Thursday, August 7, 2014

Case Study: EZPW - Beautifully Deceptive

I recent came across EZ Pawn (EZPWN). It showed up in my filters after a big drop in the stock price. From what I knew about pawn shops from watching reality tv about pawn shops, they're basically brick and mortar shops, and not financial companies. A quick glance at the financials and it was love at first sight. I estimate free cash flow by subtracting capital expenditures from cash from operating activities. Not an exactly the same as free cash flow, but it's easy enough to do in my head from google finance statements, meaning I don't have to open up the 10-K, and it's a good enough estimate to tell me whether or not to perform more research. So here's what I saw.

EZPW Cash flow statement
There's a significant, noticeable drop in net income, partly due to an unusual expense item, but we can look into that. If the reasons are temporary, it could mean the price drop was unwarranted and this could be a very good deal. Let's crack open the 2013 10-K and see what we find.

Page 4 - 107 company owned stores were closed in 2013, which is about 9% of the total number of stores. This is significant percentage of stores, but better late than never to close unprofitable stores. business model of pawning is to give a collateralized loan. If the borrower cannot pay, EZPW effectively has bought the collateral and will then sell it to recover principal. Yada yada about fees and interest, which obviously equate to triple digit APY's in order for making small loans to be economical, and about ~80% of the loans actually get repaid as cash.

Page 6 - Credit enhancement services - Didn't see how they're making money off this but I suppose they're charging fees. Since EZPW is effectively guaranteeing loans, I'll be looking for some kind of liability to account for it.

Page 18 - Phillip E Cohen beneficially owns all of the voting stock - This is a bigger deal that most people realize. When one person controls the company, they can make the company engage in behavior which is beneficial to him and detrimental to all other shareholders. This section also explains that common stock which is publicly traded do not have voting rights. This may or may not be a good thing, depending on who runs the company.

Page 25 - This stock does not, and will not pay dividends.

Page 30 to 31 - breaks down most of the 46M unusual expense. Looks ok, mostly from closing the locations.

Page 33 - Pawn Loan and Sales Revenue Recognition
We record pawn service charges using the interest method for all pawn loans we believe to be collectible. We base our estimate of collectible loans on several factors, including recent redemption rates, historical trends in redemption rates and the amount of loans due in the following two months. 

So the way pawning works is that you walk into the pawn shop with an item of value, let's say market value of 100 dollars. The pawn shop gives you a loan of up to let's say 50% of the value, so you get a loan of 50 dollars. 2 months later, you will be required to pay back the loan, plus interest, plus fees, which will probably be around 80 dollars. If you do not pay it back, then the pawn shop sells your item for 100 dollars, and pockets the difference. This covers the interest, fees, and risk of obsolete inventory. The fees (not talking about interest) are a significant portion of the revenue. There's a good chance that it will go unpaid (~20% of loans are not repaid). The pawn service charge is what they're saying they're using the interest method for, meaning they will recognize revenue over the course of the loan, even though they will only receive the cash if the borrower does not default. I did not think this was a big deal, granted that most loans were under $1000.

Unsecured Consumer Loan Revenue — We accrue fees and interest in accordance with state and provincial laws on the percentage of unsecured loans (single-payment and multiple-payment) we have made that we believe to be collectible. Accrued fees related to defaulted loans reduce fee revenue upon loan default and increase fee revenue upon collection.

EZPW records the revenue from the fees first, and then reverses it when the borrower defaults. This is a little earlier than I'd like to see, but as mentioned before, with most loans being under 3 months and under $1000, this doesn't seem to bad.

Page 42 - There is a 42.5M imparement on their ownership of Albermarle & Bond. If you try to look up this company, you'll see that it's been delisted. EZPW basically lost their whole investment in the company. This is pretty bad. It reflects a very poor acquisition decision.

Page 51 - Off-Balance Sheet Arrangements - This is where we finally see something which is less neutral and more bad. Those loan guarantees from earlier are addressed here. The liabilities for those loans do not show up on the balance sheet. It says the maximum loan exposure is 28.8M, which is not the end of the world (yet).

Page 61 - Cash flow statement - This is where it gets really bad. This is the official cash flow statement, not the generic one which google and morningstar parse into a watered down form. In the screenshot above, you may have noticed a -113M Other Investing And Cash Flow Item. This is a bucket which generally contains the amounts used in acquisitions and purchasing stocks and bonds with spare cash. 113M is significant proportional to the 126M Cash from operating. If you look for "Loans made" and "Loans repaid, you'll see -923,103 and 597,528 for 2013. 237,717 is the recovered amount on selling collateral. So in net, we have -923103 + 597528 + 237717 = -87858 (everything in thousands). This means that 87M is outstanding loans + loans which have not been repaid. This is ok if we see an influx of money from prior years in the Other Investing And Cash Flow Item line, but this is not the case. This is a leak in the money flow. Money is leaving the company and it is not coming back into it. This is a big red flag. This is as dangerous as a company can get for our style of investing. We have a company which not only shows positive net income, but also positive free cash flow. This is a clear example of a company where the rules for calculating net income does not properly capture the financial health of EZPW.

If we redo our calculation of Cash from Operating - Capex - 87M, we get 126M-46M-87M = -$7M for 2013. This is a stark comparison with the 126M-46M = ~80M cash flow that we thought we had. This is the where you can safely stop researching the company, but I decided to skim through the rest of it.

Page 88 - Related Party Transactions - $7.2M is spent on "consulting services" from Madison Park LLC. Madison Park is wholly owned by Phillip E Cohen. Phillip E Cohen..... hey that's the guy who owns all of the voting stock! As if not being able to run a profitable company was bad enough, there's a shareholder who has prevented all dividends to other shareholders, but gives himself a $7.2M dividend. This is the danger of a company where control resides with one person. He can make the decision to pay himself and no one else via a related party transaction.

This is where I stopped my research. This company will only ever benefit Phillip E Cohen, and no other shareholder. I can't really say it's a bad company, because I imagine that this company will continue to run. However, any real money that it can generate will be sucked out by Phillip Cohen. This is his cash cow and I know that he will figure out how to ensure that EZPW stays in business. With that said, I am still learning. Researching companies is time consuming, and this is the first time I came across such a company. It's the first time I really understood why a majority vote is so dangerous in someone else's hands. I've read about that many times, but I never saw a clear example. I hope that you might have benefited from reading this case study. Needless to say, EZPW is not a stock that you should own. However, you'd be a fool to short it since the very viability of the company seems to be entirely under someone's control. If you have this stock, get rid of it.

2 comments:

  1. Can you do an analysis of TPL?

    ReplyDelete
  2. Hi Steven. I unfortunately cannot do an accurate analysis of TPL. It's not a type of company which I understand very well, and I won't be able to evaluate the proper values of their land / leases. However, what I was able to see rather quickly was that it has a market cap of 1.5BN. Its operating cash flow for 2013 was only 30 million, and its net income was 27 million, which is about 2% or so of the market cap. These are not the types of returns that I'd be interested in, especially since you can get better returns by buying US treasury bonds.

    ReplyDelete