Description

I believe World Acceptance (WRLD) will be roughly $200 per share in 12-18 months.  While this seems like hyperbole and a 600+% return would seem preposterous, we can build a bridge to there, it is a simple 3-step process of the market, taking into account recent regulatory actions, the removal of regulatory overhang, and a return to growth.  We would point out that the stock traded at over $95.00 in May.  Despite incredible upside, we believe that WRLD is actually trading significantly below liquidation value. 

World Acceptance is an installment lender, issuing small consumer loans to subprime borrowers. The typical loan is roughly $900 paid over 12 $100 installments. Interest rates and fees are high at over 60%, and a large portion of the loan book is refinanced loans. The business has produced exceptional returns since its founding in 1962.  The company operates over 1,300 stores in 15 states and Mexico.  The company is expecting action from the CFPB.

Before we look at upside, let’s look at downside:

If WRLD is asked to make changes to its business model that are punitive enough to make the company unprofitable, we would expect WRLD to go to court, and assuming they lose, they would be forced to liquidate or dramatically change the business in roughly 1Q 2017.  The company has seized buybacks so all cashflows between now and then would go towards debt paydown.  Making some fairly conservative assumptions, believe that there is a fair amount of upside in a liquidation scenario (see Exhibit 1 below).

While orderly liquidations are rare, we are comforted by WRLD being quasi controlled by lead shareholder Prescott General Partners (over 30% shareholders), an outstanding investor, who is highly unlikely to let the company squander its capital on frivolous business plans.  Additionally, we do see a potential transition to a smaller higher loan business, similar to Spring Leaf (LEAF), which would yield further upside. 

As further testament to the ridiculousness of WRLD’s current valuation, we looked at companies with payday lending segments, both of which trade for significant premiums (See Exhibit 2 below) to WRLD.  We note that almost all of WRLD’s book value is tangible vs. less than half for FCFC & CSH.  Payday lender’s under-announced proposed rules by the CFPB would seem to be toast. WRLD is also drastically undervalued vs. direct competitor Regional Management (RM), which trades over 8x 2015 EPS and above book value.

WRLD & the CFPB:

Various business practices of WRLD’s are currently being scrutinized by the CFPB.  The outcome of the CFPB’s final decision will be the key driver of how much upside above liquidation value there will be in WRLD shares.  I believe WRLD will be forced to make minimal changes to the company’s business model.  Below I review the various areas the CFPB is or may be looking at in WRLD:

Credit Insurance:

In the states where it is allowed, WRLD sells a variety of voluntary credit insurance products to its customers. These include credit life insurance, accident & disability insurance, and credit unemployment insurance. During FY 2015, WRLD earned ~$24 million on brokerage commissions from the sale of these products representing approximately 13.6% of WRLD’s $176 million of pretax profits.

Credit insurance covers a customer’s loan payments if a specified event occurs. For example, a buyer of credit unemployment insurance would not need to make loan payments if he or she lost his or her job. Credit insurance is controversial, as the proceeds from the policy go to the lender (even though the borrower pays for the policy) and the insurance is typically very expensive compared to its actuarial costs. Brokerage fees are high (typically upwards of 66% of premium) though low in dollar terms.

While there are groups who oppose credit insurance generally, the CFPB’s prior actions lead me to believe that the bureau is unlikely to try to eliminate credit insurance altogether. However, based on prior enforcement actions, it is clear that the CFPB is focused on the manner in which credit insurance is sold. The key issue is whether credit insurance products, which are required to be voluntary, are really being voluntarily selected by the borrowers or if they are being bundled into the loans without the borrowers’ understanding or knowledge.

As detailed in the ProPublica article referenced earlier, it is possible to find former employees from World who will report systematically bundling credit insurance products in some branches prior to 2012. However, since then, WRLD has substantially improved its compliance and its training. Based on my own due diligence, I am comfortable that WRLD employees sell ancillary products properly and have done so since at least the start of 2013.  Fortunately for WRLD, these improvements resulted in only a modest decrease in the attachment rate of the products, indicating that prior non-compliance had only a small impact on attachment rates.

My interactions with many typical WRLD customers, made it clear that the despite being expensive on an actuarial basis, if properly and compliantly sold, credit insurance products could be very popular with borrowers. This observation runs contrary to the presumption in the bear case that given the high cost and limited actuarial benefit of credit insurance, few borrowers would actually knowingly purchase it.

I believe that WRLD’s current sales practices with regards to voluntary ancillary products will withstand CFPB scrutiny and that any fine for past sins will be manageable. If I am wrong, WRLD’s profits from the sale of these products are ~$24 million before taxes (13.6%), so their loss or impairment, while impactful, does not pose a mortal risk to the business.

