SOFI - FirstCash Executing Well And Still Undervalued

Summary

• Core pawn operations were healthy in the fourth quarter, with double-digit growth in pawn receivables and mid-teens core pretax income growth.
• The lease-to-own operations are seeing steady credit trends, but weaker demand/volume and competition from a myriad of point-of-sale finance options could be playing a role.
• With access to stable and attractively-priced funding, FirstCash has an advantage over many fintech-based consumer finance rivals and should benefit through this more challenging phase of the cycle.
• Core long-term FCF growth in the high-single-digit, underpinned by steady results in the U.S. pawn business and ongoing expansion in Latin American pawn operations, can support a higher share price.

When times get tougher, FirstCash ( FCFS ) often gets going, as FirstCash's core customer base often finds their access to credit more limited once the cycle has turned over. And given the number of banks increasing their provisions and openly talking about reducing risk in their loan operations, that's where we're at today.

While demand and loss trends are well worth watching in the America First Financial lease-to-own business, particularly given management's lack of familiarity with the business through a full cycle, I don't see any particularly concerning operational trends. Moreover, while AFF is certainly big enough to bite hard if FirstCash makes mistakes with the business, the pawn operations will continue to generate the large majority of the company's earnings and the growth outlook remains attractive.

FirstCash shares have risen more than 20% since my last update , and that's pretty strong compared to other pawn lenders, lease-to-own operators, and consumer finance companies like SoFi ( SOFI ) and Dave ( DAVE ). Truthfully, this is a difficult company to benchmark, but while I expect to see some macro headwinds in the business next year, I'm still comfortable with a mid-to-high single-digit growth outlook that supports a fair value close to $100.

A Bit Soft On Revenue, But With Healthy Margins

I'll state upfront that FirstCash's earnings reports are not really for the novice investor, as there's a lot to sort through between GAAP and adjusted earnings. In any case, core results were a bit light on the topline (due to weaker volume in the lease-to-own business), but overall margins were a bit better than expected.

Revenue rose 49% year over year and 11% quarter over quarter as reported, or 50% yoy and 11% on an adjusted basis (the adjustment coming from purchase accounting treatment for the leasing business). Overall retail revenue rose nearly 10% yoy as reported (up 19% qoq, boosted by the holiday season), with pawn fees up 16% yoy and 3% qoq and lease-to-own revenue up 3% sequentially.

Revenue from U.S. pawn operations rose 12%, with core pawn revenue up 8% on 4% same-store retail sales growth and 16% same-store pawn fee revenue. Latin American pawn operation revenue increased 20% as reported or 15% in constant currency, with a 14% same-store constant currency improvement in retail revenue and a 10% same-store constant currency improvement in pawn loan fees.

Pre-tax earnings rose 15% yoy and 18% qoq in the U.S. pawn operations (with margin up 50bp to 24.5%), while the LatAm operations improved 14% yoy in constant currency, and 17% qoq in reported terms, with margin down 20bp to 21.5%. The AFF business saw an 11% sequential improvement in profits, with margin up 110bp to 14.2%.

Retail margins were solid in the U.S. business, down one point yoy and up one point qoq to 42%, while down two points yoy and qoq to 34%, but still largely in line with historical trends. Likewise, I see nothing that concerns me much in the inventory turn or pawn collateral numbers, though I'm a bit concerned about FirstCash continuing to find attractively-priced merchandise to keep the U.S. retail operations cruising along.

AFF transaction volume was up 5%, with a 1% decline in origination volume, while consumer balances were up 2% on a 15% increase in lease-to-own merchandise and a 25% adjusted decline in finance receivables. Overall charge-offs looked stable at 13.3% for the quarter (versus 13.6% in the prior quarter).

Healthy Consumer Finance Demand, But Mixed Trends In Lease-To-Own

Guidance for 2023 was generally positive, with mid-single-digit core pawn loan growth against more challenging comps as 2023 develops. Pawn receivables were healthy on a year-over-year basis (up 8% same-store in the U.S. and 12% same-store constant currency in LatAm) but definitely slowed on a sequential basis (up 1% in the U.S., down 13% in LatAm).

