• This post expresses a bullish view on Cash Store Australia Holdings, Inc. (AUC), an emerging payday lender in Australia.
• AUC is a well-managed payday lender expanding in a country where the payday loan market is still in its early stages. Assuming that legislators decide to keep payday lending legalized, AUC should experience rapid growth in both revenue and profitability over the next 5-7 years.

In this post, I’m going to write about Cash Store Australia Holdings Inc., which trades under the ticker AUC on the Toronto Venture Exchange. Cash Store Australia is a startup payday lender in Australia with 44 branches as of December 31, 2009. Regulatory risks notwithstanding, AUC is a fast-growing, well-run business with high returns on invested capital and an ability to generate substantial amounts of free cash flow on a per-store basis. As well, its rapid growth trajectory is occurring in a virtually untapped market for payday lenders. Already, at 44 branches, it’s the leading payday lender in Australia. The sky is the limit, if the regulatory landscape turns out favorable. This regulatory risk shouldn’t be taken lightly. If Australia effectively bans payday lending, as has occurred in some states in the United States, the stock will likely suffer a material loss. But it’s difficult to imagine Australia banning payday lending throughout the entire country, nor are there any signs that the country is trending that way. Even a somewhat tightly regulated payday lending industry should allow AUC to grow at a steady pace, given that the company is currently the best-managed operator in the country, and likely to become the lowest cost operator over time. If Australia adopts a regulatory landscape akin to Canada or the United Kingdom, we think there are few obstacles preventing AUC’s stock price from being 3x to 10x higher 5 years from now.

All figures in this writeup are in Canadian Dollars. Our model and other excel materials are attached here.

Accounts managed by Kerrisdale currently hold AUC, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.

As well, AUC is a tiny company with an extremely illiquid stock. Its market cap is approximately $60m, and the bid-ask range has witnessed extremes of $2.41 – $3.60 over the past month, a whopping range of 50%. For the non-professionals on my list, this means that you could potentially lose 30%+ of your capital if you buy today, change your mind and try to sell tomorrow. As such, the stock is more akin to a private equity investment; once you buy in, you’re in it for the long haul and you may not have the opportunity to sell at a gain if you change your mind in the near future.

Finally, no one should invest in AUC until they’ve decided they’re morally comfortable with investing in a payday lender. We discuss the payday lending business here. Payday lenders make short-term loans at high effective interest rates, often to lower-income and financially disadvantaged borrowers. They are accused of preying on the financially unsophisticated and pushing them into painful spirals of increasing indebtedness. Defenders of payday lending argue that while some people may find payday lending unsavory, the alternative of banning it makes society even worse off in a variety of ways. The moral issues behind payday lending are beyond the scope of this writeup. But to our earlier point, if one invests in AUC and then decides that they don’t want to invest in a payday lender from a moral standpoint, their investment in AUC may very well suffer a material loss due to the stock’s high illiquidity.

Having made our disclaimers, let’s discuss the company, industry and valuation.

We’ve included a discussion of two important subtopics related to AUC on separate posts on our commentary blog. Those posts are:

1. A post on The Cash Store Financial Services, Inc., which is a leading payday lender in Canada. Cash Store Financial trades as CSF on the Toronto Stock Exchange. Accounts managed by Kerrisdale currently hold CSF, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date. As we’ll discuss later in the post, understanding the growth trajectory of CSF in Canada over the past 10 years is key to understanding the growth prospects of AUC in Australia over the next 10 years. As well, CSF is the sponsor behind AUC and CSF management run AUC. CSF and its management also own the majority of AUC shares. We’ll discuss why CSF made AUC a separate company, as opposed to a wholly-owned subsidiary.

2. A post on the payday lending industry and the evolving payday lending regulatory environment in the United States, Canada, and Australia. Government regulation on payday lending is the main risk facing AUC. The topic deserves its own lengthy discussion. Particularly important is understanding how the Canadian and American regulatory regimes evolved differently.

The remainder of this post on AUC will assume you have read the above two posts.

