Description

Intro:

Goeasy has been written up twice on VIC (5/1/2018) & (12/20/2018) and the company as well as the stock have done very well since then. Nevertheless, we still think Goeasy looks very attractive as of today and we own the stock. The company has a competitively advantaged business model in a niche market with a long runway for growth and a board/management with skin in the game (Chairman Emeritus Donald Johnson and Executive Chairman David Ingram with an 18% and 2.4% stake in the company). To set the tone we want to review the most important facts about the company and industry, then focus on new developments since the last write-up and conclude with some thoughts on the current valuation.

Business model & industry:

Goeasy is a Canadian company that focuses on an underappreciated sub-prime lending niche, where it acts as a “lender of last resort” for people with low credit scores and offers a wide range of different credit products at rates from 9.9% to 46.9% (subject to change – more on this later). 

There are around 30mn Canadians with an active credit file and around 8.5mn of them are considered non-prime based on their credit score (719 or lower). The total of consumer credit balances in the non-prime consumer segment is estimated to be about CAD 194 billion. The split between products is 32% auto loans, 28% line of credit, 22% credit cards, and 18% installments. Especially installments have been neglected by big banks after the GFC and traditional financial institutions today are generally unwilling or unable to offer credit solutions to consumers that are deemed to have a higher credit risk due to the consumer’s financial situation or less-than-perfect credit history.

At this point, we want to draw a line between sub-prime lenders like Goeasy and pay-day lenders, who sometimes charge annual rates of up to 600%. Goeasy’s position in the industry is more than justifiable. Their importance can be seen from a survey the company has conducted in the past, where 72% of customers stated that they have been denied credit by a bank or a credit union and 80% of customers stated that they rely on access to credit when a financial emergency arises. It is also important to mention that Goeasy offers its customers different tools to enhance their credit score (reporting when payments are made on time) and financial literacy resources. As a result, 60% of customers improve their credit score within 12 months of borrowing from Goeasy and 1 in 3 customers graduate to prime rates. 

Since the last write-up (in 2018), Goeasy has continued to grow its financial metrics in a very strong manner. The credit book has grown from CAD 833mn in 2018 to CAD 3.2bn (per Q2 2023) and revenues have grown from CAD 506mn to over CAD 1bn, where 85% is generated in their easyfinancial segment (wide range of secured and unsecured lending products) and 15% in their legacy lease-to-own segment “easyhome”. Strong revenue growth in combination with continuous margin expansion (eg. operating margin from 23.7% to 36.2%) operating income and net income (adjusted for one-time effects and M&A amortization) have grown to CAD 369mn (+208%) and CAD 192mn (+262%) respectively by the end of 2022.

The continued strong performance stems from the following factors:

Advantage Nr. 1 - Omnichannel Model with large existing Branch Network

The company offers its products and services through an omnichannel business model. Goeasy had 304 easyfinancial locations and 144 easyhome locations per Q2 2023. In addition to its retail branch network, customers can also transact online on their website, which remains a critical source of new customer acquisition. The company also originates loans through its point-of-sale channel, which includes approximately 6,500 merchant partners across Canada. This combination creates a nice broad customer acquisition funnel for the company.

In contrast to online-only market players the large branch network (90% of Canadians can reach a branch in 50km or less) does not only have a positive impact on brand image and top-of-mind awareness but also creates a critical human interaction/relationship. This is a key factor for success in this business because it leads to a better understanding of customers, a better assessment of the ability for repayment, and also a higher sense of responsibility for repayment from the customer side, given the personal touchpoint with someone from the local community. Goeasy has ramped up its branch network very successfully over the last decade and is nearing a mature build-out. Management estimates their sweet spot to be between 320 – 350 easyfinancial locations as they are still somewhat underpenetrated in the area of Quebec.

Advantage Nr. 2 - Large Scale in their market

As mentioned already Goeasy has seen very strong growth in the past. Larger scale allows for higher efficiency (operating leverage) and leads to an advantaged cost structure versus smaller competitors. The improvements in their cost structure can be seen from their efficiency ratio, which compares adjusted operating expenses (operating expenses less bad debt for newly originated) to revenues and allows for a better assessment of operating leverage than operating margin. The efficiency ratio has declined from 63,2% in 2016 to 33,6% for the fiscal year 2022. The company is currently at a stage where incremental growth comes at a very high margin and management mentioned in the most recent earnings call that they still see an opportunity for a couple of 100 bps per year improvements until it gets to the mid-20s.

