FirstCash Holdings: Profit taking (NASDAQ: FCFS)
A few months ago, I launched the cover of FirstCash Holdings Inc. (NASDAQ:FCFS) with a bull article. My main bullish thesis is that countercyclical pawnbroking is poised to outperform during the current tough economic times.
While I keep on Like FirstCash’s countercyclical pawnbroking business, I’m increasingly worried about an impending recession and its impact on the cyclical POS LTO business. After a quick 20% gain on my bullish call, I recommend investors take profits and look for opportunities elsewhere.
Brief overview of the company
For those unfamiliar with FirstCash Holdings Inc., the company is the largest pawn shop operator in the United States and Latin America, with over 2,800 outlets. FirstCash also operates a point-of-sale (“POS”) payment solution that offers hire-purchase (“LTO”) loans to consumers with limited credit.
Unlike other forms of consumer lending such as payday loans, the credit risk associated with pawn loans is very low because the loan receivables are fully secured at a fraction of the market value of the collateral.
Historically, the use of pawnbroking services has tended to be countercyclical as financially strained consumers increase their use of alternative credit solutions like pawnbrokers under difficult economic conditions. In fact, US FirstCash stores saw their pledge receivables increase by 50% during the 2008 financial crisis (Figure 1).
The 2020 COVID pandemic was an unusual economic downturn as pledge receivables actually declined for FirstCash. This was likely because government stimulus checks had been issued to help financially strained consumers, often beyond their monthly income. For example, according to a recent CNBC article Looking at the lessons from the COVID stimulus, we can see that those earning less than $10,000 in adjusted gross income received over $3,900 from the 3 rounds of COVID stimulus, or over 39% of their gross income. Similarly, those earning between $10,000 and $20,000 received nearly $4,800 in COVID stimulation (Figure 2).
However, with the end of government stimulus measures and inflation weighing on household budgets, the use of pawnshops has increased in recent quarters.
Excellent results in the third quarter confirm the thesis
Figures reported by FirstCash in their latest quarterly results certainly confirmed my bullish thesis on pawnbroking. Q3/2022 consolidated revenue increased 68% year-on-year to $672 million and adj. EPS rose 55% year-on-year to $1.30, easily beating Wall Street estimates of $1.17/share.
In my opinion, the highlight of the quarterly release was management’s outlook for 2022 and beyond as it relates to the pawn sector. In the management’s own words:
Cash-to-customer funding (new pawns and direct purchases of goods from customers) in the United States and Latin America remain exceptionally strong, with October funding above pre-pandemic comparative levels in 2019 and growth continued double-digit same-store pawnbrokers over the past year.
– FirstCash Q3/2022 press release
Looking at the details, we can see that US pawnbroking grew 15% year-on-year to $280m, surpassing the Q3/2019 level. Similarly, within the Latin American segment, pledge receivables increased 17% year-on-year to a record $125 million (Figure 3).
Crucially, I believe there is still plenty of room for growth for pawnshops over the next few quarters, as loan volumes are still low relative to historical numbers.
For example, in the US segment, if we look at the additional operational metrics provided by the company in its press releases, we can see that the average loan size in Q3/2022 was $232, compared to $167 in Q3/2019. . This means that the total number of loans outstanding in Q3/2022 was 1.2 million ($280 million in receivables divided by $232), a decrease of 25% from 1.6 million loans in Q3/2022. 2019.
Per store, the average store had only 1,120 loans outstanding in Q3/2022 compared to over 1,500 loans in Q3/2019 and over 1,700 loans at the peak of 2017. Similarly, in the Latin American segment, the number of loans per store was 894 in Q3/2022 compared to 1,083 in Q3/2019 and more than 1,200 at the peak of 2017. As a result, FirstCash still has plenty of room to do more pawnshops, provided that it has the balance sheet capacity to extend them.
Amended Revolving Credit Facility Supports Additional Growth
To meet balance sheet capacity, FirstCash amended its revolving credit facility at the end of August, increasing the size from $500 million to $590 million with an additional $200 million accordion function.
This new credit facility should give FirstCash more than enough runway to grow its loan receivables over the next few quarters, as only $338 million has been drawn as of September 30, 2022 (Figure 4).
Profitable LTO POS so far…
One of the key risks I highlighted in my previous article was America First Finance’s (“AFF”) LTO POS payments business which FirstCash acquired in December 2021 for $1.17 billion. Management feedback so far suggests that the LTO business continues to perform well despite the economic headwinds.
AFF continued to grow its market share in the LTO space, with approximately 8,600 active retail and e-commerce merchant partners in Q3/2022, a 40% year-over-year increase. Adj. segment operating profit totaled $28 million in Q3/2022 and $78 million year-to-date.
Provision for loan and lease losses was about 31% of adjusted revenue, showing how risky customers are (Figure 5).
… But will it continue to be in recession?
While LTO and pawn both serve the same limited credit customer, the two companies have subtle but important differences in operations and credit management. As mentioned above, pawnbroking tends to have very low loan losses because loan receivables are fully collateralized and the pawnbroker lends only a fraction of the market value of the merchandise. The customer also brings the merchandise to the store, so operationally it’s very efficient.
On the other hand, the LTO business lends on the retail value of the commodity. Although LTO lease payments are priced to account for high potential loan losses (more than 30% according to AFF’s financial statements), the actual loss rate is variable and can be influenced by the economy. Additionally, customers tend to keep merchandise at home (a major category for LTO is furniture and big-box items like televisions), and repossessing merchandise in the event of a defect can be inconvenient. .
Traditional LTO players like Aaron (NAA) and Rent-A-Center (RCII) have extensive store networks, so when customers don’t pay, merchandise can be picked up and put back into circulation quickly. Although the AFF allows customers to return goods to FirstCash pawnshops, it is unclear how successful this will be if economic conditions deteriorate and defaults increase. A small footprint pawnshop is probably not designed to handle large furniture or appliances.
Finally, AFF was only launched in 2013, so the POS LTO business model was never tested in a real recession. Unfortunately, according to conference board and other economic forecasters, a recession in the United States is virtually a foregone conclusion over the next 12 months (Figure 6).
The techniques suggest a break
Technically, after aggressively recovering from the strong Q3 2022 earnings report, FirstCash has hit resistance near 2019 highs that will take time to overcome. I wouldn’t be surprised if the stock consolidates here for a few weeks at least (Figure 7).
The next big catalyst for FCFS is Q4 2022 earnings which are not expected until early 2023.
Even more stretched valuations
After the recent rally, FirstCash’s valuation has further stretched relative to the financial sector. FCFS is now trading at 18.7x Fwd P/E versus 10.3x for the sector. As a reminder, the valuation was only 16.1x when I wrote my primer article a few months ago (Figure 8).
While I continue to like FirstCash’s countercyclical pawnbroking business, I am increasingly concerned about an impending recession and its impact on the cyclical POS LTO business. After a quick 20% gain on my bullish call, with valuations even more stretched, I recommend investors take profits and look for opportunities elsewhere.