Qualitative Introduction

Cash Store Australia Holdings, Inc. began in 2004, with a single payday lending branch in Australia. It was the brainchild of Jack MacIsaac, a friend of Cash Store Financial founder Gordon Reykdal and an industry veteran with extensive experience in payday lending. MacIsaac made a simple observation: unlike Canada, the United States, and the UK, Australia had a somewhat nonexistent payday lending sector. There were a few small players here and there, but none of the large, savvy, well-managed companies that were operating in North America. His idea was to take the Cash Store Financial business model, which had become a wild success in Canada, and apply it to Australia.

Reykdal liked the idea. But because Australia’s regulatory situation was even less resolved than Canada’s at the time, he didn’t want to expand into Australia via a wholly-owned subsidiary. Class action lawsuits against payday lenders were just beginning in Canada, and the lawsuits and legislative wrangling in Canada ended up lasting until 2009-2010. Reykdal didn’t want to expose his public Canadian company to additional lawsuits from Australia. So he entered into a business arrangement with MacIsaac whereby Cash Store Financial would test the profitability of the stores in Australia in order to determine if its Canadian business model could be successful in Australia. The first store was built in 2004, and a subsequent 18 stores were opened while Cash Store Australia remained private.

By 2008, Reykdal had seen all he needed to. The initial Australian stores were proving even more successful than the initial Canadian stores in 2000 to 2003, and the Australian competitive landscape was materially more attractive than the Canadian one when Cash Store Financial launched operations in 2000. Regulatory issues remained unresolved, but the rest of the story was terrific.

Through a series of transactions, Reykdal took control of Cash Store Australia and quietly took it public in March 2009. AUC went public via a reverse merger with a Canadian shell company Bubbee Ventures. Reverse mergers typically do not receive a lot of press and thus there wasn’t the usual IPO hoopla when AUC went public.

Today, according to my estimates, AUC is owned 19% by CSF; 24% by Gordon Reykdal; 4% by the AUC CEO and CFO; 5% by other CSF employees and the remainder by unaffiliated holders. Insider ownership is high.

The future plans are simple. AUC plans to grow to 300 branches by 2014, from the 44 it had as of 12-31-09. The stores are modeled after the Canadian stores. CSF’s emphasis on cashless lending, highly incentivized branch managers, and customer relationships have carried over to Australia. The store layouts are similar. The managerial infrastructure is similar. The logos are even identical, except that the Australian stores feature a kangaroo instead of a maple leaf. A Canadian Divisional Vice President, Don Steffanson, was appointed to Chief Operating Officer of the Australian operations in March 2009 and is spearheading the expansion. Prior to moving, Steffanson managed a network of 79 branches in Canada. Many of the other senior and regional managers in Australia are also seasoned executives from the Canadian operations.

Financially, Australia’s growth trajectory has mirrored the Canadian operations in its early years, except a bit better. Later in this writeup, we compare our projections for Australia to the historical growth of the Canadian business, and discuss the extent to which Australia’s future growth could mirror the Canadian business’s gradual maturation from 2003 to today.

We also discuss individual store financials, and show how a new branch ramps up on a quarterly basis, with a focus on revenue, EBITDA and capex per branch. Using these single-store financials, we then build a full company model to 2018.

Before elaborating on the model, though, let’s discuss valuation. It’s a bit backwards to discuss valuation before the model. But the model discussion is a bit dry and granular, and my writeups are tedious enough as it is. If you’ve persevered to read thus far, we might as well discuss some of the fun stuff first. By “fun stuff”, we’re discussing how much we expect to make on our stock purchase, assuming that Australia does not effectively ban payday lending.

Valuation

There are a variety of ways to value AUC today. Because the company is a startup, trailing EBITDA or P/E multiples are meaningless, as are multiples of 2010, 2011 or even 2012 EBITDA. Discounted Cash Flow valuation is the most appropriate way to conceptually value AUC, but from a practical standpoint it’s not my preferred method of deriving the appropriate stock price that AUC should trade at today.

Rather, I’d prefer determining what stock price AUC should trade at when it’s semi-mature, and discount that stock price to today. This is a valuation methodology often employed in the private equity world: estimating an “exit” EBITDA and valuation multiple in some future exit year, and discounting that valuation to today.