Credit property insurance:

Consistent with state laws, WRLD requires that borrowers have property insurance in place on the collateral that borrowers provide and that they make WRLD the beneficiary of that insurance. If borrowers do not have insurance or do not want to make WRLD the beneficiary of their existing policy, they may buy credit property insurance instead. While it is not required that borrowers buy the credit property insurance from WRLD, many do. Few borrowers have other insurance (such as renter’s insurance) in place, and small property insurance policies to cover loan payments are not typically available from other sources. When WRLD sells a customer a credit property insurance policy, the company earns a brokerage commission. WRLD earns approximately $12 million per year pretax (or ~7% of pretax profits) from the sale of these sorts of property insurance policies.

Since WRLD rarely forecloses on borrower collateral and does not rely on its value to underwrite loans, the argument has been made that it is improper for the company to require property insurance on the collateral and that the only reason they require the collateral is to sell the insurance and earn the brokerage commission.

WRLD’s practice in this area is common throughout the industry, and in theory, WRLD could (ironically) ameliorate some of the issue by more frequently and more aggressively pursuing borrowers’ collateral. If the CFPB were to pursue the argument that the practice is unfair, deceptive, or abusive, the debate would likely hinge on whether the act in question is the act of requiring and offering the insurance or the act of failing to foreclose on the collateral. Clearly, a lender electing not to foreclose on collateral on which it could otherwise foreclose benefits consumers and would not be unfair, deceptive, or abusive. However, one can see how requiring unnecessary insurance in order to earn brokerage commissions could be viewed as unfair, deceptive or abusive.

I am not sure if the CFPB will choose to pursue this argument or if such an argument could win in court. WRLD and the CFPB may also choose to negotiate some sort of settlement on the matter. In either case, this issue is not too significant in the scheme of things. In total, out of WRLD’s $176 million of profits before taxes, we estimate that WRLD makes approximately $12 million per year selling property insurance on consumer goods which it rarely repossesses.

Encouraging struggling or potentially struggling customers to renew their loans:

Renewing loans is central to WRLD’s business model. Since, like a mortgage, payments early in a loan are more heavily weighted to interest and fees than payments later in a loan, and, depending on the state law, certain origination fees are non-refundable, WRLD makes a good deal of profit when a customer renews.

WRLD routinely markets the opportunity to renew loans to customers. In general, when a customer comes into the store to make a payment, a WRLD employee will present the opportunity to renew the loan if the customer is eligible. WRLD also markets the opportunity to renew via direct mail and more recently through text messages.

WRLD’s customers utilize renewals in a variety of ways. New customers who have previously taken out smaller loans often renew into larger loans as they earn the trust of the WRLD branch manager. Some existing customers repeatedly renew their loans as a tool to manage their cash flows, essentially using the product as a revolving line of credit. Lastly, and most significantly from a regulatory perspective, WRLD offers renewals to customers who have made series of payments and are current or near current but are struggling to make a payment that month. The typical customer will renew his/ her loan about 2.5 times, thus extending the relationship with WRLD from the average initial contact term of 13 months to about an average of approximately 24 months.

Renewals of loans, particularly delinquent or struggling loans, is a concern to the CFPB, which believes that consumers can be harmed by being stuck in a cycle of debt when they are forced to repeatedly renew a loan that they cannot afford. In particular, the CFPB recently announced its intention to propose rules regulating payday lenders and installment lenders whose loans are collateralized by vehicles or have access to a customer’s checking account. These rules would substantially curtail lenders’ ability to renew loans in general and of struggling customers in particular.

We believe that CFPB’s legal theory behind this rule is that these loans are “abusive.” We believe that the relevant portion of the definition of “abusive” as contained in Dodd Frank is:

“takes unreasonable advantage of a consumer’s inability to protect his or her interests in selecting or using a financial product or service”

Thus, the CFPB will likely argue that when a lender has access to a customer’s bank account or vehicle, it can coerce a struggling customer renew his/ her loan even if doing so is not in his/ her interest. Hence, such a practice is abusive because it “takes unreasonable advantage of a consumer’s inability to protect his or her interests in selecting or using a financial product or service.”

Since WRLD never has access to a customer’s bank account and only rarely takes a security interest in a vehicle, the direct negative impact of the CFPB’s likely-to-be proposed rule on WRLD will likely be limited. In fact, given the significant negative impact that these rules are likely to have on many of WRLD’s competitors, it is probable that these rules will significantly benefit WRLD by allowing the Company to take market share. However, a risk is that, through enforcement, the CFPB could attempt to expand its definition of abusive to include WRLD’s loans and renewal practices.

