A case study for growth, but at what cost?

So here’s the thing; I think I’ve found a company that offers decent future returns but, also, there is a catch.

I’m unsure on how to unpack it so it's probably best to start from the basics and work our way into it.

The company is Cash Converters.

Thematic:

This is now a small company that was even, as of the last quarterly rebalance, removed from the tracking list of ‘all ordinaries’. It’s total market capitalisation (how much it is worth) comes in at $96m. No managed funds are covering this company because it is so small. In fact, it is small enough to be swallowed whole by any one fund. This leads to a lack of research and it ‘flies under the radar’ to a degree. Keep in mind, at its height, this is a company that was valued at $895m in 2013.

It also has the ‘ick’ factor. That is, who the hell wants to admit that they own shares in a payday lender, especially one with a severely damaged reputation. Second, which fund manager wants to take that risk either?! Hence, it tends to be given a wide berth.

The first 9 months of the last financial year (think July 2019 to March 2020) were well above the levels of business even Cash Converters expected. This shows that people were in struggle town well before COVID-19. The sweeping bigger picture here is; do you think those same people (or more) will be in trouble and need a payday loan again when the Rona bucks get cut back?

Speaking of the Corona cash, many of Cash Converters customers have paid off their loans using the extra welfare money. Good for them but also good for Cash Converters. This has allowed them to hold a decent amount of cash, pay down their own debt and ‘tread water’ until the shit hits the fan in people's lives and they head back into one of those bright yellow businesses.

In the short term, the tightening up of credit and the extra Corona money will mean Cash Converters will probably do less business this year than it did last year. That being said, if we are just brave enough to take a longer term view, do we think there will be enough customers coming back into the store when the welfare cheques get cut back to make up for it and, potentially, have a bumper financial year in 2021/2022? I’ll let you decide if you think the Liberal government will invert itself for life and just open the taps on social welfare spending forever...

Ethics:

Here is the thing, Cash Converters lends to desperate people. There is just no other way to look at it. Nobody borrows at that rate of interest (read on to see exactly how much) and thinks they are in a good place. If you think that is wrong, they I would suggest you just stop reading and never invest in them. If you think that Cash Converters is offering a product that is in demand because there is a gap in the market between the public social security market and the more traditional lending market then you can probably sleep well at night knowing that you are doing good, if not God’s, work.


The Past:

Started way back in the day in Perth (where else but the loosest place for investing in Australia a la the micro cap mining stocks) this business has been around the traps for 36 years. Since beginning life as a pawn broker it now has the majority of its business tied up in the payday lending game. It got into a lot of hot water in the last 5 years thanks to some pretty loose lending and high charging of interest. In fact, it ended up having to settle some pretty massive lawsuits. Now, here is the good stuff you need to know.

The Good:

The lawsuits are now a thing of the past. Cash Converters recently made its very last installment ($10m if you don’t mind) to settle the class action lawsuits brought out of Queensland and the thousands of poor bastards that got choke holded on their loans. The reason this is in the good news category is because there are no more liabilities sitting out there for this. The offending occurred between 2009 and 2013 and it is now all paid for. Believe me, if those lawyers looking for fat cheques could have found a way to take them to court again in the 7 years since 2013, they would have. The question you might want to ask yourself at this point is; if Cash Converters had a lazy $42.5m plus the $5.8m in legal fees lying around that they didn’t have to pay out, would that be good for me as a shareholder? (Remember, they paid $32.5m last financial year and the last $10m in this financial year).

Cash Converters are now well into the car lending game with their company Green Light Auto. Why is this such a good thing? Well, it turns out that over the GFC period the finance people were watching and what they noticed was kind of interesting. The very last asset that was left and the last debt people stopped paying on was the car and the car loan. So what Cash Converters have done is leverage into a business that has a strong history of debt payment and follow through. Even so , this makes up a tiny portion of their earnings at $2.9m compared to personal finance at $49.2m.

Here’s the real meat and potatoes of the situation. The accounting books of Cash Converters show they lost $10.5m last year. Here’s the rub. Their accounts show the total lawsuit cost of $42.5m as a charge against earnings. So the accountants (never trust an accountant) report a 1.7c per share loss but if we add back in the $42.5m then the business operated on a 5.1c per share profit. This would give the currently 16c per share company a P/E of 3.1. We’ll get to this in a bit though.

The more interesting (and some say more complete) way of looking at how a business is going is by peeking at the cash flow statement. Now if you’re an Afterpay buff this statement would be enough to make you puke but things are decidedly rosey for Cash Converters. Keep this in mind ok; Cash Converters is valued at $96m. Last financial year (so ending June 30 2020) their day-to-day operations made them $70m dollars. This includes the $32.5m they paid as the first of two payments on that lawsuit. Next year, that figure will show $10m instead of the $32.5m going out the door and the cash flow statement will be $20m richer for it. In that same 12 months Cash Converters also managed to pay off $35m of their own debt and still put $24.8m in cash into the piggy bank. Tell me that isn’t a business in rude health!

