2023-04-10 08:13:59 ET
Summary
- goeasy Ltd is a Canadian non-prime lender trading close to its 52-week low due to regulatory headwinds.
- Canadian government plans to reduce the maximum allowable rate of interest by 12% to APR of 35% with possibility of further reduction based on industry consultation.
- Portfolio quality could come under stress in an economic recession although recent tightening of underwriting standards may soften the blow.
- I don't see a screaming buying opportunity yet with a compelling margin of safety, nevertheless, investors should keep goeasy on their watch-list for further weakness.
goeasy Ltd (EHMEF), (GSY:CA) is a Canadian non-prime lender specializing in unsecured and secured instalment loans, merchant financing and lease-to-own merchandise. The target market for non-prime lenders are typically individuals whose credit score is below the threshold where one is able to obtain a loan from traditional banks.
The stock caught my eye because it is trading close to its 52-week low although most of its key performance metrics like ROE and growth outlook look pretty impressive at first glance. So I decided to investigate if the stock presents a profitable opportunity.
The stock trades at CAD94.73/USD69.52. This is a far cry from its COVID-19 pandemic peak of around CAD218.35 in September 2021. In the past one year, the stock price has been going up and down in a range between CAD95/CAD145. Crucially, in the last few days, the stock seems to have been on the verge of breaking below this trading range.
Business model
goeasy has a spread-based business model where it lends out money under various loans products at an average yield of 36%pa. It raises funding from sources like senior unsecured term notes, securitization warehouse facility, secured borrowing and revolving credit facility at 5.6%pa cost. The spread between the assets and liabilities is an astonishing 30%pa. Nevertheless, non-prime loans being highly risky, the level of un-collectible loans is also relatively high resulting in 9% of loans being charged off every year. goeasy offers loans at fixed interest rates. Although some of its funding is at variables rates or is in USD fixed rates, it usually fully hedges its interest rate risk and currency risk using swap contracts. The only funding facility that's not hedged is the revolving credit facility. In FY2022, goeasy generated a return on equity of around 24% adjusted for one-off items.
Regulatory headwinds
The latest bout of selling in goeasy shares came on March 28th after Canadian government announced plans to reduce the maximum allowable rate of interest by 12% points to an annual percentage rate of 35% ((APR)) from 47% previously. In its announcement, the government also mentioned that it will launch consultations on whether the criminal rate of interest should be further reduced.
The announcement itself wasn't totally unexpected but the timing surely took the market by surprise because the government had yet to conclude the stakeholder consultation process started back in August 2022.
In their 4Q-2022 results conference call held on February 16th, the management had mentioned that:
We know that the consultation that they [federal government] said they would do last year was done last fall. Since then, there's been no news, no announcements, no posting of the results of the consultation or the consultations themselves. So based on everything we know and all of the information we've gathered, we are still of the same view that we believe the probability of a change to the regulation is low.
In Canada the debate around high cost lending is centered around the idea that the maximum allowable rate of interest was spelled out in the regulations back in 1980 in a high interest rate environment. Market interest rates have come down quite a lot from that time while non-prime lending rates haven't budged.
The non-prime lenders contend that a reduction in the maximum allowable rate will eliminate access to credit to a section of the non-prime borrowers, forcing them to rely on more expensive sources of borrowing, such as payday loans or unregulated loan sources.
In my view the truth lies somewhere in between. For example, the Canadian province of Quebec already prescribes a maximum allowable interest rate of 35% on consumer loans which is inline with the new rate proposed federally. Similarly, a quick glance at OneMain Finance Corporation website, a US-based non-prime lender shows that it offers an APR range of 18.00% - 35.99% on personal loans. This compares with an APR range of 9.99% – 46.96% offered by goeasy's subsidiary Easyfinancial .
Given the government's plan to reduce maximum allowable rate of interest by 12% points and its stance of reducing this maximum rate further, the non-prime industry will remain under regulatory headwinds for some time to come.