I believe that such an interpretation of the abusive clause by the CFPB would be overly expansive and unlikely to hold up in front of a judge. However, since this is a new area of law, there is no precedent. Instead, our analysis hinges on parsing the text of the abusive clause. In particular, we think that it would be difficult for the CFPB to show all three criteria of the definition of abusive:

1) That the renewal isn’t in the customers “best interest”

I believe in most cases, it is in a consumer’s best interest to renew a delinquent loan. Renewing, as opposed to defaulting, helps a borrower to maintain and continue to improve his/ her credit rating (not true for payday loans), access additional funds at a time of need (not true for payday loans), and maintain a relationship with a lender that can act as a source of funds for future liquidity needs.

2) That the customer is unable to avoid the renewal

Consumers can and frequently do refuse WRLD’s offer to renew. In these cases, customers elect to file for bankruptcy, refuse to pay, or elect to make payments in their own time without renewing. We also think that Congress chose the word “inability” carefully, that it clearly was intended to limit the abusive clause to situations where consumers are clearly unable to protect their interests, and that it excludes from the definition of abusive situations where consumers have an ability, even a limited one, to protect their interests.

3) That WRLD is taking “unreasonable” advantage

Even if a renewal is not in a consumer’s interests and even if the consumer is unable avoid it, WRLD is allowed to take “reasonable” advantage of the situation. Whether renewing a loan on similar terms is or is not reasonable would of course be subject to judgement, but it reduces the question to one of degree; i.e. how much can one charge, not if one can charge, for such renewals.

Renewals are critical to WRLD’s business model, both in terms of building customer relationships and in terms of mitigating losses. If the CFBP significantly curtails WRLD’s ability to renew loans, the impact would be significant and difficult to predict. It is possible that an adverse outcome in this area could put the company out of business altogether.

WRLD is a Great Business:

Absent of any changes that could be forced upon it, World Acceptance is truly a great business.  Returns are a rare combination of extremely high and non-cyclical returns with low leverage over a very long period of time (see exhibit 3 below).

So how has WRLD profited so strongly in booms and busts?  A bear’s quick retort would be that the company rips people off, but payday lenders charge much higher rates and the businesses are nowhere near as good. In fact, to our knowledge, no other subprime model comes close to matching WRLD’s economics. I believe what drives the great economics of WRLD is the face-to-face nature of the business, which appears to dramatically lower charge-offs, since 2001 Net charge-offs have been 12.0%-16.7%.  This is certainly much lower than any non-securitized subprime lending. The rational here is simple: borrowers go into WRLD every month, since most borrowers are repeat customers. This has been happening for years. If you want to stop paying for whatever reason, you are not stiffing some large corporate entity but your friend the manager who you have met every month for the past couple of years and who lives in your town. From this lens, it is easy to see why WRLD’s charge-offs are so low. 

So why can’t somebody just copy this great model, well they do but not on a large scale.  WRLD has encountered higher charge-off rates , when they have had less fewer experienced managers. Therefore, there is somewhat of an art or a soft touch to this lending, which can-not simply be replicated overnight.  Remember, it took the company over 50 years to get where they are today. Repeat customers are the most profitable, so newer stores are therefore less profitable.  It would seem that building a large scale operation from scratch is likely impossible.  WRLD does lose an occasional manager, who starts up on his own to run a small business.

Is World good for consumers?:

Let me preface this by saying, I think that it is obvious that a loan with an interest rate above 60% is unlikely to be shrewd financial move.  However, I would say that a 20% credit card balance is also foolish. For WRLD’s customers, it is the best option. Payday lending’s rate is well in the triple digits. Other rates that these consumers can get like rent-to own stores are similar at best. WRLD also reports to credit bureaus (payday lenders do not), allowing its customers to build a credit history. In fact, when Congress issued the military lending Act, putting a hard 36% interest rate cap on military loans, installment lenders were exempted. 

If all these forms of lending were to be banned, the resurfacing of loan sharks appears to be inevitable.  While forcing these people to give up high interest rate debt would seem to benefit them.  There are clearly instances when people need money, no matter the cost. I would note that studies have shown suicides rates are higher if access to payday lending is removed.