Advantage Nr. 3 - Lower Funding Costs & Good Access to Capital Markets

Their current size in combination with very healthy financials have also helped the company to drive down their funding cost. By the end of 2018, the cost of borrowing stood at 8%, while they achieved their lowest average rate in Q3 2021 (4.3%) and currently stand at 5.6%. A recent report by the Canadian Lenders Association stated that the average cost of capital for their members is 13%. This indicates a solid advantage in funding cost over competition for Goeasy. Additionally, Goeasy has benefitted from excellent access to capital markets. Since 2018, they have successfully been able to establish securitization facilities (underwritten by a broad syndicate including five of the major Canadian banks) in addition to bank and bond funding sources. 

Advantage Nr. 4 - Excellent Credit Scoring Models for their customer base

Goeasy has constantly evolved its credit models for decision-making. As can be seen from the chart below, their models have improved significantly over time. Their current data repository of 22.2 TB of data and 76,642 data points from close to 8mn historic applications allow their models to outperform generic credit bureau scores regarding predicting expectations of losses for a non-prime consumer. This has been a key factor for stable credit metrics and in combination with a higher secured credit mix led to an improvement in the net charge-off rate from 12.7% in FY18 to 9.1% in FY22.

Recent developments:

So, what’s new since the last write-up? Let’s look at internal things first:

Product expansion & increased share of secured loans

Back in 2018, the loan book of Goeasy stood at CAD 833mn, and almost 94% of its loan book consisted of unsecured loans. Over the last several years the company has diversified its product suite with new types of loans and today offers a very wide range of different loan products. An essential part of this transition was the acquisition of one of Canada’s leading providers of point-of-sale financing - Lendcare. Since then, they have widened their network and now offer loan products through partnerships with over 1,600+ merchants (retail financing), approx. 800 veterinary clinics, dental clinics and medical device companies (healthcare financing), 400 national-scale distributors (home improvement loans), and 2,300+ merchant partners (powersports financing). Another big initiative was the launch of auto loans back in 2021, which allowed Goeasy to access the single largest product category within the non-prime credit market in Canada. Their initial efforts in auto financing have been going quite well (but it is still early) Their auto loan product is currently offered through 2,500 dealerships with a target to scale to 8,000.  

The growth within the auto loan, powersports financing and home equity loans has increased the share of secured loans from 6% in 2018 to 41% per Q2 2023. Management thinks this could move towards 50% - 55% in the next couple of years and in the very long-term to max. 60%. This transition leads to a more diversified and higher quality loan book.

Launch of Mobile App and increasing cross-sell opportunity given broader product offering

During the Q1 2022 earnings call, management mentioned that they started their journey of further improving their digital lending ecosystem by connecting their products and channels through a mobile app. Initial tests and surveys carry some promise as 83% of financial customers intend to use the app. Early 2023 they started a pilot and mentioned in the most recent earnings call that they will launch a big rollout in Q4 2023. Customers will be able to track their payments, track existing applications, get connected with their home branch, receive pre-approved offers, and have access to a wide range of financial literacy resources, which should further improve the customer experience and deepen the customer relationship. The cross-selling opportunity appears to be promising one too. Many of Goeasy’s customers are not aware of the wide range of borrowing options available or presented offers for loan products they are eligible for. The cross-selling activity that is done today, uses a basic approach of phone calls and e-mails. The mobile app should make this process a lot more efficient and improve the current conversion rates of 10-30% after one year when cross-selling customers from one product to another, thus driving further future growth. Important to mention is that the app will be only available to existing customers, which eliminates the risk of deteriorating the quality of the loan book.

Before providing some thoughts on valuation, we want to dig a little bit deeper into several external influences that have impacted (COVID) and are currently impacting (regulatory changes & current macro environment) the company.

COVID

Goeasy was able to weather the COVID crisis very well. In hindsight, it wasn't a particularly difficult time for lenders, given the record government support and lack of opportunity to spend money foolishly. Anyway, they also took the right steps internally. During the onset of COVID, when uncertainties were very high, they stayed conservative, adjusted requirements for new originations, and reduced marketing expenses. In combination with a general lower demand, they saw a short-term reduction in new loan originations. Once uncertainties decreased, they were very quick to reaccelerate new loan originations and continue growing the loan book. In addition, where sensible they were offering payment deferrals and loan extensions and as a general benefit, a large portion of the unsecured portfolio carries incremental insurance for unemployment risk with a third-party provider of credit insurance.

