| 2010 | 2011 | ||||||
| Price: | 52.05 | EPS | $4.33 | $0.00 | |||
| Shares Out. (in M): | 16 | P/E | 12.0x | 0.0x | |||
| Market Cap (in $M): | 815 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | 203 | EBIT | 0 | 0 | |||
| TEV (in $M): | 1,048 | TEV/EBIT | 0.0x | 0.0x | |||
| Borrow Cost: | NA | ||||||
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Description
World Acceptance is a legal loan shark whose financials and business practices do not add up. Either the business is much less attractive (returns shown are being accomplished by hiding the commensurate risks), or it is preying on the weak and must be regulated away. Neither scenario paints a favorable outlook of WRLD's future. Current regulation provides an imminent catalyst, which I believe will play out over the next 12-18 months. I believe we will be able to "see the white's of their eyes" on this investment, and can scale into this accordingly as the regulatory pressure builds. I think this could be a potential zero or very close to it.
In the company's own words, the business model could be regulated away (10K):
"...proposed or pending legislative or regulatory changes have been introduced that would, if enacted, have a material adverse effect on, or possibly even eliminate, our ability to continue our current business. We can give no assurance that the laws and regulations that govern our business will remain unchanged or that any such future changes will not materially and adversely affect or in the worst case, eliminate, the Company's lending practices, operations, profitability or prospects."
WRLD was founded in 1962 and makes installment loans aka small dollar loans, unlike others in the payday or pawnshop space. They are the only public company operating in this niche. In FY2010, the company's average originated gross loan size was $1,067 and the average term was 11 months. The annual percentage rates on the loans range from 25% up to 204%. WRLD operates ~1,000 cheap small storefronts in 11 states in and around the south, as well as in Mexico. Growth is severely limited as the company operates n all states that legally allow their business model. WRLD's goal is to operate by the letter but not intent of the law by utilizing a series of loopholes. Up until recently, the regulatory pressure on small subprime lending has been focused on the very short term payday loan space.
Sources: Company reports
Analysts, however, are asleep at the wheel, having focused on Mexico and its potential for new growth. Mexico is a rounding error, accounting for 80 offices and 4.5% of the company's loan book while not turning a profit until the most recent quarter, in which it earned $279K pre-tax. It seems unclear if their business model works the same in Mexico (lack of social safety nets). Either way, the impact is minimal given it is starting from such a low base.
Sources: Company reports
Excess Returns
WRLD uses a method of precomputing the interest on the loans called the rule of 78s, a largely archaic loan method leftover from the era before computers. The effect of this is to penalize prepayments by frontloading the interest into the loan structure. WRLD states loans are prepayable at any time without penalty. WRLD further misleads customers by claiming they get a rebate if they prepay but this is much less than the normal savings for prepaying a loan due to the front loaded nature of the interest on the loan.
http://en.wikipedia.org/wiki/Rule_of_78s
The real insidious part of this loan structure is how it is used to juice returns and create a cycle of debt many customers get locked into (without any understanding). WRLD aggressively markets refinancing of loans before maturity. Once a customer has paid a few months of the loan (which was mostly interest), the customer is eligible for another loan. Due to the rule of 78s, the loan structure and new origination fees dramatically increase the effective APR well beyond what would have been if the loan was simply paid off in due time. Thus, the company is able to charge interest rates upwards of 204%.
From the 10K:
"As of March 31, 2010, the annual percentage rates on loans offered by the Company, which include interest, fees and other charges as calculated for the purposes of the requirements of the federal Truth in Lending Act, ranged from 25% to 204% depending the loan size, maturity and the state in which the loan is made."
Below I show a synthetic calculation of WRLD's net interest margin since the company is clearly not a bank. This is calculated by dividing the net interest income, FTE by average interest earning assets. As you can see below, this has ranged above 60% for the past decade.
Net Interest Margin: north of 60% for the last decade
As a result of the excessive interest rates WRLD has charged clients, the company has generated returns on equity around the 20% level for the past decade.
One might suspect that credit quality would tell a story of the aggressive growth and egregious business practices, but quite the opposite is true. Credit trends have remained impressively healthy over The Great Recession.
Net Charge-offs: Business as usual for WRLD, even throughout the recession
Sources: Company reports
Loans Origination and Receivable: I argue that the company has been kicking the can down the road by extending and pretending. The company's loan book has grown along with originations.
Sources: Company reports
Over 70% of originations have been refinancings over the past 3 years. This enables the company, in my belief, to garner excess returns by the rule of 78. Further, I believe the credit quality of the portfolio is not nearly as good as credit metrics contend, given the fact that the company literally extends and pretends on many of the loans.
Sources: Company reports
Loan balances have increased while the company has been refinancing existing loans, indicative of loan optics (loan mods/extending and pretending).
WRLD continues to increase loan balances even throughout the downturn as customers roll loans and increase balances
Disappearing shareholder value when the music stops: What could the company be worth? I argue the value of the loan book could erode drastically if regulation makes their current business model illegal.
Note: As of 12/17/10 Sources: Company reports
Regulation as a Catalyst
In the company's own words, the business model could be regulated away:
10K:
"...proposed or pending legislative or regulatory changes have been introduced that would, if enacted, have a material adverse effect on, or possibly even eliminate, our ability to continue our current business. We can give no assurance that the laws and regulations that govern our business will remain unchanged or that any such future changes will not materially and adversely affect or in the worst case, eliminate, the Company's lending practices, operations, profitability or prospects."