WRLD’s 3 step process to $200 per share:

Much of the upside in WRLD simply comes from undoing the damage of the last 6 months.  WRLD originally started sliding as the company attempted to float a bond deal in May/June. WRLD expected better terms than it originally received, so it pulled its high yield offering. We have heard some short sellers say that the company could not get a deal done, but we do not believe that was the case.  In the end, WRLD expanded the company’s credit facility but was forced to eliminate buybacks under more restrictive covenants. The stock incredibly dropped more on this news than any accretion WRLD could have made through share repurchases. After this, WRLD posted weak 2Q loan volumes and earnings.  The combination of these events cut the stock nearly in half to just above $50 per share.

On August 10, World Acceptance announced that it had received a NORA letter from the CFPB and the stock tanked over 30% to $34.00.  The free fall took a break but resumed on no news in September plummeting to today’s levels.

Step 1, a better understanding of NORA:

A NORA (Notice and Opportunity to Respond & Advise) letter is simply a step in the process of a complaint and eventual decision by the CFPB. World Acceptance had already announced that it was being investigated by the CFPB. The company disclosed on March 12, 2014 that it had received a CID (Civil Investigative Demand).  Because the CFPB was investigating WRLD, investors knew with near certainty that the company would not get off scot-free. There are essentially 3 – 4 steps: the CFPB issues a CID and investigates, then they notify the company with what they believe the violations were and give the company one last chance to respond, which is what the NORA is, then CFPB issues their decision. The company can then choose to fight this decision in court. But the NORA notice is just a step in the process and not an indication of how severe a punishment will be.

Investors appear to have completely misinterpreted what a NORA letter is. This misinterpretation is likely due to the limited history of the CFPB. If investors truly understood the CFPB’s process, we believe WRLD would still be trading in the $50’s.  However, it is unlikely that the market will be able to better decipher the CFPB’s process before a decision that should come within the next 4 - 6 months, which brings us to step 2 in our revaluation process.

Step 2, a reasonable outcome from the CFPB:

As I laid out above in WRLD & the CFPB, I believe that World operates, within the law.  This is based on extensive due diligence and channel checks along with a careful parsing of the law.  With a clean bill of health, the stock should rerate. Arguably, WRLD should then trade at a premium to what it did in the past, since it would likely not face major regulatory scrutiny for the next decade or more. This would place WRLD at just 8x would yield $89.36 per share, but you also have untapped leverage that the company likely unlock with some new financing. I would estimate the equivalent of another year’s worth of buybacks. That gets you to $99.51 per share.

Step 3, a return to growth:

WRLD was an amazing growth machine from its founding in 1962 till 2012. The company consistently grew the number of stores and the average loan balance and revenues per store (see exhibit 4 below).

So World’s growth formula worked for 50 years, but loans per store peaked in 2011, leading to revenue declines today as loan volumes decline. So what is driving the revenue decline? We have looked at economic indicators and indicators like gas prices, but the correlations are small, if existent at all. I believe that the cause of WRLD’s growth problems in the last few years is clearly the rise of cheap smart phones. To know about WRLD, you were either a customer or knew one, because the company’s web presence was essentially non-existent. Until a couple of months ago, World’s website was basically a mid-90s IR site with not even a store locator. Outgoing CEO (retiring September 30) Sandy McLean, seemed to have a “don’t rock the boat” and “it ain’t broken don’t fix” it attitude. While competent, I believe that the company missed a lot of easy marketing opportunities, leaving a lot of low hanging fruit for incoming CEO Janet Lewis Matricciani. The new CEO already has done some impressive work since coming on board as Chief Operating Officer at the beginning of 2014. She was able to start a program to sell defaulted credits, increasing ongoing EPS by roughly a dollar per share. On previous conference calls Matricciani discussed some early results of new marketing programs. Results are so far encouraging.  Though loan growth continues to be negative, there has already been some improvement in the rate of change.

In addition to the digital marketing opportunities, the stranded payday lending customers offer a large amount of upside. The installment loan business is a fraction of the size of payday lending, so even a small shift could make a large difference. There is a very long runway for growth. Just looking at the density of stores in South Carolina shows that WRLD can triple its store base over time without going to new states. I believe that growth will return for WRLD, so with buybacks and growth (WRLD also likely has some spare capacity for growth, further juicing earnings in the short-run), EPS should be above $13.00, roughly $13.25 in 12-18 months. If you place a 15X multiple (very reasonable with 10% earnings growth with an additional 3+% sharebuyback) on that, you get roughly $200 per share.

 Risks:

Major change in business model forced by CFPB, coupled with extremely high fine.

Catalyst

CFPB decision

New financing with share buyback

Return to Growth

A Short Squeeze (over 100% of the float is sold short)