I wanted to bring to your attention the shares of EZCORP (EZPW), which are the shares of a company operating in profitable 'instant cash' businesses. The company became undervalued as a result of a series of short term issues, as well as a lack of management focus. EZCORP is one of the three largest providers of instant cash solutions in the US, their services consist of pawn loans, unsecured loans, auto title loans, and a Mexican pay-roll lending operation. In addition, the company owns interests in other companies within the same industry. The problems encountered by EZCORP were primarily related to management's poor execution and focus as well as the steep decline in gold prices.
The company is quite profitable and growing. EZCORP currently holds a cash flow generating ability around the low $100mm area with a market cap of $702mm. As demonstrated in the valuation section below, should the business stabilize, there is significant upside to current valuations.
The following write-up comprises (1) a summary of EZCORP's business, (2) an evaluation of the current issues, (3) valuation, (4) ownership details, and (5) the catalysts that would allow for value realization.
(1) EZCORP's business:
EZCORP is focused on the basic pawning service of providing instant cash to those without access to savings and/or the ability to receive a bank loan. These small, relatively distressed loans, have higher collateral requirements and higher rates from what a bank would normally charge. In the current market environment EZCORP charges 20% per month for pawn loans (which are secured), 15%-20% in their unsecured loans, and in their payroll withholding loans business in Mexico rates are at 56%. Since most loans have significant collateral, EZCORP is able to sell the collateral at a profit if the loan does not perform. For the uncollateralized consumer loans, default net of collection has represented 11%-13% of those loans (and around 5% on all loans) in the last few years. Overall, it is a very profitable business; gross margins have been around 62% in the last three years with little variation. Rates charged by EZCORP have stayed relatively unchanged in the last four years and the expectation is for them to stay that way in the near term.
As far as competition is concerned, EZCORP operates in a relatively mature and competitive industry. It is also a very fragmented industry, which has allowed for companies to maintain attractive margins. Every indicator suggests that it will remain as such. When people go pawn something they tend to go to their local pawn shop, when they need payday lending their employer has a local provider. It is a highly recurring business where return customers develop a loyalty towards their cash provider. Additionally, as evidenced by their market behavior, companies in the industry have been under short term difficulties that should make it relatively unattractive for new entrants.
Last thoughts on the business. This is a business that benefits from economies of scale, specifically when selling the forfeited collateral and when complying with regulation. It is a business with substantial seasonality. It is a relatively low capex business to maintain, once a store is open its maintenance is relatively inexpensive. Given that the majority of pawned items are gold, the company is susceptible to outsized short term movements in the price of gold.
For more of the specifics on EZCORP's business, there is a detailed break down of the different operations in their 2013 10K; I would suggest reading pages 3-8 (http://ift.tt/1pxyjLJ).
(2) Evaluation of the current issues
- Loss of focus and share dilution with aggressive expansion: Since the end of 2006, EZCORP assets have grown close to 7 times and revenues increased at a 18% CAGR, this was a result of an aggressive expansion plan embarked upon by management. The expansion plan included external acquisitions and new store openings. The massive growth caused the company to loose its operating excellence; costs and inventories have risen disproportionably, and implementation of new acquisitions was not always successful. Furthermore, some of these acquisitions were paid with stock. The company has increased its share count by 31% in the last five years, mostly due to the financing of these acquisitions. The dilution faced by shareholders and the lack of proper management in the previous years are of real concern.
However, there is a silver lining. Management has recognized their overly aggressive execution, with the CEO making it clear in the last earnings release that he now needs to work on re-focusing the company and going back to striving for operational excellence. There is some execution risk, but given current valuations, execution does not have to go as expected for the investor to make an attractive return. Lastly, the CFO mentioned that he does not plan to issue more stock at current valuation or for the foreseeable future, so there is no risk of further dilution.
- Regulation: The instant cash industry is a strongly regulated industry, just like with any other financial institution, the government wants to ensure that no unfair practices take place. This has been part of the industry's general operating environment. Furthermore, with the Dodd-Frank reform, risk of new potential regulation has emerged. The company adeptly frames the situation in its 10K (page 14). This is a real risk and there is ambiguity as to what regulators are thinking (an investor should demand a margin of safety for this uncertainty). The language within the 10K suggests that regulators will focus on unfair and predatory practices. So far as my knowledge goes, EZCORP is not engaged in those practices. One aspect to consider, the instant cash solution industry is an important industry, it gives cash to those who face significant barriers accessing it. Given the uncertainty around it, it is impossible to quantify the effect of new regulation, my view is that new regulation would slightly lower the big players' (EZPW, CSH, and FCFS) profitability through higher compliance related costs.
