This hasn’t been the easiest year for pawn and payday lenders not named First Cash Financial (FCFS), and EZCORP (EZPW) has certainly found itself caught in that downdraft, with the shares down more than 40% over the past year. While fellow Seeking Alpha writer Igor Novgorodtsev gave a good rundown on EZCORP’s gold scrapping issues, I believe there is more at work here than just the price and profitability of gold scrapping. Not only does EZCORP have a shareholder-unfriendly structure, but the company’s losses on consumer loans and market positioning both concern me.
Now, the real question is how much a “concern” is worth. I think First Cash is hands down the better company (and I’ve owned it for quite a while), but it’s hard to see EZCORP get hammered to such a level and not wonder if it has gone past the point where enough’s enough. I do worry about EZCORP’s fundamental market positioning and the risk to the model from both credit losses and regulatory changes, but even conservative assumptions seem to suggest these shares could hold real turnaround potential.
Scrapping Is A Known Issue, But What About The Rest?
I don’t want to spend much time going over the same ground that Igor trod earlier this year. Like other pawn lenders including First Cash and Cash America (CSH), the decline in gold prices and scrapping profitability has sapped what had been a good source of revenue for these companies. That said, I don’t want to give EZCORP management a total pass here – they did, after all, allow scrapping to grow to 20% or more of revenue and should have known the risks.
I’m not completely sold on management’s strategy for managing through this problem. EZCORP’s CEO has talked of driving down scrapping back into the low teens as a percentage of revenue, in part by shifting away from scrap and toward a hold-and-sell model. In contrast, First Cash is opting to take their medicine and just push through this tough patch in scrapping profitability. I’m not sold on EZCORP’s strategy – inventory turns on jewelry sales tend to be in the neighborhood of 2x per year, while pawn lenders can turn scrap inventory more than eight times a year. I worry, then, that EZCORP is simply extending the pain and stretching out the medicine-taking over a longer period instead of really dealing with this in a better and more profitable way.
Setting aside the scrapping issue, I am concerned about the company’s recent increase in debt losses. Losses on consumer loans jumped by two-thirds in the fourth quarter, to over 30% of consumer loan fees from just over 20% last year. Much of these appears to be due to the Cash Genie operations (where losses were apparently up to a whopping 50%-plus of fees), but management also talked about higher losses on auto title loans. While EZCORP certainly prices its consumer loans with more than enough slack to absorb losses, there is a limit to how far these losses can climb before the profitability is meaningfully impacted.
I’m also concerned about the pace of the company’s growth. While it sounded as though same-store merchandise sales were solid, merchandise gross margin fell about six points year-over-year in the fourth quarter. At the same time, same-store pawn loans outstanding were down 4%. First Cash also saw some merchandise gross margin pressure, but not as much (down about half as much as EZCORP), while pawn loan receivables were up 2% in the U.S. store base.
A Difference In Model Should Mean A Difference In Valuation
For as often as I see straight-up valuation comparisons between First Cash and EZCORP (almost always done with the idea of highlighting EZCORP’s apparent cheapness), I think such a comparison is dangerous without exploring some significant differences in the models.
For starters, although First Cash has been on a bit of a consolidation binge in the U.S. here of late, EZCORP has almost four times as many U.S. stores as First Cash, while First Cash has almost 90% more Mexican stores. What’s more, EZCORP’s Mexican pawn store base is, like most of the Mexican pawn market, much more heavily weighted toward jewelry-based lending.
These are important differences. Mexico is a better growth market today, with double-digit same-store sales growth not at all uncommon (and First Cash’s stores in Mexico are growing a little faster on a same-store basis). On the flip side, the U.S. pawn market is seeing very sluggish growth trends as part of the wider pressure in discount retail sales.
I also believe it is important to note that EZCORP has much more extensive non-pawn operations. About one-quarter of EZCORP’s revenue comes from non-pawn lending, with about half of that sum coming from payday lending and the rest coming from online loans, installment loans, and auto title loans. Not only do these forms of lending carry much higher risks of loss (as seen by the increased bad consumer loan expense here lately), but there is more regulatory risk with them as well. What’s more, banks like Wells Fargo (WFC) and Regions (RF) have quietly stepped up their payroll lending (not the same as payday lending, but in the same zip code) and that could be a threat to the industry over the longer term.
Along those same lines, I’m not as bullish as some on the fact that a significant portion of EZCORP’s Mexican business revolves around payroll withholding – while that is an option that appeals to those who do not have pawnable collateral, there is a lot of distrust in Mexico towards financial institutions in general (the banking sector is less than 20% of GDP) and there are rumblings from political figures in Mexico towards increasing the regulatory oversight of payroll lending in favor of supporting more bank-based lending.
Last and not least, there are issues tied to management and corporate governance. The ownership structure is questionable: Phillip Cohen completely controls the voting stock of this company, and the company pays over $7 million in various “advisory fees” to Cohen’s Madison Park LLC financial advisory firm.
Growth Still In The Cards
EZCORP’s foray into the U.K. has not gone terribly well, as 30%-owned Albemarle Bond is in rough shape. Still, I do believe there is growth potential in Mexico (particularly now with a shift towards more merchandise-based lending) and I believe there is still ample room for consolidation in the U.S. Moreover, I like what I see as a shift towards more sophistication in the U.S. operations with respect to merchandise pricing. With that, I’m willing to model high single-digit revenue growth and low teens free cash flow growth over the next decade – a few points less than First Cash, though, as I believe First Cash is better-served with less leverage to the U.S. market, better merchandising operations, and a better merchandise-based focus in Mexico.
The Bottom Line
You could argue that on a DCF basis, EZCORP’s fair value approaches 20% upside. Clearly the sell-side doesn’t see it that way now, as the average price target is under $14. Along those lines, I must again highlight the risks of ongoing credit losses and essentially stashing low margins on scrapping as threats to the model.
I like bargains, but I’m not terrifically impressed with these shares. I don’t like the capital structure, I don’t believe management communicates particularly well to the Street, and I just don’t like the structure of the business (payday lending, auto title lending, jewelry-based ops in Mexico, etc.). Even so, for those who aren’t as negative about those aspects of the model as I am, there could certainly be some value here and EZCORP could be looking at a strong rebound trade if/when those losses and margins stabilize.
Disclosure: I am long FCFS. 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.