Wednesday, September 29, 2010

Everything Looks Great...Except The Law

Two parties can want to make a deal, but a third party (namely, the government) can prevent that deal from taking place. Such is the case for Advance America (AEA) provider of very short-term loans in Canada and the United States. At the current price, the company looks like a steal.

The company's P/E is under 5, and while the company trades for $230 million, it has earned over $200 million in the last four years! The company has been able to generate returns on equity in the mid-to-high 20 percents, showing that it's got an economic moat.

But that moat is under pressure from the government, at more than one level. For many years, it was the states that have gone after this industry. State legislation has forced Advanced America out of several states, most recently Arizona. Now, however, the federal government is stepping in, further clouding the regulatory environment.

Short-term and even same day loans are often made to those with poor credit. Furthermore, the loans are much smaller than regular loans, both in amount and in length (often extending only to the borrower's next pay day). As a result, companies that advance loans do so at relatively high lending rates. Governments are trying to prevent what they see as predatory lending practices that seek to exploit a group that is already poor. Industry groups argue that these borrowers don't have other options, and so the existence of this industry is better than the alternative (illegal loan sharks).

Wherever the investor's political leanings lie, the difficulties facing this company and industry are undeniable. Governments will be looking to directly reduce the profits of companies like Advance America through caps on lending rates, fees and borrower frequencies, which will likely cause reduced profitability for this company. Furthermore, the mounting legal costs to constantly fend off government lawsuits is likely to continue to increase. The company's description of its legal proceedings in its annual report is five pages long, and still doesn't cover every lawsuit in which the company is involved.

Advance America may still be undervalued even after accounting for the regulatory environment. However, that conclusion is far from certain. Rather than attempting to predict the effect of past, current and future legislative proceedings, value investors may be better off not swinging at this particular pitch.

Disclosure: None


jeff said...

This is the exact reason that I have never pulled the trigger on AEA, CSG, or EZPW. Way too much of the pawn broker's revenues come from check cashing!

If I ever found a traded pawn shop, that only pawned, I would love to be a shareholder of the company!

Simon's Thoughts In London Fall '07 said...

With regard to EZPW, I actually was a shareholder for quiet some some time and made a sizable profit (luck of the draw i guess) however, the uncertainty of government action is a catalyst to value--in my opinion. I take the recent government trends as an example: "financial reform" which caused such a stir and left many financials reduced so much so that one couldn't help but take a second look at the opportunity. The same for many pharmaceuticals and healthcare sector stocks. Credit card reform etc.

Saj, thanks for the post. I am skeptical to think the government will institute major changes to this sector. Therefore it just might be a potential play. I'll look over the financials and send u my take.

Anonymous said...

I feel like this is another case where government is over-reacting to the recent recession and taking it out on someone else for their failure to regulate the large banks. Either that or large bank are lobbying to close down these smaller profitable loan office for whatever reasons. Either way, I would not want to invest in any company that does not actually sell a tangible products.

Taylor said...

Saj, you mentioned that the company earned over $200m in past 4 yrs; however, the company's FCF numbers really jump of the page. Over the past two years, the company has brought in over $350m in free cash flow alone.

Epic Ahab said...

Thanks for looking at this! Assuming that governments are unable to totally close the business, this could be a classic value situation where the lawsuit is casting too large a black cloud over the share price.

Saj Karsan said...

Good question, Taylor. I wrote about this issue here: