In this post, we're going to profile The Cash Store Financial Services Inc., which trades as CSF on the Toronto Stock Exchange.
Accounts managed by Kerrisdale currently hold CSF, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.
Our PDF materials for CSF can be downloaded here. All figures in this email are in Canadian Dollars. Financials have not been updated for 3-31-10 figures released late last week.
Although we own CSF, the main purpose of this post is to provide background information for our monthly investment writeup AUC. AUC is essentially a startup version of CSF in a new country where the payday lending market is a fraction of the size of Canada's. AUC management are former Canadian executives from CSF, and the business strategy is to simply export the successful Canadian business model to Australia. Understanding CSF's historical growth in Canada is integral to envisioning how AUC could grow in Australia.
CSF was begun on February 23, 2001, when founder Gordon Reykdal launched a new company called Rentcash Inc. Prior to Rentcash, Reykdal had founded and lost control of two companies in the furniture rental business. For Reykdal, the third time was a charm. Rentcash initially operated two unrelated business lines; one was The Cash Store, a new payday lender, and the other was Insta-rent, a rent-to-own business that allowed consumers to rent, with or without purchase options, brand-name electronic products, appliances and household furniture. Insta-rent wasn't much of a success. It was spun off on March 31, 2008 and is no longer part of Cash Store Financial. Following the spinoff, Rentcash was renamed The Cash Store Financial Services Inc.
In its nine years of operations, CSF's payday lending stores have grown to 469, with 99 of those stores coming through an acquisition of competitor Instaloan Financial Solutions in April 2005. By my estimates, aside from the Instaloan acquisition, which cost $35m and was funded largely through an equity raise, the company raised less than $15m to grow its organic business. As of 12/31/09, the business generated $160m of sales, $36m of EBITDA, and $23m of free cash flow. Its return on invested capital is approximately 30%, an impressive statistic. Capex has been relatively light throughout the company's history.
Below are CSF's stores, revenue and EBITDA from inception to 2009, excluding the Insta-rent division. Because the company was comprised of both the payday lending and the Insta-rent businesses prior to 2008, the pre-spinoff EBITDA and post-spinoff EBITDA shown below are not directly comparable. CSF's methodology for allocating corporate overhead to the payday lending business was different pre- and post-spinoff. But for our purposes, this is not important; we intend mainly to show how rapid CSF's growth has been over the past 9 years:
The Company posted a decline in its payday lending business in 2007, when regulatory headwinds prompted the Company to discontinue rollovers (ie. allowing current customers to roll over their current loan into a new loan on their payday). Aside from that, the company's growth has been fairly rapid.
CSF's business is fairly simple. It's a payday lender; see our post on the payday lending business / industry. The company lends money on a very short-term basis to low-income borrowers with poor credit histories at very high interest rates. The short-term nature of its loans; its ability to lend without doing credit checks; and the personal relationships it develops with its borrowers allows CSF to achieve low default rates relative to the very high interest rates that it charges borrowers. It's a fairly proven business model that generates high returns on capital as long as (a) the government doesn't ban it and (b) the classic forces of competition haven't yet reared their ugly heads to drive down profit margins.
So if the business model is so simple, how did CSF grow so fast with so little capital? Hundreds of thousands of startups launch each year. Probably less than 0.1% achieve $160m of sales, $36m of EBITDA, and $23m of free cash flow eight years later.
As I give my answers below to this question, I'll add a note related to AUC after each one.
1. The payday lending market in Canada was fairly unsaturated in 2000 and was still in the beginning stages of its growth phase. It's important to note that the payday loan industry began growing rapidly only in the mid-1990s. It's a relatively new business model within specialty finance. (AUC sidenote: Australia is just as unsaturated today as Canada was in 2000)
2. When Cash Store Financial began operations, there were no other new entrants with equally hyper-aggressive national ambitions. Money Mart, a subsidiary of U.S.-based Dollar Financial, was the market share leader in 2000 and was growing steadily. But the other sophisticated and aggressive payday chains in North America were in the United States, and they were focused on gaining market share within the United States. Out of the Canadian payday lenders that were looking to expand in the early 2000s, it was mainly CSF that had a seasoned management team capable of rapidly establishing a national chain. Today, Money Mart and CSF remain the only two publicly-traded payday lenders in Canada (but American companies have announced intentions to expand into Canada). (AUC sidenote: AUC's management team currently finds itself as the only hyper-aggressive, seasoned management team capable of building a 300+ store chain by 2015 in Australia. At 44 stores, they already are the largest player!)