Later in this post, we’ll discuss our model for AUC, where we’ve taken single-branch projected financials and used that to model the company’s projected profitability over the next 8 years. Based on our model, we project FY 2016 EBITDA of approximately $35m. Below, we’ve shown our modeled 2016 AUC stock price at different EBITDAs and EBITDA multiples.

In the next sensitivity table, I’ve chosen 8x EBITDA as my assumed valuation multiple in 2016. Although I estimate AUC will have 460 branches in Australia by then, free cash flow growth prospects should continue to be promising. If we look at the Canadian operations today, CSF currently operates 470 stores, and trades at 8x EBITDA. We think that even this 8x multiple in Canada is too low; we own CSF shares and expect material cash flow growth in the coming years.

Using that 8x multiple, we can now estimate a discounted current stock price, sensitized by the two variables of (i) 2016 EBITDA and (ii) the discount rate we use to discount the 2016 stock price.

Based on our figures, we get to a range of $3.52 to $12.64, in terms of what AUC should trade at today. Note that our low-point of $3.52 assumes a discount rate of 25% – that effectively means that we can expect the AUC stock price to grow 25% per year until 2016. That’s not exactly a “worst-case” scenario.

My base case estimate for AUC’s intrinsic value today, assuming Australia doesn’t ban payday lending, is about $6.50. That’s approximately double AUC’s stock price as of April 29, 2010. I assume a discount rate of 17.5%, which, again, means that we expect AUC to appreciate 17.5% for the next 6 years until 2016. If AUC makes $25m EBITDA in 2016, today’s price should be around $5. If it makes $45m+, AUC should be worth $8.50+. If we assume a lower discount rate, such as 12.5%, our current stock price range is $6 to $12, assuming an EBITDA range of $25m to $50m.

As we said before, AUC faces a somewhat binary outcome. If payday lending is effectively banned in Australia, all bets are off, to some degree. The company’s core business model would be deemed unprofitable and AUC would likely halt its growth prospects. It’s quite possible that AUC would find a way to eke out some sort of profit, but the growth trajectory would likely be materially less than what we estimate in our model. What could AUC be worth in such a scenario? Well, the company is currently trading at an enterprise value of approximately $50m to $60m. In a banned payday lending scenario, a potential estimated enterprise value could be $30m. Given the company has no net debt, that implies a stock price downside of about 50%.

What are the chances of payday lending being effectively banned? See our writeup on payday lending regulations to try to come up with your own probabilities. My take is that there’s a 5% chance of sufficiently prohibitive rate caps being passed in Australia to make payday lending effectively unprofitable. While it’s possible, I view an outright national effective ban on payday lending as quite improbable.

As well, there’s an argument that rate caps could be enacted such that the payday lending industry is still viable, but less profitable than the Canadian payday lending sector. But keep in mind that very-low-but-still-viable rate caps would discourage competition in Australia. Given that AUC will likely be the largest, lowest-cost and most efficient operator in the industry by the time regulations are finalized, AUC may still generate fairly attractive margins under such a tightly regulated scenario. I think a $25m 2016 EBITDA could still be achievable in such an environment. When handicapping the likelihood of this sort of environment emerging, it’s important to see the issue from the legislators’ perspective. If they choose to allow payday lending, it’s not necessarily in their interest to make rates so low that a single low-cost lender will become the dominant player in the space. As a general rule, in capitalism, price caps are rarely as effective as competition. If competition is limited via low rate caps, a dominant AUC will probably find other ways to generate high margins.

So our risk-reward scenario looks like this: there’s a 95% chance that AUC is reasonably worth 20% to 350% higher than its current price, with my base case being that it’s worth 100% higher than the current price. Then there’s a 5% chance that AUC is worth 50% lower than its current price. This risk-reward payoff scenario is fairly attractive to me.

