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Blue Tower Asset Management 1Q17 – EZCORP and Subprime Auto

Blue Tower Asset Management 1Q17 Letter, April 17, 2017

Relative Weakness in Small-Caps

  • Russell 2000 have market caps between $133 million and $3.9 billion; Russell 2000 returned 2.5% relative to S&P 500 of 6.1%
  • Relative weakness of small cap stocks is the result of tremendous post-election rally that small cap stocks had after the election
  • Post-election bump had was largely due to the belief that US corporate tax reform would be forthcoming
  • Small companies in the US pay a higher effective tax rate than large cap stocks, with the average for Russell 2000 and S&P 500 being 30.6% and 25.8%, respectively
  • As hopes for a rapid tax reform process dim, Russell 2000 stocks have pulled back

EZCORP

  • Over the past year, company has grown loans in the US faster than either of their two major competitors
  • Creation of a new point of sale system for EZPW is a major initiative for the company
    • System will use individual history of each borrower to determine the relative likelihood that the borrower will repay their pawn loan
    • For individuals who are more likely to pay back the loan, can give a larger loan and therefore boost the balance upon which they are collecting interest
    • For the opposite, can give a smaller loan and thereby lower the cost of their merchandise and boost their gross margin
  • Also doing a major refurbishment of their stores due to significant deferred maintenance
  • Important to note several of the senior executives at the company left far larger corporations to work at EZCORP
    • Restricted stock vesting for the management is based on EBITDA and net debt hurdles
    • Incentive period for these hurdles begins starting in September 2017
    • Reasonable to assume that management of the company is front-loading business investments and non-recurring expenses to the months before the incentive period in order to make their future numbers look better
    • Expect the company’s profitability will increase after September and that this improved profitability may be a catalyst towards a higher valuation in 2018

Subprime Auto Meltdown

  • Subprime auto lending space has been under significant pressure so far this year
  • Hit by a perfect storm of several factors: rising interest rates, increased competition between lenders, declining used car prices, and rising defaults by borrowers
  • According to Morgan Stanley, loans given to borrowers with a FICO score of below 550 now make up 32.5% of all subprime auto loans (5 years ago, that number was 5.1%)
  • Have 3 stocks which are in subprime auto lending (NICK, CACC, and CRMT), giving us significant exposure
  • Thesis is that over a multiyear cycle, lenders that have structural advantages in underwriting will outperform their competition
    • Unlike many other lenders, these companies do not securitize their loans and sell them off to third parties, but instead hold them to maturity
  • Because of investor fears over declining fundamentals for the subprime auto sector as a whole, entire sector sold off – creates a value opportunity over the long-term as these quality companies now trading at bargain valuations

Subprime Credit Cycle

  • 4 sequential phases with a repeating cycle
  • High profitability: with tight access to capital and few competitors, lenders are able to negotiate favorable terms with borrowers; ROA is high, financial leverage is lower, and lenders are able to get high net yields and profitability
  • Expanding leverage: new entrants begin to enter the market; capital markets are willing to lend more money at more favorable terms; increased competition causes ROA to fall as borrowers have more options; lenders begin to lever up in order to boost ROE
  • Low profitability: intense competition forces lenders into a choice of surrendering market share or decreasing lending standards; loans are given at lower rates; leverage is increased even more to maintain ROE; fraud and mismanagement increase throughout the sector
  • Decreasing leverage: defaults increase dramatically; loan yields fall below profitable levels; deteriorating loan performance of the industry causes capital markets to tighten; deterioration will often happen at the same time as an overall economic recession which causes capital markets to be tight across the economy in general; lenders are forced to exit the subprime auto market as business is unprofitable and access to capital markets is absent; some lenders go into bankruptcy
  • We are currently in the “Decreasing Leverage” phase and can expect a return to higher profitability soon
  • NICK: increased its book value per share by 9.4% in 2016 even though stock price did not move; currently trading at 0.72x tangible book value, making it tempting for a larger financial company to acquire; business model perhaps would make more sense under the umbrella of larger parent company
  • Magnolia Capital Fund, a hedge fund, has been buying up shares of NICK and currently owns 17% of the company – have no plans to push for management changes or a sale of the company and they are buying up shares due to valuation
Image Source: St. Louis Fed
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