Description

Set Up:

Enova International (ENVA) is a profitable, unloved, spin-off showing extremely attractive 4.7 trailing PE and hence appears to be a classic value investment play… but instead offers a 90-100% capital return opportunity as a short due to new UK and US regulations that devastate Enova’s profitability, leaving it struggling to survive.  While the initial characteristics mentioned above make for a very easy long thesis to those who are ready to accept management's spin unquestioningly, those who perform a closer examination will find a company with existential threats to its core business only partially obscured by management's extremely misleading narrative. 

Summary position:

-The UK business has already been devastated by British regulatory reform, with profits down over 100% to negative territory in recent quarters.  However, the full impact was only present in the last two quarters and hence is not yet fully visible in TTM numbers.

-Pending US regulation will result in an 80-100% decline in the future profitability of the US business just as it has with the UK business. At a 4.7 PE the company appears cheap on a backward-looking basis, but this is only a useful measure to the extent that the future is like the past, as it certainly will not be with Enova.  The company’s price to book ratio of one is supported only by $267MM of goodwill; it has negative tangible book. EV and EBITDA measures are irrelevant because Enova is a finance company that does not have a viable “enterprise” that can be separated from the need for outside financing.

- Enova will struggle to earn enough money to convince the markets to roll over its $500MM term loan (currently yielding 18.5%) due 2021 at reasonable rates and eventually will either go bankrupt or issue massively dilutive equity.  Enova has $477MM in cash in loans and $554MM in long term debt.

- Qualitatively, management is completely misleading in a great number of its claims.  This false narrative prevents the price from fully reflecting the disappointing operating results that Enova is almost certain to experience going forward.  While qualitative, the continued demonstration of management’s lack of candor should make investors question claims regarding future resilience, growth, and business quality.

Brief Description and Background:

Enova is an online lending company operating mostly in the US and the UK.  Its main products are short term "payday" loans (the legacy product which used to dominate operations) and somewhat longer-term installment loans and lines of credit (newer products that the company is trying to expand).  Enova was spun-off from Cash America (CSH), a pawn shop and brick-and-mortar lender, in Q4 2014. 

The UK Financial Conduct Authority (FCA) overhauled the regulation of short term lending in 2015.  Legacy loans that did not meet new standards were not immediately called but were allowed to run off as long as they weren’t rolled over.

The US Consumer Finance Protection Board (CFPB) announced in early 2015 a draft proposal to regulate the short term lending industry along two lines: 1) requiring lenders to assess a borrower’s ability-to-repay  and 2) limiting the number of times a loan can be rolled over within a short period.  (The CFPB does not have the authority to limit interest rates; that power rests with individual state legislators.) The formal rule proposal will likely be issued in March and after a comment period, implemented in late 2016 or early 2017.  The CFPB regulations are not subject to the legislative approval of any body and therefore are extremely likely (90%+) to be implemented in some form.

Claims vs Reality:

I believe the best way to illustrate why ENVA is an over-valued short candidate is to go through different facets of the management's narrative and the bull case and refute them one by one.  Most claims are paraphrased but can easily be verified by going through a company presentation or conference call transcript.

Claim 1: Pending regulatory changes may actually be a positive for Enova since many brick-and-mortar competitors will be driven out of business while Enova will not.  Hence Enova will end up gaining market share so the net impact of the changes could actually be positive.

Reality 1.1: The above claim, which suggests regulatory changes might actually be beneficial due to market share gains, was made for both the UK market (which experienced most of the implementation of new regulations in 2015) and the US market (which will experience the regulatory impact 2016-2017).  Management said on the recent Q4 call, “As we demonstrated in the UK…Enova will thrive under any likely regulatory construct.”  So what does a “thriving” Enova look like in the UK?  International (almost completely UK) Income from operations went from  27.7MM and 20.9MM in Q3 and Q4 2014, respectively, to -1.2MM and -2.1MM  in Q3 and Q4 2015 (the Q4 2015 number includes my estimation that international SG&A is unchanged… the official number in the Q4'15 10Q isn't out yet).  2^nd half revenues declined 67% and 56% from 2013 and 2014, respectively.  In short, the UK business wasn't just hit with a 50% or 70% decline in profitability, but rather the business was completely decimated and is no longer profitable (ahem, that is not profitable even before interest expense).  This is the single most important data point in the whole case:  UK regulatory changes have rendered the business unprofitable.  It is worth noting that on a full year lookback the UK business still appears profitable due to the run-off of previously-profitable-but-no-longer-viable business in Q1 and Q2 2015.    This misleadingly flatters any TTM multiple analysis. 