It's not unusual to see some deceleration in the fourth quarter, and I believe FirstCash has some important operating advantages going into 2023. Funding costs are shooting up, and many competing unsecured lenders are facing significant increases in their borrowing costs. I expect many of these lenders, particularly app-based fintech lenders, will turn to higher minimum fees and other charges to offset the funding cost pressure, and that could well end up alienating their customer base when they run the numbers on the total costs they're paying and compare them to alternatives like FirstCash. By comparison, FirstCash has the advantage of well-established operations and established financing that gives them access to advantageously-priced capital.

The biggest risk to FirstCash's core pawn operations in 2023 may well be that the economy doesn't really slow. Employment and wages are still quite strong, and borrowers may not find themselves in the position of coming up a little short of hours when they need to pay a medical bill or pay for a vacation. By the same token, though, expenses like medical bills or car repairs come no matter where we are in the economic cycle, and FirstCash has an established core customer base that is accustomed to the company when temporarily short of funds (75% of the company's pawn loans are ultimately redeemed).

I'm less confident on the lease-to-own business going into 2023, particularly with management guiding that most of the topline growth will come from expanding the number of stores offering their services. It's not that surprising that customer demand for bigger-ticket items like furniture would be weaker, but I do still have my doubts about full-cycle consumer demand for lease-to-own at a time when "buy now, pay later" financing alternatives are growing so rapidly.

As far as credit quality issues go, I'm not too concerned. The repossession process is pretty straightforward if lessees miss payments (and don't make arrangements with the lessor), so it's not as though months of unpaid lease payments are going to accumulate. There is a risk that FirstCash won't recoup full value on repossessed assets, but it's not as if management isn't experienced at maximizing the value of surrendered merchandise, nor pricing their financing with an eye toward loss mitigation if the transaction goes south.

Said differently, while lease-to-own is still new to FirstCash, lending to this customer base is not new, and FirstCash understands the basic concepts of estimating likely credit outcomes and pricing accordingly.

The Outlook

For the pawn businesses, not a lot has really changed. I continue to expect the U.S. operations to be a slower-growing, high-margin business that generates attractive cash flow. I also expect FirstCash to continue benefitting from its status as a preferred acquirer, with owner-operators of smaller pawn chains using FirstCash as a cash-out option to fund their retirements.

For the LatAm operations, there are still growth opportunities in Mexico (including different formats/store sizes), as well as in many other countries, and I expect management to continue with a cautious and deliberate organic store growth approach, supplemented by opportunistic M&A. Management has also said that they're looking to eventually expand the lease-to-own concept into Latin America.

I consider the lease-to-own business a "we'll see" proposition. I've been less bullish on this business since FirstCash acquired it, and while I see opportunities for this business to generate profitable growth, I've also seen a surge in point-of-sale financing alternatives. I may be too pessimistic on this business, but I would note that FirstCash has written down the contingent payment obligations for the acquisition, meaning it hasn't lived up to the level contemplated when they did the deal.

I've bumped up my 2023 estimates, mostly on the momentum FirstCash carries into 2023 from a stronger second half of 2022 than I'd expected. I do think AFF could be a little more margin/cash flow dilutive in FY'23 and FY'24, but I'm still expecting high-single-digit long-term revenue growth (7% to 8%) and low-double-digit adjusted FCF margins that should drive high-single-digit FCF growth. Higher charge-offs in AFF and a faster pace of organic growth in LatAm (leading to higher capex spending) are the two biggest risks I see on the FCF margin side of the ledger.

The Bottom Line

Discounting those cash flows back, I get a fair value of about $100 today, and I think that's still enough upside to make these shares worthwhile, particularly given that there could still be an operational upside to both the pawn and lease-to-own operations relative to my expectations. I will note, though, that this company has had a lot of cyclicality/volatility in its earnings and share price over past cycles, so this isn't a name for investors who can't stomach some sizable swings along the way.

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