All in all, Goeasy saw its net charge-off rate decrease from 13% by FY19 to a low of 7.8% in Q3 2020 and never exceeded its target range of 8.5% to 10.5% during the COVID times. Many investors probably expected or are still expecting net charge-off rates to normalize to historic pre-pandemic levels (2016-2017 mid-teens / 2018-2019 low-teens) as this is the case for many credit products. However, there has been a structural shift going on within Goeasy's portfolio, driving permanent improvements, that counterweight an overall normalisation. The combination of a higher percentage of secured loans (40% per FY22) and proactive credit and underwriting enhancements to reduce risk (especially last year in the wake of record inflation) are keeping a lid on net charge-off rates. The structural improvements are also showing up in management expectations. They have gradually adjusted their target range from 14% to 16% in 2016 to the most recent target of 8% to – 10% (since Q1 2023).  Goeasy is also very consistent in hitting their expectations. Actual values, have comfortably hovered in between these ranges and currently sit right in the middle of the range at 9.1% per Q2 2023.

Regulatory Changes

The threat of a changing regulatory environment has always been a concern, but a decreasing one over time. Before 2023 the regulatory environment has been very stable. Section 347 of the Criminal Code regulates the entire lending market, setting the maximum effective annual rate of interest that can be charged at 47% (APR), while several further regional regulations set the maximum interest to be charged even lower.

This changed on March 28, 2023, when the Federal Government announced its plan to decrease the maximum allowable rate of interest to 35% (APR). The initial stock price reaction was very negative and dropped 20% over a couple of weeks. However, Goeasy is very well positioned to weather this change and will likely even be a beneficiary over time due to a reduction in competition with higher barriers to entry. In the past, the company has been able to continuously reduce its weighted average interest rate from 46% in 2017 to 30.5% in 2022. Besides a change in product mix (higher share of secured loans), they have also been decreasing the rates they are charging to customers due to continuous improvements in their cost structure through operating leverage and a favourable financing environment. When this change was announced one-third of their loans were higher priced than the 35% (average of 42.5%). A reduction to 35% right away, would have reduced the weighted average interest rate on the total portfolio by approx. 270 bps to 27.3%. However, as this change will take time to implement, the existing loans over the 35% limit will just run off over time. (The final implementation has not started yet, but it should only be a matter of time.) Thus, this will only impact new originations and will lead to some customers being priced down, some will see a lower maximum loan amount, and some will lose access. Management seems to be very confident in the wake of these changes. Smaller providers will have a much harder time going forward. They generally have a lot less operating leverage, face higher funding costs, higher net charge-offs and have a less diversified book, with generally a larger percentage of their business impacted by the cap. Some competitors will definitely run into problems and this sets the path for future market "share gains" and also creates higher barriers to entry. Comments from the most recent earnings calls support this. Management is talking about favourable competitive conditions. Lastly, Goeasy has already experience in dealing with a 35% rate cap as in Quebec there has been an existing limit for many years and Goeasy is still able to produce ROEs north of 20%. Accordingly, their midterm guidance has been kept basically unchanged as better loan book growth and lower net charge-offs offset a lower yield on the loan book.

Current environment

Despite high inflation, rising interest rates, and some general weakness within the economy, Goeasy continues to do well.

In terms of demand, the current environment benefits companies with scale as smaller players see margin compression, economic concerns require credit tightening, and access to funding might be limited/expensive. This is supported by management’s comment on visible headwinds for smaller competitors (eg. the number of companies bidding directly against Goeasy within Google paid search during the most recent quarter was down nearly 40% YoY / direct competitors have kept origination volume flat or even reduced it). Additionally, due to the tightened lending criteria of banks, Goeasy can tap into the market of higher quality borrowers as some of them have lost access to bank credit.

In terms of cost structure, where inflation is impacting operating expenses and higher interest rates impact borrowing costs, Goeasy is very well positioned to more than offset this margin pressure by driving additional operating leverage.

Also, credit metrics have remained stable despite a difficult macro environment. Over the last several quarters, Goeasy enhanced underwriting and income verification processes, tightened credit tolerance twice, and lowered debt-to-income ratios to reflect increasing consumer expenses.

