behind them management is likely to have confidence in this guidance.  Analysts are also projecting $0.88 per share for the year ending September 30, 2007 and $1.07 for the year ending September 30, 2008.  We believe that these projections are achievable and perhaps even conservative.

 Our view is that the current valuation is extremely cheap and we expect that the stock will trade between $17 and $20, representing upside of 40 – 70% within nine months.

Notice:  Funds affiliated with the author are long shares of EZPW.




The market realizing the the pawn broking/payday lending space is not impacted by the sub-prime meltdown or issues affecting the broader credit markets.

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