3. Low-cost operator. One of the factors that has made CSF's business model so successful is the low amount of capital required to grow and operate its business. Although this is true for the payday sector as a whole, it is particularly true for CSF. The company budgets $130,000 for new store openings, which entails $65k for initial capital expenditures on leasehold improvements and another $65k to fund operating losses for the first 7 to 9 months at the new location. Capital expenditures are kept low because the company provides funds to customers via prepaid debit cards instead of cash. This reduces the need for secure cash handling infrastructure like bullet proof glass, money safes, and steel reinforced doors and walls. As well, CSF suffers minimal loss or leakage of cash, as would happen when physical cash is handled by employees; either through theft or error. (AUC sidenote: AUC is employing the same low-cost operator strategies in Australia that parent CSF honed in Canada)
4. Better management, corporate culture and more incentivized branch managers than peers. This topic is less quantifiable than the others, but from the work I've done on the industry, I have a sense that CSF does a better job establishing a decentralized branch-focused management infrastructure where branch managers are properly incentivized to maximize branch revenue and profitability. At the more senior level, CSF's rapid growth in nine years from zero stores to one of the nation's two industry leaders speaks for itself in terms of management competence. (AUC sidenote: AUC senior management is comprised of top-performing Canadian regional and divisional managers who have been given AUC equity and have become highly incentivized to turn AUC into an even more successful version of CSF)
5. Customer relationships. Relative to peers, CSF creates a more inviting and comfortable environment for customers. The store layouts are modeled after banks, and customers sit across desks when interacting with CSF employees. At peer stores, customers often speak into microphones through bullet-proof glass. (AUC sidenote: AUC has same store layouts as CSF)
6. Brokerage business. CSF does not lend its own capital; rather, it acts as a broker for 3rd party lenders. Historically, this has been because the company didn't want to be penalized for exceeding regulatory interest rate caps on its loans. Now that the Canadian provinces have established official rate caps and the regulatory environment has stabilized, the company is looking to begin lending its own capital instead of using 3rd party lenders, in order to take advantage of a lower cost of capital. While the brokerage model may lead to lower profit margins, the business model was conducive to faster growth than the balance sheet lending model, because CSF's growth was not limited by the size of its balance sheet. (AUC sidenote: AUC operates a brokerage model, similar to historical CSF)
Other features of the business
- Insider ownership is high. Founder Gordon Reykdal owned 21.5% of shares as of 6/30/09 and as of August 26, 2009, the Company's directors and executive officers together beneficially owned 4,574,650 (27.4%) of the Company's outstanding Common Shares.
- Capital allocation decisions have been intelligent and shareholder friendly. Examples include (i) spinning off the Insta-rent business to unlock value, (ii) buying back 15% of their shares in FY09, (iii) instituting and raising dividends.
- The regulatory developments in Canada have been excellent for CSF. The rate caps mandated by the provinces are actually above CSF's average blended rate caps, according to some estimates. The rate caps are however lower than the blended rates of some of the smaller, higher-cost payday lenders, and should therefore drive marginal players out of business or into the hands of CSF, Money Mart or other larger players. In a sense, the legislation has the impact of making the Canadian payday lending business a more oligopolistic industry.
At about $17.40, the stock trades approximately 19x trailing PE. Given the company's high FCF generation and promising near-term financial prospects, I think a more appropriate valuation is 23x+. I have a target price of $22+.
Given strong underlying fundamentals, particularly in the near- to intermediate-term, the current valuation is too low. Over the long-term, competitive pressures are a more serious concern. My bet is that when the Canadian market becomes more saturated, overcapacity will steadily chip away at the profit margins of the Canadian payday lenders. That inflection point is probably several years away though.
With respect to AUC, the CSF story from 2000 to 2009 paints a promising future for the Australian operations over the next 10 years. If AUC can match CSF's growth trajectory, AUC's stock price should be several multiples of its current value in 4-5 years. Regulatory risk remains a serious risk. Payday lending, after all, can be altogether banned, as has been done in many states in the US. If, however, payday lending legislation in Australia evolves similarly to how it did in Canada, I expect the Australian business fundamentals to match, and probably exceed, the operational performance of its Canadian parent.
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