Goeasy also appears to be well positioned to weather a much weaker environment. First, research shows that the non-prime segment has been the most stable (smaller relative changes) during economic shocks. During the dot.com bubble, auto-market collapse/financial crisis in Detroit, and the oil crash in Alberta the delinquency rates of subprime loans were less impacted than other segments. Reasons for this are, among other things, lower levels of debt (55% less debt than prime) government support (Canada’s standard unemployment insurance program covers approx. two thirds of average consumers after tax income) and the customer cohort being in general in more of a state of crisis. On top of that Goeasy has loan protection insurance on almost 50% of their portfolio for unemployment risk with a third-party provider.

Some thoughts on Valuation 

Goeasy’s market cap per October 10th stands at CAD 1.87 billion and the stock trades at 10x LTM earnings, however, there have been several one-time and non-cash items that have affected earnings over the last couple of years, including (pre-tax):

• 2020:

  • CAD 21.7mn positive effect related to unrealized fair value gain from investment in Paybright

• 2021:

  • CAD 8.7mn negative impact from amortization of Lendcare

  • CAD 114.9mn positive impact from realized and unrealized fair value gains mainly on investments in Affirm and its TRS

• 2022:

  • CAD 13.1mn negative impact from amortization of Lendcare

  • CAD 28.7 mn negative impact from realized and unrealized fair value losses mainly on investments in Affirm and its TRS

  • CAD 20.5mn from software contract write-off due to cancelation

The development of adjusted EPS shows a much better picture of their real earnings power (and continuity as well):

Thus, the stock is actually trading below 9x LTM and 8,4x ann. Q2 2023 earnings. Historic earnings growth has been fantastic and it won't end here. Management always provides an outlook for several key metrics, which they usually have been able to surpass in the past. Within their base case, Goeasy would achieve around CAD 240mn in net income by 2025. Based on their strong execution track record, several newer product initiatives and an ROTE of >35%, we think these goals are very achievable and also not the end of their earnings growth story. 

Historically (below the last 10 years for reference) the company has traded between 10-18x earnings with the only real short exception during the initial pandemic shock. The early 2022 window below 10x has more to do with unadjusted one-offs. The average overtime was 13x. Given the fantastic growth, one can argue the company was always undervalued. 

At 13x and CAD in 240mn 2025 earnings this would lead to +80% including dividends in a little over 2 years. 

The earnings and return prospects beyond that time frame also seem quite attractive. The company currently produces a ROTE of over 35%, which allows them to comfortably fund expected growth and still pay out a good chunk of their earnings (general proxy is around 30% of earnings). When growth decelerates, management said that the dividend payout ratio will be kept around these levels and they will allow for alternative capital allocation (buybacks and M&A). They have opportunistically bought back stock in the past and they have also some history in M&A (quite successfully, but it's a risk as well). Without providing a more detailed model, we believe a company with these characteristics at 8,5x annualized Q2 2023 earnings is too cheap and positions one well for a very good long-term return. 

Some risks

Further regulatory changes

While there will always be a risk of further regulatory changes, it looks rather unlikely that this will change as the level is now harmonized with Quebec, it is lower than other regions like the US, Australia & UK and if they go lower regulators will start impacting some bank products (high 20s/low 30s).

Macroenvironment

As already mentioned, another risk for the company is increasing losses during a weakening macroeconomic environment, however, due to the reasons stated above, we believe Goeasy remains well positioned in such a situation. They have done well during phases like that in the past and have a big cushion built in. The net charge-off rate could more than double before they were to generate losses. They also have very strong cash flow generation if the portfolio is held flat.

Shift of focus

Geographic expansion has been a part of Goeasy’s strategy since the beginning. They have successfully increased geographic reach within Canada and yet they appear to be still quite underpenetrated in Quebec (22% of Canada’s population vs. 7% in Goeasy’s loan book). This is because Goeasy only entered the market six years ago and acts more cautiously due to a more complex lending environment, but growth initiatives are further increasing. While organic growth potential (regional & product) is still high, management, however, has also talked about possible longer-term international growth opportunities in other English-speaking countries like the US and UK further down the road. We hope they will not try to do that. 

Execution hiccups

The company has a growth mindset and is still quite ambitious, which can be dangerous, especially with financials. However, their track record managing these risks so far is very good. Usually, they start out small and only scale something if they feel like they have sufficient data. Anyway, it's another obvious risk, to mention and it ties to the potential long-term international ambitions. 

Catalyst

no hard catalysts