Macroeconomic headwinds
Non-prime lending being on the outer spectrum of credit quality, goeasy began to tighten its underwriting standards in 4Q-2021 in anticipation of a potential worsening of borrower credit health in an economic recession. As mentioned in their 4Q-22 earnings call, they aim to de-risk their loan portfolio by gradually raising minimum credit scores and adjusting their loan affordability calculations to moderate borrowing levels among higher risk customer segments. Due to incremental loan growth and natural portfolio turnover, around 75% of the loan book has been underwritten during or since Q4 2021, when they began making these changes. The real test of changes in underwriting standards will come when unemployment level increases and borrowers face hardship in servicing their debt. So far employment levels have been quite strong despite the talk of an upcoming recession.
Guidance remains upbeat
Management upgraded its three year growth outlook in February 2023 after successfully achieving its 2022 guidance. It aims to generate 22%+ adjusted return on equity while concurrently passing along interest rate reductions to its borrowers. It plans to achieve this by growing its loan book by 25% in 2023, 20% in 2024 and 15% in 2025.
The key aspect of the outlook is to bring down the weighted average interest rate to below 30% and total yield inclusive of ancillary revenues to gradually decline to between 33% and 35%. Management also expects the charge-off rate on loan portfolio to range between 8.5% and 10.5% throughout 2023 and gradually decline in the outer years. They also see some cost savings from scale and operating leverage, resulting in gradually increasing profit margins.
The management is looking to grow the proportion of secured lending from 39% of total portfolio in December 2022 to around 50% by the end 2025. This should reduce the weighted average interest rate as well as reduce the level of charge-offs.
I think guidance looks balanced in the context of maximum interest rate regulations because management seems to have incorporated this possibility in its forecast.
Dubious capital allocation track-record
I've noted goeasy management pivoting sharply between issuing new capital and buying back its shares over the past couple of years often issuing new shares at a lower price and buying back at a higher price. On its part, management has rationalized its buyback activity by highlighting that they bought back when stock price went below the intrinsic value and the company's leverage level was comfortable within their target range.
For context, goeasy issued CAD172.5million worth of shares in April 2021 at an offer price of CAD122.85/share and CAD57.9million worth of shares in November 2022 at an offer price of CAD118.50/share. The company bought back CAD62million worth of shares in 4Q-2021, CAD41million in 1Q-2022 and CAD20million in 2Q-2022 at average prices of CAD187/share, CAD146/share and CAD119/share respectively. Target price assigned by security analysts has trended down from high CAD200/share in early 2022 to CAD162/share at the moment.
On the face of it, this abrupt pivoting between equity issuance and buybacks indicates weakness in capital planning.
Growing into Auto Financing
goeasy has established a strategic partnership with Canada Drives which is Canada’s largest 100% online car shopping and to-your-door delivery platform. goeasy provides automotive financing to a committed portion of the non-prime borrowers who purchase and finance a vehicle through Canada Drives platform. In my view auto financing ties in well with goeasy's strategy of growing its secured lending book.
Valuation
Despite the steep decline in stock price, goeasy valuation metrics haven't yet fallen sufficiently to make it a screaming buy.
It trades at a price to tangible book value of 2.83x, Trailing 12-month P/E multiple of 11.25x and offers a dividend yield of 3.90% (based on the latest quarterly dividend of CAD0.96/share).
If you are a dividend seeking investor, a diversified ETF like Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY:CA) offers you a yield of around 4.8% and trades at a P/B of 1.7x and P/E of 11.9x.
I would prefer the regulatory and macro headwinds to take their effect before pulling the trigger on goeasy.
Final Thoughts
A close examination of goeasy shows that the recent under-performance can be traced back to unexpected regulatory changes. Regulation remains a hanging sword because Canadian government has left the door open on further downward revision of maximum interest rate. Moreover, credit stress could potentially develop if an economic recession plays out over the near future. I don't see a screaming buying opportunity with a compelling margin of safety here. Nevertheless, I think investors should keep goeasy on their watch-list for further weakness.
Take everything you read with substantial skepticism and a healthy grain of salt. Invest based on your own financial profile and your appetite for volatility. Information discussed here should not be considered as an "investment advice" or as a "recommendation."
For further details see:
goeasy: Hit By Regulatory Headwinds