Reality 1.2: The decimation of the UK business by regulation isn't surprising when you understand the nature of the business and the regulation.  Payday loans default with staggering frequency and so require staggeringly high interest rates (200-450% per annum) to be profitable.  Many loans default immediately, so payday lenders make the bulk of their profits in "successful cases" when people end up rolling the loan over many times, paying multiples of the original principal in interest and fees in the process.  One successful case can pay for multiple defaults.  The UK regulation by and large did two things: limited lenders to charging no more than 100% of the original loan in total interest and fees, and limiting the number of times a lender could automatically "ping" a customer's bank account in an attempt to withdraw funds.  The first rule greatly limited the revenue lenders could effectively charge and the second rule greatly increased the cost of collection.  It is no surprise then that the profitability of the industry has been decimated.  It is hard to imagine any increase in market share making up the difference, and clearly it hasn't so far (most competitors are private so market share data is hard to come by).  The proposed US regulation isn’t exactly the same but enjoys broad similarities that should decrease viable market of the product and increase operational costs.

Reality 1.3: The CFPB’s regulations will so drastically reduce the size of the payday industry such that any market share gains required to keep revenue neutral would have to be unrealistically enormous, in the neighborhood of a quadrupling of market share.  ProPublica reports, "according to the rough estimates CFPB provided in a lengthy analysis, if payday lenders had to underwrite their loans [as proposed], they would be forced to cut their lending by 70 to 80 percent."  As in the UK, the combination of massive decreases in industry revenue accompanied by substantial increases in costs will not be materially, let alone completely, offset by any Enova market share gains...should they even exist at all.  Taking the CFPB's suggested 75% reduction in loans made as a baseline, and assuming this results in a 75% reduction in profits for Enova, would turn Enova's attractive 4.7 TTM PE into an 18.9 PE at current prices, which is expensive for a business with Enova's inherent regulatory and credit risks.  I believe the ultimate reduction in profits will be greater than any reduction in loans made due to high fixed cost nature of a software operation and therefore is likely be greater than 90%.

Claim 2: Enova has a better model than brick and mortar storefront. The company makes a big deal of its lack of physical storefronts, vast stores of customer data, and proprietary algorithms.  After leafing through an investor presentation, one is left with the impression that, like many online businesses, they have a cost advantage achieved through cutting-edge technology.

Reality 2.1: Online lenders are at a cost disadvantage compared to storefront (like publicly traded WRLD) because of higher default rates.  Quoting the PEW Trust’s October 2014 report titled Fraud and Abuse Online: Harmful Practices in Internet Payday Lending, "Approximately 44 percent of Enova's revenue covered charge-offs-i.e., losses on loans that were not repaid.  This figure dwarfs the 17 percent of revenue used for charge-offs by the largest storefront lender and the 23 percent used by the largest consumer finance company.  The higher losses illustrate the difficulty that online lenders face in verifying borrowers' identities, incomes, and willingness to repay.  Losses are a leading reason for online lenders' failure to gain a cost advantage over store despite their lower overhead-and for their higher prices.”  In a reflection of their cost structure, online lenders charge higher rates than do storefront lenders.  Online lenders are at a disadvantage when it comes to costs because the money saved on storefront rent is a small percentage of total costs.

Claim 3: Any bad effects of the coming regulation will disproportionately affect Enova’s competitors.

Reality 3.1: It seems at least possible if not probable that the regulations will harm Enova's operations disproportionately compared to others in the industry.  The US regulation focuses on forcing lenders to conduct and ability-to-repay determination which includes verification of borrowing history, income, and major financial obligations.  As previously stated, online borrowers default at higher rates than storefront borrowers so any effort to assess ability to repay should disproportionately affect online lenders.  Additionally, it begs the question: can this verification even be done online at all?  As stated in the Pew report, online lenders actually charge higher interest rates than do storefronts... the actual advantage of their business model is that they can provide loans faster and more conveniently without a trip to the store.  Substantial verification will not only slow down loan approvals, but could also prove difficult for Enova's low income customers to do online (imagine them attempting to scan and upload documents to a website).  At the very least enhanced verification requirements will be a substantial new cost of origination. 

Reality 3.2: Online lenders in general are more abusive than storefront lenders and so can expect to be disproportionately affected.  According to Pew, “9 in 10 of payday loan complaints to the Better Business Bureau were made against online lenders, although online loans account for only about one-third of the market.”

Reality 3.3: Again, disproportionate or not, the observed effect of the UK regulations was to render the business unprofitable.