- Steep drop in 2013 of the price of gold: At EZCORP, the pawn business represents close to 39% of the company's revenues. 55% of items pawned are jewelry, the vast majority of that is gold jewelry. As a result, roughly 20% EZCORP business is influenced in some way by drastic movements in the gold markets given that loans range from 60-120 days (drastic since loan to values are generally quite low). Gold experienced a terrible 2013, dropping 27% for the year. This is a short term issue, a financial asset such as gold cannot have permanent wild short term negative swings (the key here is short term). Lastly, over the last three years, one year rolling correlations between gold and the share price of EZCORP have been as low as 0.011 and peaked as high as 0.282 in mid 2013. An investor in EZCORP should only worry about gold if he thinks its value will be at 0 in the near term.
- Decision to sell jewelry in the retail space instead of scrap: EZCORP decided to retail (instead of scrap) a larger portion of their forfeited jewelry, with the reasoning that margins are more attractive when retailing. This is a sensitive decision which should help the company achieve greater profitability. However, in the short term, there is a time of transition where inventory builds and revenues decelerate. Given the seasonality of the business, the company expects to sell a significant amount of the surplus during the Christmas through Valentine Day's jewelry shopping seasons. If the company is not successful retailing they can rely on scraping without hindrances.
- Poor results in the acquisition of Albemarle & Bond Holdings: EZCORP owns 30% of Albemarle & Bond Holdings (A&B), one of the UK's largest pawnbrokers. A&B had a very poor 2013, weighing down EZCORP results. EZCORP has written down the investment to $9.4mm so this previous headwind will no longer have a negative impact.
(3) Valuation
The preceding analysis should comprehensively demonstrate that EZCORP has an attractive and profitable business, while also uncovering the nature of its recent headwinds and the course taken by the company in addressing them. Furthermore, the reason why I write about EZCORP today, the reason that really highlights the opportunity is valuation. In 2011 and 2012 the company was making ~$100mm in FCF to equity (in this case FCFe is equal to Operating FCF less maintenance capex and some working capital adjustments). Given the aforementioned headwinds, FCFe came in around $84mm for 2013 (this was on terrible operating performance and several systematic issues affecting the company at the same time) and it was completely driven by margin compression. With their historical margins, taking into consideration the impact of the headwinds, the company can conservatively generate a FCFe of $110mm by 2015 and into the next couple of years ($110mm top line and 10% margins). For reference and as a sanity check, WFC the only firm that I found with 2015 estimates, has a 2015 EPS of 111mm (EPS 2.16 assuming no change in shares outstanding).
Looking at the situation through a pessimistic lens, if the company does not straighten shop so to speak, and the current 'temporary' headwinds affect the company for a prolonged period of time making them stay at $84mm FCFe for 2015. Even at these levels, the company looks undervalued, with a market cap of $702mm the shares at selling at a P/FCFe of 8.35x. Now assuming the company straightens up shop, and their operating capability comes through, it can generate at least $110mm of FCFe with expected revenue growth and attractive - but not excessive - margins. If you assume they can trade at a 12x multiple (which is over a 20% discount over the general market valuation) then the company would be capitalized at $1.32bn or $25.73 a share (99% higher than today's $12.87 share price). This is a company that the market can get excited about, it has done so in the past, if things go back to normal and sentiment changes, the upside potential is even higher.
What I am trying to portray is that the investor does not have to buy the new found focus argument or have conviction on the current issues going away soon. At current poor operating levels, the investor is buying with a margin of safety. If operating activity does get back to normal - and I mean normal not better - the upside optionality is significant.
The balance sheet gives good clues into EZCORP's business. On the profitability side, the company consistently grows its book value through retained earnings. On the asset side, goodwill is a large piece (32% of assets) and inventories have increased too rapidly (33% yoy growth). In general, a healthy balance sheet is depicted with total liabilities at $370mm, all covered by current assets. Tangible book value stands at $499mm (representing a P/TBV of 1.41).
(4) Ownership details
Investors in EZCORP should consider that 100% of the company's voting shares are owned by Phillip E. Cohen, and that directors and executive officers as a group own about 2.19% of the company through non-voting shares.
(5) Catalysts
So why EZCORP now? In the earnings call (November 2013) the company finally recognized and realized that it has to address the issues that it has been facing. Given that an important part of the issues come from the very issue of prioritizing growth vs focus, the change in priorities should contribute through the bottom line; specifically with margin expansion. There is, of course, execution risk but recognizing the issue and addressing it should take the company back to normalized profitability levels. For investors that want affirmation, waiting for the next quarter, or two, to track execution might make sense (yet prices might have gone up from current levels). I believe there is downside protection at current valuations and currently have invested half of my target position.
Management has indicated that they will start to aggressively sell the forfeited jewelry in the first two quarters of FY 2014. If they do so successfully, revenues will see a jump, margins will increase, and currently elevated inventory levels will decrease.
Disclosure: I am long EZPW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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