Individual Store Financials

In the attached model, I show single-store financials in the “Store-by-Store” tab. I estimate a single store’s growth profile to look like this:

I generated these projections by making single store assumptions for brokerage revenue per month, non-brokerage revenue per month, operating profit margins, amortization and capex for each quarter along a store’s growth trajectory. The assumptions were based on the Australian stores’ historical performance, the Canadian stores’ store-by-store data (CSF provides good detail on revenue-per-store-per-month and operating profit margins for stores of different annual vintages) and speaking with the CFO. I’m fairly comfortable that my projections are realistic.

The return on capital and payback for a single branch is impressive. The payback period is just under 3 years (ie. the company has made back all its initial capital expenditures and cash operating losses by year 3). By year 8 our sample branch is achieving return on equity of 30%, based on my numbers.

AUC’s branches achieve high returns on capital for a variety of reasons. Branches are not especially large and leasehold improvements not especially onerous; CSF and AUC don’t install bulletproof glass in the way some other payday lenders do because they give customers prepaid debit cards, not cash (technically speaking, AUC branches are in the midst of shifting from cash to prepaid debit cards this year). As well, generally speaking, payday lending is a fairly profitable business prior to industry maturation, as has been shown by the growth of CSF and other public payday lenders in the United States or Canada over the past 20 years. Australia is an untapped market, and AUC doesn’t have to worry yet about viable competitors driving down lending rates and profit margins.

Our Model

On our Store-by-Store tab in the model, I’ve taken our single-branch financials and added them up based on the company’s stated branch growth plans. Then on the “Company Projections” tab, I’ve used our store-by-store analysis to project company financials, on both a quarterly and annual basis. A summary of the projections is on the Summary tab. My summary projections look like this:

In the dotted lined box, I’ve taken my 2016 stock price assumption, and assumed that in each year leading up to that, we’d see a stock price increase of 18% to 20% (see the line labeled “Gain from Prior Year”). Under that assumption, we see that AUC’s stock price should be worth around $6 today.

Branch EBITDA is built up via our store-by-store analysis. Regional expenses, corporate expenses and capex are based on general discussions with management, as well as comparisons with the Canadian operations. The “Other” line item is mainly comprised of changes in working capital and cash taxes.

Comparison of Canadian / Australian growth trajectory

It’s instructive to compare our financial projections for AUC with Cash Store Financial’s historical growth in Canada. Here is the comparison:

Our projections for Australia are somewhat comparable to the historical growth in Canada. There are a few differences to keep in mind. First, we project the company reaching 390 stores in Australia by 2015, which corresponds to the 384 stores that the Canadian operations had by 2008. However, the Canadian company made an acquisition of 99 stores in 2005 for $35m. So our organic growth projections are more aggressive than the historical organic growth in Canada. Specifically, the Canadian store base grew at a CAGR of 34% from 2003 to 2009, whereas we’re assuming a store growth CAGR of 40% from 2010 to 2016.

Our store growth in 2015 and 2016 is particularly aggressive. We have the store base expanding from 318 to 462 in two years. That’s 72 new stores a year. In Canada, the company opened 70 new stores in 2005 and 61 in 2006, so opening 72 new stores would not be unprecedented.

Additionally, we show lower margins in 2016 for Australia as compared to Canada. There’s no reason to believe that the Australian operations should suffer lower margins than the Canadian business. Currently, the less crowded competitive environment and lower industry penetration would imply that the Australian business would achieve margins higher than the Canadian one. From the forty-four stores in Australia thus far, we’ve seen signs that the Australian branches may experience higher revenue per branch and profit margins than those experienced in Canada. But much depends on the regulatory environment and the rate caps that are ultimately legislated in Australia. So we’ll stick with our 20% EBITDA margin in 2016 for AUC, compared with the 23% EBITDA margin in 2009 for CSF.

In conclusion, our projections for Australia seem reasonable in light of the Canadian historical trends. It’s fair to expect 2016 EBITDA to fall somewhere between $25m and $45m for AUC. If the company hits those numbers, AUC stock should prove to be a solid long-term investment.

As usual, this email does not constitute investment advice or a recommendation of any sorts. Kerrisdale Capital may buy, sell or short any of the stocks mentioned at any time. I may be wrong; it would not be the first or last time.

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