Start to Batten Down the Hatches

 | Aug 19, 2012 | 8:40 PM EDT  | Comments
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csfs

For today, I will leave the debate to other contributors as to whether the U.S. is falling back into recession. If it is, however, it is time to pepper your portfolio with companies selling inferior goods. "Inferior goods" is not a judgment on my part; this is a term from economics referring to products that people trade down to when money is tight. When the economy slows, names like Wal-Mart (WMT) and McDonald's (MCD) shine. Another sector that thrives is payday loan/pawnshops.

There are a number of "alternative financials" plays, but one that I stumbled upon recently that looks very intriguing is Cash Store Financial Services (CSFS). CSFS is the market leader in Canada's payday loan market, with 36% market share and 586 stores. The company has struggled over the last few years with falling return on equity and reduced store productivity, but a new management team is poised to turn around results. Average store operating income fell from $133,000 in 2009 to $97,000 in 2011 as average yield on loans fell to 20% from 25%. ROE peaked in 2009 at 30%, but fell to 12% in 2011. This led to five straight earnings misses throughout 2011 and into 2012.

New management was installed recently, and this team has a great opportunity to restore the business to healthy growth and profitability. There are several avenues toward accomplishing this -- and the most important is improving loan mix, with a greater focus on payday loan relative to signature loans, which sport higher yields. Store productivity can be improved, as CSFS meaningfully trails Dollar Financial (DLLR) on this metric. Dollar has nearly double the revenue per store as CSFS does!

CSFS could also expand geographically in Canada beyond the current 586 units, add online lending and accelerate the introduction of new products. In particular, other products such as check-cashing, money transfer and so on generate 42% of revenue at Dollar Financial, vs. only 28% at CSFS. Should the company increase revenue per store even modestly, it could enable store operating margin to double to 30% from the current 15%.

The company recently reported earnings, and it shows the trends are just starting to turn positive. There were tangible improvements in branch productivity, as per-branch loan volume and revenue were up sequentially, breaking a three quarter deceleration streak. Total loan fees increased, despite 40 fewer branches, and the loan-loss provision declined as a percentage of loans internally funded or brokered. Operating income increased both year over year and sequentially. CSFS also made significant progress in closing 25 underperforming branches, which should result in $25 million of annual savings.

CSFS represents a good combination of cyclical benefit from a slowing economy, as well as secular improvements in operations that can pay off even if the economy does not falter. The stock is a nice fit for both the defensive allocation in your portfolio, and it has attractive upside potential.

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