Claim 4: Enova is pivoting to new installment loan and line of credit products which it claims are better.  Management really emphasizes growth (especially originations growth) of these newer products. 

Reality: 4.1: Again, despite an emphasis on new products, Enova is not profitable in the UK post-regulation.  Now we see why management promotes growth in loan balances in these new products as opposed to growth in profits earned from new products.  In fact, during H1 2015 installment loans actually had higher gross charge offs as a percentage of revenues (49%!) than payday loans did over the same period(38%).

Reality 4.2:  Enova lacks the capital to continue its push into new products: this is a key point that many investors miss.  Enova previously had excess cash to invest in installment loan growth which somewhat offset the decline in payday loans, but now they are running out of capital to continue this growth.  Any future expansion in loan balances will require new debt or asset-backed securitizations which will bring with it additional costs.  The company currently has $511 million net debt yielding 18.5%, a market cap of $212 million, and tangible book value of negative $67 million.  Forgetting for a moment about capital constraints, even if they could continue the push into installment loans, these products carry much lower interest rates (100-300% so about half) which makes it impossible to achieve the fantastic returns on capital seen in the past.  Even if the company could maintain its pre-US-regulation 2015 ROA of 5.4% (which it can't), that business won’t exactly scale when debt costs exceed 18%.  To be fair the company has successfully completed their first asset-back securitization facility but this isn't a cure-all and was only for their NetCredit product which is a higher quality "near-prime" product which carries interest rates about a third of those of on the much larger portfolio of traditional installment loans (35-99% vs 100-300%).

Reality 4.3: These new products introduce substantial credit risks as they involve much larger sums (thousands instead of hundreds) and time frames (3-12 months vs. 14-60 days).  Management had previously highlighted about their stellar credit performance during the financial crisis due to the loans being so short term that they could be scaled back at the first sign of trouble.  This won't be possible now that they are making loans with terms up to 5 years (as they are doing with their Net Credit near-prime installment loan product)!  Due to the increased reliance on longer-term larger-dollar loans, a recession could now be life-threatening for Enova.  Recall that Enova already has greater charge offs as a percentage of revenue in installment loans compared to payday loans.

Reality 4.4: In their presentations, management heavily emphasizes their proprietary algorithms built over many years that allow them to make loans quickly and effectively.  What difference do the legacy algorithms make if they were designed for old products when the company claims to be going in a new direction?

Reality 4.5: Installment loans are also subject to the new regulations about to be put out by the CFPB!  The effect on this business isn't likely to be as pronounced as will be on payday lending, but the installment loan space is certainly no safe haven from regulators.

Reality 4.6: There are a number of companies rushing into the subprime installment loan space, and the increased competition will likely render the space much less profitable in the future.  The Wall Street Journal recently noted there are about 200 online lending startups in the US.  New entrants include Goldman Sachs and Avant, which is run by the original founder of Enova and recently raised $325MM from private equity.  Note that both these new entrants chose to build their operations from the ground up rather than attempt to acquire Enova. When it comes to funding loans, these operations should easily be able to outcompete Enova due to their lower costs of capital.  Companies such as OnDeck are already missing analyst forecasts and announcing slower growth with lower margins… and this is area tp which Enova is pivoting in order to save itself.

Claim 5: Enova is a responsible company with a wholesome business model.

Reality 5.1: The closer you look, the more you learn that Enova is engaged in a slimy and abusive business (at least as it applies to the short term payday lending product).  A business model that inspires hatred from customers and regulators is a business model that has substantial risks going forward.  Additionally, a disreputable business it will never trade at a high multiple of earnings (assuming it even has positive earnings in the future).  Enova claims they operate with industry best practices and are not like other players, but they have the 2nd highest number of complaints on the CFPB's database of complaints regarding online lenders.  While not part of the investment short thesis, I encourage investors to log on and read some of the complaints; they are heartbreaking.  More importantly, a perusal of the complaints serves to illustrate that despite historical performance, Enova is not a “high quality” business.

Reality 5.2: Industry abuse is not simply limited to usuriously high rates and fees that customers cannot afford.  When a customer applies online (with their bank information) and Enova chooses not to grant a loan they sell the applicant's information to all comers, including other players in the industry.  There are widespread reports of fraud from this practice.  For example, the customer may receive a call from someone claiming to be from Enova that their loan was approved and when the caller gets access to the bank account no loan is made and they simply debit funds - i.e. theft.  Other problems include debt collection practices (for which Enova's parent Cash America paid $14MM in refunds and $5MM in fines for doing things like robo-signing and shredding documents), fraudulent collections, and unrequested loans.  All of these abuses inherent in the business model mean that Enova is at a constant risk of lawsuits and regulatory action/reaction quite apart from the CFPB’s current focus on new guidelines.

