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Trends have been solidly in FirstCash’s (NASDAQ:FCFS) favor in a year or so since I last wrote about this leading pawn lender and lease-to-own financier. Not only has inflation put some pressure on household budgets, but alternate consumer finance companies have in many cases pulled back on their own activities due to rising losses and higher capital costs – once again highlighting FirstCash’s access to attractively priced capital as a key long-term factor.
I expect business fundamentals to slow some in 2024, if for no other reason than tougher comps. Even so, I see few emerging alternatives to FirstCash’s core business niche – small-value loans that can be underwritten on the spot and rolled over as needed – and I believe that regulatory changes targeting banks (including higher capital requirements and lower fees) could further reduce credit availability and lead more customers toward FirstCash’s offerings.
The “but” is the valuation. These shares have risen more than 40% since my last update and while I do still expect mid-to-high single-digit revenue growth and double-digit adjusted free cash flow, it’s harder to make the valuation work and the expected return now looks sub-double digits to me.
It’s Still Tough Out There
Whether or not the U.S. economy sees a soft landing or something worse later this year and into 2025 is still a key debate. So far the economy is holding up – unemployment is low, and consumer confidence is still relatively good, though there have been signs of increasing anxiety, with The Conference Board’s Expectations Index of 73.8 in the range that often signals an upcoming recession.
As far as credit providers are concerned, there is a widespread expectation on the Street that companies like Bread (BFH), Capital One (COF), Discover (DFS) will see delinquency formation peak relatively soon (first half of 2024), with charge-offs peaking in the second half of the year. In the meantime, though, that means higher reported loss metrics, and indeed Capital One and Discover have been seeing higher charge-off rates in recent months (up 25bp and 50bp month-over-month in February).
Looking at the larger consumer finance sector, higher losses are commonplace across the sector and many companies are seeing more limited access to capital as rates have shot up and lender risk tolerance for unsecured lending has fallen. That, then, has meant less capital available to consumers for short-term secured and unsecured borrowing, particularly those consumers with poor credit ratings.
All of that is, on balance, a positive for FirstCash. The pawn business, which generates around 75% to 80% of adjusted segment-level profits, caters to clients who need relatively small loan amounts (the average in the U.S. was $258 in the last quarter) and prefer to get them quickly and in cash. With that, the company has seen double-digit growth in pawn loans outstanding in the last two quarters (accelerating in the fourth quarter) and double-digit growth in pawn fees.
While management has guided to slower reported growth in the second half of this year against those tough comps, I think core demand for FirstCash’s pawn loans should remain healthy in 2024. Wages aren’t going up fast enough, prices aren’t going down fast enough, and I see real risks that rival financing options are going to continue to face financial and regulatory pressures that will lead them to rein in some of their lending activity, creating more demand for FirstCash.
To underline this point, FirstCash just priced $500M of senior notes at a 6.875% rate, and I believe many of its rivals are seeing significantly higher costs of capital.
Lease-To-Own Merits Some Caution
FirstCash’s American First Finance lease-to-own business posted solid results through 2023, with segment-level profits improving from 14.2% at the end of 2022 to 17.4% at the end of 2023, with progress throughout the year. Delinquency rates have been tracking higher, from 21% to 21.7% in merchandise and 20.7% to 21.8% in finance receivables, but charge-off rates have been fairly steady and it’s worth remembering that FirstCash takes a fairly conservative provisioning approach (27% of origination amount overall).
If the economy does see a harder landing, those loss metrics are going to head higher and the opportunity to reclaim the property and resell it through the pawn shops is only going to partly offset that. Again, though, those high initial provisioning charges and FirstCash’s investments into IT to further refine credit scoring and loss projections should create a cushion, and on balance, I think FirstCash has more to gain from consumers being pushed in their direction by weaker credit availability than to lose on charge-offs.
I do have some concerns about the pace of growth. FirstCash has been doing a good job of building the door count, adding more retailers and service providers to their customer base. At the same time, the 10% decline in same-door fourth quarter transaction (following a 5% decline in Q3’23) is a concerning number. I believe this has less to do with FirstCash aligning with less-competitive/less-appealing retailers and just a downturn in the overall market, but this certainly bears watching as adding more doors to compensate for weak same-door sales is less than ideal from a sustainability perspective.
An Early Look At Q1’24
I expect results in the pawn business in the first quarter to be more or less a continuation of fourth quarter trends. I expect healthy demand for pawn loans in the U.S. (good growth in receivables and pawn fees) given the aforementioned tighter credit conditions. I don’t expect great results from the retail side given overall trends in retail and the ongoing tight inventory situation with FirstCash’s stores.
I also expect higher opex to take a bite out of profitability. Good growth in higher-margin pawn lending should offset that in the U.S. stores, but while I expect decent local currency results for the LatAm store base, I expect a bigger bite from wages and other operating costs. It’s also worth mentioning that while the reported constant currency results are not likely to look that great, FirstCash generally leaves the cash generated by the LatAm businesses in-country to support further growth.
The first quarter likely won’t be a fantastic one for the lease-to-own business, as revenue growth is likely to be below-trend for the year and provisioning is likely to be higher, pressuring reported profits. I’d also expect to see a continuation of higher delinquency rates and higher charge-offs.
As far as the Street goes, estimates came down about 5% after management’s guidance with Q4’23 results but have been largely stable since then.
The Outlook
As the company continues to execute, I’m gaining more confidence that the American First Finance business will be a solid one for the company over time, though this upcoming year isn’t likely to be the strongest operating environment for that business.
Meanwhile, it’s business as usual in the pawn operations, and that’s fine with me as these are well-run operations with ongoing growth potential – in the U.S. that growth potential is from FirstCash being a “preferred buyer” for pawn store operators looking to retire and cash out, while the LatAm growth potential is based more in under-developed consumer finance options in the formal economy and a large fragmented sub-scale population of competitors.
My long-term growth expectations haven’t changed much; I’m still looking for long-term revenue growth in the neighborhood of 7%, with most of that growth coming from the LatAm operations (store expansion and same-store growth) and the AFF business. The U.S. pawn business could get a boost from reductions in consumer lending, but that’s not likely to be a long-term driver.
On the bottom line, I’m still looking for gradual improvement in adjusted free cash flow margins toward the low double-digits. Although the AFF business does carry lower margins, it should be a solid cash generator over time and I continue to expect good cash yield from the U.S. pawn operations as well as improving yields in LatAm as stores mature.
The Bottom Line
Discounting that all back, I think today’s price is reasonable, but I’m only getting a high single-digit annualized total expected return from here, and that’s not as high as I’d like from this type of business. I don’t think FirstCash is a clear-cut bargain today, even if I do see opportunities to outperform expectations (given better access to capital and other potential lenders potentially pulling back), but I’m reluctant to pull the plug on a story that isn’t clearly overvalued to me and continues to execute well, as well-run companies have a way of outperforming and “growing into” valuations that may otherwise seem a little high.
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