In times of economic difficulty, investors may wish to seek out counter-cyclical companies and business models. I believe pawnshops are a business model that could potentially thrive in this environment. Recently I wrote a bullish article on FirstCash Financial (FCFS), the biggest player in space. In this article, I will cover EZCORP, Inc. (NASDAQ: EZPW), a major pure-play pawnshop competitor to FCFS, and also provides more thoughts on the pawn’s business model.
EZCORP, Inc. is one of the leading pawnshop operators in the United States and Latin America. EZCORP has 1,163 stores in 5 countries, with the vast majority in the United States and Mexico (Figure 1).
What is the pawn?
Pawnbrokers are local retail stores that buy and sell second-hand consumer goods such as electronics, jewelry, gaming devices, musical instruments, and tools. In many cases, pawnbrokers act as a secured lender to unbanked/underbanked/limited credit consumers by offering small non-recourse loans that are secured by the pledged asset.
For EZCORP, a typical customer walks into the pawnshop with his personal property. About 15% of the time, the customer sells the item directly to the store. and receives money. The asset then enters the pawnbroker’s commodity inventory and is exposed to a 35-38% mark-up.
For the remaining 85% of clients, they obtain a pledge loan secured by their assets. Pawnbrokers have monthly returns of 12-13%. Credit losses in the pawnshop business are generally low, as the pawnbroker lends only a fraction of the market value of the asset. If the customer defaults (i.e. does not repay the loan), the pawnbroker takes possession of the asset and it enters the store’s inventory, where it is resold at the margin of 35 to 38%. Figure 2 shows an overview of EZCORP’s pledge business.
Note that this basic business model is very similar to the one I described in my FirstCash Financial article. The only difference between EZCORP’s business model and that described for FCFS is the propensity of customers to sell directly to the pawnshop (15% for EZCORP vs. ~25-30% for FCFS), and the retail markup that the company usually charges. (35-38% for EZCORP versus 35-45% for FCFS).
The pawn is countercyclical
Historically, pawnbroking has performed well in most economic cycles, especially downturns. The following is an excerpt from my FCFS article, which explains why:
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 pawnbrokers 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 2) .
Increased use of EZCORP pawnbrokers
As government stimulus measures related to the COVID pandemic have come to an end and persistent inflation eats away at stretched household budgets, I expect the use of pawnshops to increase over the coming quarters. Already, we can see EZCORP’s pledge loan balance increase 30% year-over-year to $205 million as of June 30, 2022 (Figure 3).
The business model generates high returns and low losses
The most attractive aspect of the pawnbroking business model is the high cash yield these loans generate. Contrary to payday loanwhich has interest rate caps in 18 states and is banned in 12 other states, the pawnshop business model has no interest rate cap.
From Figure 3 above, we see that year-to-date, EZCORP has generated $233 million in pawn service fees out of $190 million in average outstanding pawn loans (average between Q3/22 loan balance of $205 million and Q4/21 loan balance of $176 million), equating to annual returns of over 160%. This is comparable to the returns generated by FirstCash Financial’s pledge business.
Another aspect of the pawnbroking business that is underappreciated is the relatively low loan loss rate. In other forms of lending to risky customers (eg, payday loans), the lender must charge high interest rates to compensate for the increased likelihood of loan losses. However, for pawnshops, the lender lends only a fraction of the market value of the item. If the customer defaults, the pawnbroker takes possession and resells the item at a 35-40% markup.
But suffers from heavy store infrastructure costs
The challenge with the pawnshop business model, however, is that there is no easy way to generate loan volumes. Pawning your valuables for pennies on the dollar is often a last ditch effort that most people would avoid if possible. This means that in times of economic prosperity, pawnshops can suffer from a strong SG&A drag, as its assets are underutilized.
For EZCORP, although the pawnshop business generates high cash returns of more than 160%, after deducting store and business expenses, EZCORP has had only a modest net profit since the start of the year of $43 million or $0.58/share EPS on net margins of 6.6% (Figure 4).
However, we expect net margins to increase as the economy deteriorates, as loan volumes increase and fixed store costs are spread over more loans. For context, in the years leading up to the GFC, EZPW’s net margins grew steadily from 9.3% in 2006 to 11.5% in 2008 and 13.3% in 2010 as consumers were asked to use more company services (Figure 5).
Appraisal is at a premium
In terms of valuation, EZCORP trades at a slight premium to the financial sector, with a non-GAAP forward P/E multiple of 11.9x versus 9.5x (Figure 6). We believe this premium is warranted as financial companies such as banks currently have depressed valuation multiples due to economic uncertainty, while EZCORP benefits from a weak economy, as mentioned above.
EZCORP is also trading at a reduced valuation compared to its peer peer, FCFS, which has a forward P/E multiple of 16.0x. In some ways, EZCORP is preferable to FCFS because it is a pure pawn, whereas FCFS has a nascent lease-to-own (“LTO”) business that is sensitive to a downturn in the economy.
Risks for EZCORP
Although consumers’ use of pledge loans increases in difficult economic environments, their ability and willingness to spend on goods may decline, counteracting some of the benefits of higher pledge volumes. This risk would appear in the merchandise gross margin line and inventory turnover rate, i.e. EZCORP might not be able to charge such a high markup on the pledged merchandise or sell the goods as quickly.
From EZPW’s latest 10Q report, we can see a decline in commodity gross margin, with Q3/22 GM of 37.5% vs. 38.6% YTD and 43 .9% at Q3/21 (Figure 7). So far, the negative impact has been minimal, as gross profit on goods actually increased 1.7% year-on-year to $48.1 million, while pawnshop fees increased 32.8% year-over-year to $80.3 million as pawnbroking volumes increased. Net-net, deteriorating economic conditions have been a big tailwind for EZPW. However, investors should monitor inventory turnover and the commodity gross margin line over the coming quarters as a prolonged period of economic weakness will hurt the resale of pledged commodities.
Another risk for EZCORP is that the volatile price of precious metals could hurt jewelry scrap margins. When pawnbrokers take possession of pawned jewelry, it is sometimes sold for its precious metal value, or “scrap.” Pawnbrokers may also offer “cash for gold” promotions and resell the collected gold.
If precious metal prices suddenly move against the pawnshop operator, he may pay a higher “cash value” than he can sell the precious metals for. For EZCORP, this has not been an issue over the past quarter, as Q3/2022 jewelry scrap margins were healthy at 13.9% versus 15.7% year-to-date. However, if we look at Q3/2021, we see that the scrap margin was only 3.5%. Indeed, in Q3/2021 (April to June 2021), gold prices spiked from around $1,700 to over $1,900 and then crashed to $1,760 at the end of the quarter (Figure 8). EZCORP was probably caught paying top dollar for jewelry that quickly depreciated in gold value.
Finally, it should be mentioned that EZCORP has moderate levels of financial indebtedness. As of June 30, 2022, EZCORP has $313 million in long-term debt and $222 million in cash, compared to $98 million in EBITDA LTM. This translates to 0.9x LTM/EBITDA net debt. Indebtedness can hamper management’s ability to react to changing economic conditions.
In times of economic difficulty, investors may wish to seek out counter-cyclical companies and business models. I believe pawnshop operators such as EZCORP stand to benefit from the current economic downturn and are worth speculative buying.