Reality 5.3: Quite aside from the CFPB action, Enova risks regulatory action at the state level at virtually any time.  Enova currently cannot profitably operate in multiple US states due to tightened regulatory stance and is facing action from the California Department of Business Oversight alleging Enova's subsidiary debited accounts more than authorized.

Claim 6: Enova should be evaluated on an EBITDA basis.  Management consistently uses EBITDA and Adjusted EBITDA metrics, targets, and valuation measures.  Management claims the newer products are successful because they have "EBITDA margins in line with our other products."

Reality 6.1: Wait a minute, is Enova a technology company or a finance company?  The company would prefer you believe the former, and perhaps this view made sense once upon a time when they only made very small, very short-term payday loans which didn't require a lot of capital to generate a lot of returns.  Now however, the company is making larger, longer, lower-rate loans which is a strategy that is highly capital intensive, and so ignoring "interest", i.e. the cost of getting that capital, is like a manufacturing company ignoring the cost of goods sold when talking about profitability.  This is why no one talks about EBITDA for finance companies, and Enova looks more like a traditional finance company every day.  Enova receives only third tier research coverage but amazingly some of these analysts follow management’s lead and model the company using EBITDA.  Anyone who takes the "[our new products have] EBITDA margins in line with our [legacy payday loan] products" line at face value misses the point that they need a lot more capital, and hence have to pay vastly more interest, to get that EBITDA.  If EBITDA margins are the same on the new products that means that both the top line will suffer due to capital constraints and the bottom line will suffer due to higher interest costs per unit of revenue/EBITDA. 

Summary. Where does this all leave Enova?

1.  Pending US regulation will likely devastate the profitability of Enova by some 80-100%.  The formal proposal for this legislation is likely to be made any day now and will likely take effect in 2017.  The negative effects of regulation will not be ameliorated by market share gains, a nimble business model, or movement into new products.

2.  Even absent any US regulatory action (which is a near certainty as it requires no legislative approval whatsoever), the new UK regulatory framework and shift to less profitable products has already devastated the profitability of the combined business.  While currently sports an attractive 4.7 TTM PE ratio, this measure includes two quarters where the UK action had yet to fully take effect.  Annualizing results from the last two quarters (again, this is before any US regulation) would yield much less attractive PE of 11.7. 

3.  Enova will struggle to earn enough money to convince the markets to roll over its $500MM in debt due 2021at reasonable rates and eventually will either go bankrupt or issue massively dilutive equity.

Risks to my Thesis:

I believe the largest risk to the thesis is not that the UK and US operations survive and thrive, but rather that the company scores a home run on operations in another region.  It has pilot programs in both Brazil and China, though these currently have no operating results to speak of.  More likely, the company could do a joint venture with or be purchased by Nakula Management (a current ~10% holder) which is controlled by a Russian oligarch who has substantial operations in Eastern Europe.  It is likely he wishes to implement a similar payday loan business in Eastern Europe by either licensing Enova's technology or purchasing it and using the company itself.  However, insider filings show that so far Nakula has been unwilling to purchase the company outright, likely due to the substantial price tag the market is still giving it.  Why buy the company now when it could be purchased at a future date for much less?  Nevertheless, the biggest risk to a short position is Enova's success in Eastern Europe, Brazil, or China.

Catalyst

1.  The CFPB will formally propose its new rules for the short term lending industry very soon, likely in March.  So far management has refused to speculate on the impact these rules would have on Enova's business (they actually issue guidance assuming no regulatory changes!).  When the rules are formally proposed they will likely find it more difficult to do so.  Additionally, the formal proposal should receive a lot of press and draw attention to the issue.  Lastly, there will be a long comment period when the industry will seek to defend itself against rules.  This will likely take the form of industry groups claiming that the rules will devastate the industry, which will make it much more difficult for individual companies like Enova to insinuate that they won't.

2.  Continued earnings disappointment.  Every quarter it has been and will continue to become more clear how devastating the UK regulatory action was to Enova's substantial business there.  Additionally, given more operating history it will become more clear to investors that the newer installment loan and line of credit products are not as not as profitable or low risk as the legacy payday loan products, especially not when interest costs are taken into account.  The stock price should suffer as Enova continues to suffer lower revenues and profits as a result of both the UK regulatory action and shift to less profitable products.