Description
First Cash is facing severe and unprecedented structural and cyclical headwinds, has potential political/regulatory headwinds into the 2020 Presidential election, and the street is vastly over-stating near- and medium-term earnings power.
Overview:
First Cash is the largest chain of pawn stores in the US and Latam, and the largest of two publicly traded pawn companies. ~40% of revenue is in LatAm and ~60% of revenue is in US, and FCFS makes money in two main ways: 1) through collecting interest on pawn lawns outstanding & 2) through selling merchandise that customers forfeit.
In the US, 60-65% of the gross profit is interest on pawn loans (at ~100%+ APR) and the remainder is retail sales. In Latam, the skew is more balanced with 50% of gross profit being retail and 50% being pawn fees.
Coming into this year, FCFS traded at a market multiple (~18-20x forward earnings) despite the US not having any revenue or EBIT growth as the market paid a premium for defensive / acyclical nature of the revenue streams and optionality on FCFS continued to grow in Latam via its greenfield store and M&A strategy. At best, on a consolidated basis, FCFS was a MSD% rev grower and LDD% EPS grower.
What has changed:
The shape of the current recession is putting immense pressure on FCFS's business and the earnings power is devolving in a way that is counter to the long-standing view that FCFS is defensive. Over the last 4 months, FCFS's loan balances have declined 40% because:
1) The core subprime / underbanked consumer has never been in better shape as a result of government stimulus, and ongoing extra weekly unemployment.
2) Customers have reduced need for funds given less driving around, less eating out, less expense overall as a result of shelter in place and changed behavior during Covid.
The impact of this loan balance decline on a fixed cost business is tremendous, and assuming no further deterioration that is likely to come with an additional stimulus, the run-rate earnings power is <$2 in 2020. Simply, FCFS earned 60c in 2Q 2020 when the average loan balance was only down 20% in the quarter (the exit run rate was -40%). Further, retail sales were up massively in the quarter as customers rushed out in April to buy work from home goods, electronics, and guns which bolstered profitability.
The modeling / math is easy to do, but 2H 2020 EPS should be <$1 and 2021 EPS will be <$3 assuming a recovery in loan balances starting in the 4th quarter. If there is no recovery, 2021 EPS will be $2 and if there is further attrition in the loan base it will be worse.
Besides the pressure on interest income from loan balances shrinking, FCFS will face tough comps in retail in 2021 for two reasons: 1) mechanically the y/y grow over is tough 2) FCFS's inventory comes from forfeited pawn loans. If loans continue to shrink, they will have no inventory to sell and therefore less retail sales.
Why does the opportunity exist:
Generally this is a fairly uncovered and underfollowed name, even by core financials investors.
The trends are obvious to those who extrapolate, but recent events have not been a significant negative catalyst. Recently, the stock has not reacted in a fundamental manner to the information that we have been presented, maybe because the company does not have an earnings call so the trends could not be publicly discussed and disseminated.
The company smartly pre-announced 2Q earnings in June (which ended up being 25% lower than original analyst expectations), and ended up "Beating" the new street number on expense control. On the day of earnings, the stock outperformed despite missing revenue and showing the astute investor that problems lay ahead.
Recently, one broker upgraded the stock to overweight, driving the stock up 5%, which has created the current very attractive entry point. The stock moved positively on the upgrade, but again it seems like it was driven by headlines/ machines/ uninformed buyers (similar to the day of the "earnings beat"). The analyst who upgraded is based out of Mexico City and mostly covers Mexican banks. His upgrade of FCFS was clearly in conjunction with a broader ratings change in his coverage, as he downgraded Mexican banks and likely needed a stock to recommend. His numbers are completely wrong, and are 30%+ above current consensus which are themselves 20-30% too high - a nefarious upgrade presenting a great opportunity to sell
Valuation:
Under the best possible scenario, FCFS will be back to earning $4 in 2022. The multiple needs to de-rate from 18-20x given that the earnings stream is likely to be much more volatile in future recessions. One way to value is to put 16x on $4 in 2022 ($64), and discount back at 10% today - a $58 stock (-4%). That would probably be the most optimistic assessment.
One could argue for 15-20x 2021 EPS of ~$3, which would be $45-60 at the end of this year (-30% to -0%).
If the bear case plays out and more stimulus further crushes loan balances, FCFS should trade at a trough multiple of 13-15x NTM earnings of $2 ($26-30 / -60% to -50%).
Zooming out, the risk reward is massively skewed to the downside. There is no real bull case, and the most you are risking is a return to 20x $3.37 in consensus 2021, which is $67 (+10%, which seems like pretty manageable downside). Not sure why one would pay 20x for a business that is not growing topline in this market, but that is the "downside."
Unlike most SMID cap stocks, there is no take-out node here: there is not a larger strategic to buy them, and it is impossible for PE to get involved in a name trading at 30x NTM earnings currently that already has leverage.
Other considerations:
Although unlikely, risk of regulatory scrutiny increases in an election year for a business charging 100% APRs.
Believe that near-term, FCFS is losing market share in the US to smaller, private competitors who have more aggressive retail programs to attract customers (i.e. a lot of competitors are buying guns,tvs etc. to supplement the merchandise they have from pawn loan forfeits and selling a single digit margin to customers).
Longer-term, fintechs may increase competition for lending to this customer (although not happening yet).
The latam business is positively levered to a weaker dollar vs MXN.
On the positive, management are solid executors and are controlling what they can control (expense) in a very challenging and unprecedented environment.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
1) Earnings over the next several quarters.
2) regulatory overhang into November