FirstCash Holdings: counter-cyclical pawnshop business (NASDAQ: FCFS)
FirstCash Holdings, Inc. (NASDAQ: FCFS) has a core pawnbroking business that is countercyclical and can potentially benefit from the current economic downturn. However, investors should keep in mind that the company recently acquired the America First Finance business, which provides Lease-To-Own (“LTO”) retail loans. This is highly cyclical and may expose the FCFS to credit losses in an adverse economic environment. I think, for now, the counter-cyclical headwinds in the pawnshop sector outweigh the risks in the payments sector, and FirstCash is worth a speculative buy.
FirstCash Holdings, Inc. is one of the leading pawnshop operators in the United States and Latin America, with more than 2,800 outlets. It also operates in the retail point-of-sale (“POS”) payment solutions business that offers consumers with limited credit LTO loans.
Approximately 80% of FCFS revenue comes from the pawnshop segment and 20% comes from the newly acquired POS Payments business (Figure 1).
Pawn is a counter-cyclical business
Pawnshops are local retail stores that buy and sell second-hand consumer goods such as jewelry, electronics, tools, and sporting goods. Pawnbrokers offer a quick and convenient source of small, secured, non-recourse loans to unbanked/underbanked/limited credit consumers.
A typical customer walks into the pawn shop with their personal property and about a quarter of the time sells the item directly to the store. Three-quarters of the time, they obtain a pledge loan, secured by their property. Of the items pawned, about three-quarters are redeemed and the pawnbroker earns monthly returns of 12-13%. A quarter of the pawnbrokers default and the pawnbroker takes possession of the asset. Assets that the pawnbroker takes possession of (either through outright purchase or overdue loans) are resold to consumers at a margin of 35-45%. Figure 2 shows an overview of Pawn activity.
Historically, pawnbroking has performed well in most economic cycles. In particular, the pawnbroking business is countercyclical, as financially stressed consumers tend to use pawnbroking services more in difficult economic conditions. US FirstCash Holdings stores actually saw a 50% increase in pledge receivables from 2007 to 2012 during the “Great Financial Crisis” (“GFC”), and receivables declined during COVID as financially strained consumers been supported by government stimulus checks (Figure 3). .
As government stimulus measures have ended and inflation eats away at household budgets, we can expect the use of pawnbrokers to increase over the coming quarters. Already, we see that U.S. pawnshop receivables are up 27% year-over-year to July 31 (Figure 4).
Financially, the pawn business model generates high returns. Contrary to payday loan, which is banned in 12 states and has interest rate caps of 36% in 18 other states, FirstCash’s pawnbrokers do not fall under these regulations. This has enabled FCFS to achieve total returns of more than 160% of earning assets over the past twelve months in its US pawnbroking segment (Figure 5). The Latin America segment’s rate of return is even higher at 190%.
On a consolidated basis, this translated to trailing year revenue of $2.2 billion and adjusted EPS of $4.64 (Figure 6).
Note that although pawnbroking generates fantastic cash returns, it requires a lot of operating expenses to maintain. After deducting operating expenses such as employee compensation and occupancy costs, FirstCash has an LTM adjustment. net margin of 9.2%.
The evaluation is rich
FirstCash is currently trading at a P/E Fwd of 17.3x, which is high compared to the financial sector’s P/E Fwd of 10.5x (Figure 7). However, we need to understand that the FCFS business is counter-cyclical, while investors may be wary of loan losses and therefore grant a lower multiple to banks and alternative lenders, FirstCash’s pawnbroking business actually benefits of a weakening economy as its pledges grow. during difficult times.
It is important to note that even during the COVID pandemic, FirstCash has experienced negligible loan losses, as FCFS typically only lends a fraction of an asset’s guaranteed fair value (Figure 8).
LTO Loans – Opportunity and Risk
While FirstCash’s core pawnbroking business appears to be benefiting from tougher economic conditions, the recently acquired POS payments business raises some questions and concerns.
In December 2017, FirstCash paid $1.17 billion (8 million shares plus $400 million in cash) to acquire America First Finance (“AFF”), a growing retail finance provider. AFF’s payment solutions are available at over 7,600 points of sale.
Similar to the increasingly popular BNPL business model, AFF’s POS payment solutions business allows consumers to apply for credit at the cash register. If credit is given, they can take the items home and pay for the purchase over time with automated installment payments (Figure 9).
On the positive side, the LTO finance business is somewhat complementary to the core pawnbroking business. It essentially targets the same consumer demographic (underbanked, limited credit) and captures transactions where that consumer purchases new assets from other retail merchants. It is also much easier to grow the productive asset base, as the lever to swing would be lending standards (one of the blows to FCFS in the past had been its lack of growth during good economic times).
However, there are subtle and critical differences between LTO companies and pawns. First, remember that in a typical pawnbroking transaction, the customer brings the pawned asset to the store, and the store retains possession of the collateral asset for the duration of the loan. The loan is usually given at a fraction of market value, so the pawnbroker is relatively protected against credit loss: in the worst case, the store takes ownership and sells the item.
In an LTO transaction, the customer requests a loan at the point of sale and takes the item home. The lender does not take possession of the property as collateral. Also, the loan is made on the “brand new” retail value of the asset (most often furniture), and the asset essentially depreciates as it leaves the door. Therefore, LTO loans have a high credit risk, especially since the customer is credit constrained at the outset.
It could also be difficult to recover defaulted LTO assets (having covered RCII and AAN in the past, I’ve read many stories of angry LTO customers acting violently towards debt collectors or destroying leased assets). FirstCash allows LTO assets to be returned to local pawnshops, however, I don’t know how likely this is to happen or if a piece of furniture like a large sofa can be sold quickly at a small footprint pawnshop.
The balance sheet is also a risk
Another risk for FirstCash is that it incurred significant debt to complete the AFF transaction. As shown in the figure, net debt stood at $1.2 billion at the end of the second quarter and is 3.3x LTM adj. EBITDA. High levels of indebtedness could limit management’s ability to react to various economic scenarios and business conditions.
In summary, FirstCash’s core pawnbroking business is countercyclical and can potentially benefit from the current economic downturn. However, investors should keep in mind that the recently acquired POS Payment Solutions business is highly cyclical and may expose FCFS to credit losses in an adverse economic environment. I think, for now, the countercyclical headwinds in the pawnshop sector outweigh the risks in the payments sector, and FirstCash Holdings, Inc. is worth a speculative buy.