I recently ran a screen for mid-cap companies that could best described as “value” plays. The goal was to find companies that weren’t broken, but for one reason or another had either lost their way or had been left behind by investors. Twelve names appeared on the list. I have done work on two of the names. I am currently long both. The first – Superior Energy Services (SPN – NYSE) is up over 7% since I got in less than 2 weeks ago. Given the run, I will save that topic for another time. The second, which is the subject of this article, is up just over 2% since I initiated my position. Over that period, the market is up approximately 1%.
Elevator pitch: recession resistant sector; focused on an underserved market; as consumers see lower take home pay as a result of higher payroll taxes, demand could rise as their spending habits will be slower to adjust; finally, the business should benefit from a rise in gold prices. The focus of this post has a number of additional positives. The company has grown book value per share each of the last five years at an average rate of 16% (Warren Buffett would be proud). Net revenues and EBITDA have grown an average of 14% and 16%, respectively, over the past five years. The opportunity lies within the depressed EBITDA margin which is 200 basis points below the 5 year average (as a result of several management missteps). If the company is able to get just half of the lost EBITDA margin back, the shares would rise by over 8% – without multiple expansion. The stock trades at a significant discount to the market multiples of comparable companies and sits 31% below the all time high reached in September 2011. It’s not all gumdrops and rainbows. Regulatory risk is an issue but seems largely priced in the shares. Interested? If so read on to find out why these shares have the potential to rise another 15%-20% over the coming year.
The above description refers to Cash America International, Inc. (CSH – NYSE, $41.76), a specialty financial services company that offers secured non-recourse loans to consumers. In plain English, CSH is a pawn lender. Cash America, is the largest and oldest publicly owned store front pawn operator in the country.
As you can see from the chart below, CSH has grown book value consistently over the past 5 years.
Cash America shares are essentially flat over the past year while the S&P is up over 14% during the same period. CSH has outperformed EZ Corp (EZPW) but has significantly lagged First Cash Financial (FCFS) since last January. On a relative basis, the company is valued at a 47% discount to its peers on an EV/Revenue basis and at a 19% discount on an EV/EBITDA basis. On a price to book basis, CSH trades at a 49% discount. If CSH grows book value by 15% (lower than its 5 year average) and gets rewarded with EZPW’s multiple, the stock would trade at over $50 – a 21% premium over Friday’s close.
Why does Cash America trade at such a big discount to its peers? Many of the valuation woes are a result of the company’s own doing. During 2012, management was forced to lower guidance not once, not twice, but three times. First, the company lowered FY 2011 guidance (reported in January) as a result of higher loan loss reserves and higher operating costs during the holiday selling season. The increase in loan loss reserves was primarily due to the growth of installment loans (discussed below). In July, the company lowered full year guidance due to slowing demand for “pawn lending”. The shares dropped 20% on the news. As you can see from the chart below, pawn loan growth is well below trend.
Finally, on the third quarter conference call, management again lowered guidance as installment loan growth continued which suppressed margins due to accounting rules. As you can see from the chart below, margins have come down each quarter of 2012. Is this a secular or cyclical trend? I believe it’s more the latter with a little execution misstep mixed in.
Management’s failure to manage the Street’s expectation has put the shares in the penalty box. Investors have now taken a “show me” attitude – management must execute its strategy for the shares to be valued in line with its industry peers.
I view the 3rd quarter announcement that the company was planning to “significantly” modify its Mexico strategy as a positive. The company is shuttering 147 Mexico based locations that solely offer pawn loans on jewelry based collateral. As a result of the reorganization, the company incurred at $21.9 million charge. While this is a costly lesson, CSH is now better positioned to exploit the opportunity in Mexico. Going forward, CSH will operate only 47 pawn stores in Mexico, this compares to 223 for EZPW and 536 for FCFS. Not only does the company now have less of an earnings drag from the unprofitable operations but it also has a better blueprint for growth in the region going forward.
As you can see from the chart below, EBITDA has grown Y-O-Y at double digit rates with only a few exceptions.
Management knows how to run a profitable shop. If management can return to historic profitability levels, investors will be handsomely rewarded.
The company is “aggressively” moving into installment lending and away from payday lending which has come under increased scrutiny by the regulators. As you can see from the chart below, consumer loans have grown above average in the past year and a half. In the third quarter, total consumer loans were larger than pawn loans for the first time.
In Ohio, the company voluntarily reimbursed customers due to the improper filing of certain court documents. This highlights the regulatory risk faced by the entire industry. However, much, if not all of that risk appears to be priced into the stock. One downside to installment lending is that the company must book the full loss provision at the outset of the loan while it recognizes income over the life of the loan. Once the growth in installment loans hits a steady state, the timing difference will become less of an issue. On the positive side, installment loans tend to be larger in size.
CSH has a robust E-Commerce platform that operates under the Enova banner. Enova was slated to go public last year. However, the offering was pulled due to market conditions last summer (when CSH shares traded at $45). Nevertheless, Enova continues to exhibit significant growth with a diverse mix of revenue. During the 3rd quarter, 46% of net revenue was generated outside of the US. If the markets continue their upward trend, it’s possible that management may revisit the offering. This could unlock additional upside for investors.
Finally, the fall in gold prices has weighed on the sector. The company’s inventory/collateral is 60% gold. If the value of the yellow metal restarts its ascent, CSH should benefit.
Cautionary note to potential investors: the company is scheduled to release earnings on January 24th, the shares could be volatile leading up to and immediately following the announcement. Happy trading.