The cash in the bank brings me to the next part that is important to look at; net tangible assets. Now old school investors will tell you all about ‘picking up dollars for cents’ and this is exactly what I’m going to try and convince you that the market is missing right now. Cash Converters, today, has 28.88 cents of assets per share (this is the value of assets you can lay your hands on and sell after you’ve paid for the debts). This isn’t too bad for a company that has a share price of 16 cents. Basically you are paying 55 cents for $1 worth of assets. But the financial health of Cash Converters gets better. First we need a lesson in accounting (this is why you shouldn’t trust accountants. They make it hard so they think you won’t understand. That and they are really boring at parties). Anything that is called ‘current’ as in a ‘current asset’ or ‘current liability’ is something that is due to be paid or be paid for in the next 12 months. All other assets and liabilities are called ‘non-current’ (I know, not very original). That being said, Cash Converters has $228m in Current Assets. That is, cash in the bank plus what their customers are due to pay them in the next 12 months. Here is the thing that should make you feel pretty good about Cash Converters. They have $106m in cash. If every customer stopped paying them immediately they would have enough cash on hand to pay all of the Current Liabilities (that is, bills due over the next 12 months) and still have $7m left over. Put another way, Cash Converters only has $87m in debt and they have $106m in cash. What I’m trying to tell you is; you can buy assets for less than they are worth and get the cash generating machine of a business for free.

Now that the company has proven they are paying down their own debt, have paid off their lawsuits, and are making monster returns on capital, what do you think that means moving forward? Well, it could mean a few things from where I see it. Most likely is that they will reinvest into their own business. They simply have to get better at debt recovery and keeping down the total amount of bad debts (people that just stop paying - I’ll get to that in a bit). They will buy shops instead of leasing, they’ll develop a better app with even fewer ‘friction points’ and generally try and enhance the earning capacity of the business. The next logical step (perhaps 12 to 18 months away) is the return of a dividend. If a $96m business has a net increase of $24m in cash while also paying a $32.5m lawsuit…. that leaves you with some room to have a little cash splashed on existing (long suffering) shareholders. It should also be noted that the large cash reserves are a perfect hedge against the shit hitting the fan while the whole world gets f*ed over by a pandemic. It certainly buys them enough time to ride it out and see where the dust settles.

This is probably a good time to take a look at the latest development in the Cash Converter arsenal of lending; online. This totally makes sense when you look into it. People hate the stigma and shame of walking off the street and into a shop to borrow enough money to pay the power bill. What Cash Converters has done is follow the leaders in this area (Nimble for example). Cash Converters has created an online portal where you can fill in your details and get a loan all from the comfort of your home. You don’t even need to change out of your daggy clothes. This removes what the business calls ‘friction points’ or points that add drama to a transaction and make it less likely the customer will follow through. PayPal and Amazon are incredibly good at this now with the ‘one click’ payment. It’s as simple as adding to your cart and checking out. Payday lending is going the same way.

While we are talking about payday lending we probably should cover the margins. They. Are. Insane. On small personal loans ($200 to $2,000) there is a 20% establishment fee and a 4% monthly fee rolling on the original balance. That is, if you take out a $1,000 loan for a period of 9 months you’ll pay back $1,560 (1 x $200 + 9 x $40). And Cash Converters has, in 9 months, converted $1,000 lent to $1,560 in capital returned. On medium term ($2,000 to $5,000) there is a $400 establishment fee and interest at 48% p.a. The longest loan you can take out is 24 months. At 48% p.a. Interest I don’t know why you would but hey, there it is. If we add up all of the fees, interest and charges, the maximum Cash Converters can charge is 217.95% p.a. And get this; this is while maintaining a 100% legal operation that they KNOW is being heavily watched for even the slightest of a f* up.

Just a quick note in the perception that Cash Converters is actually a second hand retailer as it's main function. Retail sales only makes up 20% of the total EBITDA (earnings before interest, tax, depreciation and amortization) and that part of their business runs on a 44% profit margin. This business is more about lending than selling second hand gear. They have $15m of "goods" in their shops. They have $128m in loans due to be repaid to them... at 48% p.a. plus fees and charges.

The Bad:

Now I need to tell you about the bad stuff. First we should start with the bad debts. As of the results released in September, that covered the year ending in June 2020, 18.9% of the total loan book was considered "bad". That means that about one in five customers have stopped paying their loans and the company does not expect them to start again. This obviously is not ideal as you lose not just the interest due but also the capital you gave out. This obviously has the effect of compressing margins.

There were two large and direct outcomes from the lawsuit saga that Cash Converters went through. The first is that there is now a new law limiting the amount of interest payday lenders can charge to 48% p.a. Now I still think this is in the nosebleed section but it is a hell of a lot better for the customer (and worse for the business) than the 175% p.a. they used to charge.

The second thing that came out of it was further reputation damage. When it came to Cash Converters I’m not sure they ever had a really good name for themselves but this just made it worse. Enter lawsuits and Cash Converters was welcomed to destination f*ed. Building up any semblance of respectability will be a long and hard road and they, in all honesty, might never make it to where they were.


The big question:

Should you? Well, that’s the $96m question. Here’s the thing; Cash Converters has a lot going for it as an investment but it has to make you pause, if only for a moment, and consider that people are getting f*ed up by their product every day.

Yes, they provide a service (credit) in the sliver of the market that is under-served by both the welfare system and the traditional credit market. I can very easily hear that argument and understand it but you have to wonder exactly how desperate a person is when they walk in (or log into now) Cash Converters to get a loan.

They are a dominant player in the payday lending market and they do make a lot of money. I do not find it hard to believe that they will provide a cash return that you would be very happy with moving forward.

And that’s the thing right there. If you don’t think this is a good ethical company to invest in, don’t. If you are less concerned then I’m sure you’ll do OK out of this.

But understand that I’ll always have wanted you to invest in a really boring index fund. Equally however, I know that isn’t much fun.

The next move is yours.