This article by Barry Pasikov is excerpted from a letter of Hazelton Capital Partners.
In July of this year, Hazelton Capital Partners began adding shares of EZCorp, the 2nd largest pawn shop operator in the United States, to the portfolio. The Fund has bought and sold shares of the company over the past three years, but this is the first time EZPW became a top five holding.
Historically, pawn shops have the reputation of being a sleazy business that preys on the disadvantaged by charging high fees to either receive cash or a loan for one’s personal property. Pawning personal property is a short-term loan; a pawn customer exchanges a personal item for cash equal to between 40-70% of the appraised value of the property. In order to get the item back, the individual needs to repay the original loan plus interest, in which rates and fees can hit monthly levels in excess of 25%.
It is important to remember that the majority of the individuals who use pawn shops do so because they do not have access to traditional bank loans due to the size of the loan (average pawn loan is less than $150) and/or because they lack a banking relationship. A recent FDIC survey found that approximately 27% of American Households were either under or unbanked – that equates to nearly 67 million American adults. For these working-class Americans in need of short-term money, pawn shops provide immediate access to cash to cover living expenses.
Today, pawn shops have become mainstream, moving from the back alleys of impoverished neighborhoods to upscale malls and office buildings. The majority of the roughly 13,000 pawn shops in the US are family run, customer friendly businesses that have been designed to resemble a retail store. Instead of eliminating pawn shops, the federal and state governments have chosen to regulate them, recognizing that they provide a much needed financial service.
Increased regulation actually acts as a competitive edge for EZPW, as it is able to spread this growing fixed operational cost across its 517 stores, while smaller operators are negatively impacted. This creates an environment ripe for consolidation. EZCorp is in the process of deploying a Point of Sale system that will not only help streamline store operations but will allow for real-time benefits in managing inventory, and pawn loan pricing. Very few pawn operators can afford this type of dynamic, in-store system that pays for itself in less than three years.
A mixture of declining gold prices (jewelry is the number one pawned item and revenues are highly correlated to the price of gold), bad management decisions, and a non-attentive board created a headwind for EZCorp and its share price. A new management team took over in 2014 and began exiting all of its non-core businesses to focus solely on its pawn operations. The restructuring delayed the quick recovery that the market had hoped for. However, by mid 2016, with much of its restructuring charges, write-downs and impairments already known, EZPW shares began a meaningful recovery.
By late 2016 early 2017, Hazelton Capital Partners had reduced its holding in EZCorp, waiting for an opportunity to either close out the position at a higher level or re-establish the position at a meaningful discount. The Fund got the opportunity to rebuild its position on June 27th, when EZPW announced a $125 million convertible debt offering. The market reacted negatively to the news, driving the company’s share price down over 25% from the Fund’s sell level earlier in the year and providing a nice reentry point.
Hazelton Capital Partners believes there to be a meaningful discount between the company’s share price and its intrinsic value. The contraction in operating margins is directly related to the restructuring of the company’s core pawn business. Starting in 2018, most of the write-downs, impairment and restructuring charges will have been taken, leading to increased profits and free cash flow. The improved free cash flow could be used for future acquisitions or reducing debt, allowing the company to be debt free within the next 4-5 years.
Hazelton Capital Partners has mapped out a bearish, base, and bullish case outlook for EZPW’s business plan execution. The Fund believes there to be a conservative 65% upside to its base case outlook, a smaller return to its bear case and a meaningful opportunity if the company executes above expectations.