Can Payday Lenders Survive?

Payday lenders (PDLs) and pawnshops are tremendously profitable businesses. I've writtenabout some of these companies before, but because of new guidelines from the Federal Deposit Insurance Corporation that may affect the entire payday-lending industry, the time has come to do a thorough comparison among them. The contestants are First Cash Financial Services (NASDAQ:FCFS), EZ Corp (NASDAQ:EZPW), Cash America International (NYSE:CSH), Dollar Financial (NASDAQ:DLLR), Advance America (NYSE:AEA), QC Holdings (NASDAQ:QCCO), and ACE Cash Express (NASDAQ:AACE).

These companies owe their success to the high interest rates that they can charge their clients. For pawnshops, the rates can run as high as 360% annualized, while PDLs can charge from 15% annualized to, well, infinity. But this is where those FDIC guidelines come in, and I want you to read this article so you can understand a few terms that I'll be using. The effect of the FDIC regulations on PDLs runs the gamut. Some of the lenders could be devastated, others not so badly affected. Let's examine all the scenarios, and then I'll do my company comparison.

FDIC: party-pooper
The worst-case scenario: Seven states require a PDL to use an FDIC-chartered bank to fund its payday loans. Why would this hurt a PDL? Well, if the FDIC determines that a PDL's bank doesn't meet the new, stricter guidelines, the FDIC could prohibit that bank from funding payday loans. If that happens, PDLs with stores in these states won't be able to make loans -- they'll be out of business in that state altogether. Any revenue they made will get sliced from the top and the bottom lines. In the short-to-intermediate term, PDL earnings will get hit hard. Over the long term, however, the companies can still expand into other safe-harbor states, so that earnings would be able to recover.

The best-case scenario: A state changes its laws so that PDLs can fund loans themselves instead of using a third-party bank. That's what was supposed to happen in Texas, but the bill was killed on a procedural technicality.

Between the best- and worst-case scenarios: The FDIC may permit payday advances via an alternative product, probably with a smaller interest rate. Or a third-party bank could fund loans via its chosen PDL, but under the more restrictive guidelines. Obviously, the larger the percentage of a PDL's clientele that already fits these FDIC-mandated patterns, the less impact on revenue.

The chart below shows how each company will be affected in the worst-case scenario, which is the one that investors should always assume. Note that I am presuming that revenues are equivalent across all stores; to be very clear, these percentages are rough estimates. Companies in italics have a pawnshop component to their business.

The contestants face off
Now, let's put everybody side by side.

One thing to note is that all of these stocks sold off by amounts far exceeding the expected revenue hits. That means there may be some value here. Let's check.

Dollar Financial has awful net margins. It has four times as much debt as cash, and even if all of that is due to expansion, it is not executing very well, compared with its peers. Pass.

ACE Cash has four times the number of First Cash's stores, yet it pulls in only 30% more revenue, and that translates to poor comparable net margins. Before the FDIC blowup, analysts expected only 10% profit growth anyway. In an industry that's in the early-to-middle stages of growth right now, that's not attractive to me. Pass.

Advance America holds some interest for me, but with 22% of its revenue under siege, it provides a perfect example of waiting to see what kind of alternative product the FDIC might allow. I like Advance America's net margins of 16%, so it is worth keeping an eye on, especially considering the 47% stock-price haircut. Consider.

I'm very intrigued by QC Holdings. The FDIC guidelines will affect QC less than it will its competitors, yet its stock has fallen by 40%! With only 414 stores, it is not so committed to the industry that it can't further expand into safe-harbor states. It has excellent net margins, real earnings, $40 million in cash and no debt, and a shot at grabbing market share if the worst should be visited on its competitors. Strongly consider.

Now, to the pawnshop-payday hybrids. Because these companies are diversified, they have the pawn business to fall back on, though that costs them a bit in net profits because pawnshops aren't quite as profitable as pure PDLs.

I own shares of First Cash, and I'm not happy about the potential 17% revenue hit. I'm going to stick with it for four reasons, however. First, the stock sold off 35%, which could be an overreaction. Second, management is aggressively expanding into Mexico, where there is no FDIC and where pawnshops can charge a 360% APR. Third, the expansion plan has been focused on pawnshops over PDLs by a 4-to-1 ratio. First Cash knows where the money is. Fourth, First Cash has no debt and $40 million in cash, and it generated $39 million in free cash flow over the past 12 months. Any company that can expand its business just using its own capital is a company that is executing well. Strongly consider.

Cash America International is in trouble. Not only did it just warn that earnings would fall short this year because of decreased revenues at mature stores, but also the FDIC issue will weigh heavily on the company. Pass.

Then there's EZ Corp. What's with those lousy margins -- 5%, compared with 8% and 12% for its competitors? Compare its income statement with those of First Cash and Cash America. What you see is that EZ Corp has 50% more total revenue than First Cash does, but its cost of revenue is 100% higher. In addition, EZ Corp has a problem keeping operating costs under control. Bill Mann explored why, and his argument, along with the FDIC situation, is enough for me to say: Pass.

And the winner is.
It's too close to call. I will hold onto my First Cash shares, and I may buy more as events unfold. I am going to seriously look at QC Holdings. Advance America is on my intermediate-term watch list, but I'm not optimistic about it.

And with the industry under the FDIC siege, it's theoretically possible that interested corporations might smell an overreaction and consider making a buyout offer -- something that would likely work to the advantage of shareholders of the takeover target.

Do I smell an overreaction? Let me again emphasize that the exact effect of the FDIC guidelines cannot yet be determined. But the revenue hits I quoted above are worst-case scenarios, and even if they come to pass, my gut feeling is that these stocks have sold off way too much in response, although I wouldn't jump into any of them willy-nilly for the reasons discussed above. We all know that uncertainty can create opportunity, and that's why I think there may be some very real value here. And if the worst does not come to pass, these stocks may end up being dirt-cheap.

For important related articles, be sure to check out:

• The Vig Is Up for First Cash
• Cash In on ACE Cash?
• First Cash Bash
• Pay Cut for Payday Lenders?
• Not So EZ

Fool contributor Lawrence Meyers owns First Cash but advises you to ignore what he says and do your own research, lest you end up pawning something of your own. The Motley Fool has a disclosure policy.