Defenders of payday and installment loans make the case that while these loans are predatory they still serve a function as these are customers who no one else will lend to. This argument is expressed as the alternative these customers will turn to is the local loan shark, which would be even worse. A valid legal alternative model is the successful small lender pilot program which proved very successful. This should offer critics of shutting down this lending segment a viable solution.
http://www.loansafe.org/fdics-small-dollar-loan-pilot-shows-banks-can-offer-alternatives-to-high-cost-short-term-credit-for-small-dollar-loans
On the recent call,Sandy McLean, chairman and CEO, did little to appease concern about the impending regulation that will hit the company. He merely stated they are monitoring regulation and believes the Consumer Financial Protection Bureau is the biggest impending risk to the business.
Stage Left, Enter Elizabeth Warren and the CFPB
An outspoken critic of predatory lenders, Elizabeth Warren, was appointed as a special advisor in charge of setting up the Consumer Financial Protection Bureau (CFPB), created under the Dodd-Frank Act. The new Bureau will have a $400M budget and mandate to protect consumers from "unfair, deceptive or abusive" practices and will be housed under the Federal Reserve no later than July 21, 2011, at which point, the Bureau will gain the powers from the agencies that currently hold them (Federal Reserve, OCC, OTC, FDIC, NCUA, HUD, FTC). Thus, as it's written right now, the CFPB will be up and running in July 2011, although the Bureau should be able to propose rules before it receives its full power.
Sources: www.cfpbspotlight.com
The purpose of the Bureau is to implement and enforce Federal consumer financial laws to ensure that markets for consumer financial products and services are fair, transparent, and competitive. The CFPB will have the power to write and enforce the rules, which govern how financial products are offered.
The specific authorities, which will effect WRLD:
Prevention of Unfair, Deceptive or Abusive Acts: Bureau can prevent a covered person from engaging in or committing an unfair, deceptive or abusive act or practice in connection with a transaction with a consumer for a consumer financial product or service, or the offering thereof. Adds the term 'abusive.'
Fair Disclosures: Bureau will have authority to ensure that information relevant to the purchase of such products or services is disclosed to the consumer in plain language in a manner that permits consumers to understand the costs, benefits, and risks associated with the product or service.
Warren's views on Consumer Protection and Companies like WRLD paint a grim picture for WRLD's future:
Unsafe At Any Rate - Summer 2007
"Payday lenders offer consumers a friendly hand when they are short of cash. But hidden in the tangle of disclosures is a staggering interest rate...The Department of Defense identified payday lending as such a serious problem for those in the military that it determined the industry "undermines military readiness." In fact, the practices were so outrageous that Congress banned all companies from charging military people more than 36 percent interest. This change in the law will protect military families from payday lenders, but it will leave all other families subject to the same predatory practices."
Making Credit Safer - May 2008
"Payday loans provide another example of a credit product that can impose substantial costs on imperfectly informed and imperfectly rational borrowers... Payday lenders target such customers, amassing 90% of their profits from borrowers who roll over their loans five or more times during a year." - Making Credit Safer
"Perhaps the most dangerous feature of the payday-loan product is the loan rollover. Many payday borrowers do not pay back the loan on the next payday. Instead, they roll over, meaning they renew the loan for another period." - Making Credit Safer
On State Regulatory Shortcomings:
"The current regulatory scheme thus has two systemic problems. By permitting the states to compete for business by offering less and less consumer protection, the regulation scheme starts to unravel. Moreover, federal regulations that preempt state consumer protection without substituting other protection schemes create large holes in the regulatory fabric that encourage lenders to use a national charter to evade local protection. The combination not only leaves consumers with little protection, it also creates structures in which the most aggressive lenders can pursue their tactics with impunity."
Real Change -Turning up the Heat on Non-Bank Lenders - September 2009
"But there is an even bigger change in the wind: regulating the non-banks. Democrats and Republicans alike agree that the proliferation of unregulated, non-bank lenders contributed significantly to the financial crisis by feeding millions of dangerous financial products into the economic system. Non-bank institutions were active participants in the race to the bottom among lenders. From subprime mortgage loans to small dollar loans, they showed how to wring high fees and staggering interest rates out of consumer lending. Their fine-print contracts, and new tricks and traps, transformed the market."
http://www.huffingtonpost.com/elizabeth-warren/real-change-turning-up-th_b_276887.html
The Mario Savio Memorial Lecture by Elizabeth Warren - October 2010
"Normally, agencies use supervision and lawsuits to enforce the law. This agency will do that as the cop on the beat watching huge credit card companies, local payday lenders, and others in between. Technology can help us do that better, by making sure our enforcement priorities are tightly connected to the financial market realities as experienced by customers every day.
http://media.ft.com/cms/43919d78-f7e6-11df-8d91-00144feab49a.pdf
Warren has been traveling the country, meeting with people to setup the CFPB. Many of these people shares Warren's views on non-bank lenders such as Martin Eakes (CEO of Self-Help/Center for Responsible Lending), Travis Plunkett (Consumer Federation of America). Other meetings read like a who's who for industry execs. It's clear that payday lenders won't have a seat at the table.
http://online.wsj.com/article/SB10001424052748704116004575522062731420330.html
This is particularly ominous considering that the national "default" regulatory climate today before tougher intervention excludes WRLD's business from even operating.
Conclusion
As the timeline for when new rules coming down the pipeline that affect WRLD is questionable, I'm not putting the position on in any size until the CFPB begins to reach critical mass. As such, I am letting people know about my thought process and will update this accordingly when the rule making aspect of the CFPB becomes reality. When this happens, WLRD should be forced to change its business model as we know it and given that the company has one true business, there is no where for the company (and the stock) to go but down.
Risks
The biggest risk to my thesis is the the recent selection of Rep. Spencer Bachus to serve as the chairman of the House Financial Services Committee next year. He questions the role Elizabeth Warren is playing in setting up the CFPB.
Catalyst
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