Its Never a Problem… Until it IS a Problem

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The State of Denial at World Acceptance Corp….Citron Keeps Target at 0.

To say we are entering into a new phase of consumer protection regulation is an understatement.  Just last week the US Senate, in a rare bi-partisan landslide (90 to 5), passed a credit card reform bill  — by a margin so wide that one can say the country now has a mandate to protect borrowers from lending abuses.  President Obama has even gone so far as to call for a new financial watchdog agency just to protect consumers.

In early 2009, Citron warned about future regulation in the for-profit education space, in a series of reports on Apollo Group.  Subsequently, the stock has been down over 35% and just yesterday the government announced some proposed regulatory changes regarding marketing and recruiting expenses.  As investors, we must not focus on what is status quo but rather what will be status quo.

It is the opinion of Citron that the World Acceptance Corp. will now unavoidably become a target of new regulation that will limit operations of their core installment loan business.

It can be painted with any brush but Citron believes that the facts support the conclusion that World Acceptance is the “sub-prime” wedge of the short term or payday loan business.

WRLD operates in just 11 states.  While details vary from state to state, it is indisputable that WRLD’s net yield on its loans outstanding is in excess of 85%, a rate that traps the majority of its customers in an inescapable cycle of debt.  Meanwhile, the company remains unwilling, and its analysts unable, to state the percentage of its customers who actually sign up for a loan, then pay it off as scheduled, without flipping.

According to WRLD’s 2008 10-K:

“Consumer finance companies are affected by changes in state and federal statutes and regulations. The Company actively participates in trade associations and in lobbying efforts in the states in which it operates. Although the Company is not aware of any pending or proposed legislation that would have a material adverse effect on the Company’s business, there can be no assurance that future regulatory changes will not adversely affect the Company’s lending practices, operations, profitability or prospects.”

While we await their current 10-K, we can only assume that this disclosure has to change.  As previously quoted by their own trade association (after all, WRLD’s CEO is one of its three board members), three bills on a national level “could well force the installment loan industry out of business altogether.”  http://www.nilaonline.org/

  1. S. 500, introduced in the U.S. Senate by Senator Richard Durbin (D-IL), the Senate Majority Whip;
  2. H.R. 1608, introduced in the U.S. House by Representative Jackie Speier (D-12-CA); and
  3. H.R. 1640, also introduced in the U.S. House by Representative Maurice Hinchey (D-22-NY).

It is true that, to date, none of these have passed (otherwise, the stock could already be a 0), but these risks do exist.  Many of these bills have widespread support and no one knows what will eventually get passed, let alone what action the new Federal agency will take.

http://www.consumersunion.org/pub/core_financial_services/009581.html

http://www.opencongress.org/bill/111-h1608/show

This is not Payday Lending … Yet

This is where the story gets interesting.  Citron has pointed out that while payday lending has been regulated in many states, installment lending has flown under the radar.  This has forced many payday lenders to alter their terms, in fact slipping into the installment lending business.

http://www.cleveland.com/consumeraffairs/index.ssf/2009/02/payday_loans_are_back_in_a_new.html

http://www.localdailynews.org/opinion/story.php?story_id=116683537337844600

http://www.wbez.org/Content.aspx?audioID=34360

The question now begs to be asked:  How much longer will it take to close the loophole?  We are talking about a business practice that is only legal in a handful of states.  For anyone to state there is no legislative risk, they obviously do not have CNN or read a newspaper.  Just two weeks ago, four bills in WRLD’s largest state were stranded in the committee that restricts short term lenders, while other states are passing legislation weekly. http://www.mywesttexas.com/articles/2009/05/08/news/top_stories/senate_payday_lending_bills.txt

While inaction in Texas news might be perceived as a short-term positive, it shows how this entire business model hangs loosely by a string.  Citron cannot predict what state or federal bill will be the silver bullet … unlike any other stock we have ever covered, just one legal change will expose WRLD’s entire model.  Remember, It is never a problem … until it’s a problem.

Beyond usury laws, any state that simply limits consumers to one such loan at a time damages WRLD’s business as they will no longer be able to ping pong their customers, which is the obvious intention in this picture (Note: this is not a one-off — many WRLD sites seem to be located next door to another installment loan company)
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Sterne Agee Report

On May 26, 2009, Sterne Agee released an analyst recommendation on World Finance which gave a $23.50 price target on the stock.  In the report, the analyst makes a few assumptions:

  1. Increased Credit Quality in upcoming quarters
  2. Little or no earnings growth from the company
  3. “Regulatory issues are not viewed as an issue at this time”

So as investors, we are to believe that with improving credit quality and no regulatory issues the stock could trade at $23.50 a share.  Even their cheerleading analyst admits that the company has no real earnings growth (as the company was hoping to gain from opening operations in Mexico).  This call from Sterne Agee seemed to be based solely on the argument that the company trades below tangible book value.

Book Review Anyone?

But when a company trades below book value, it isn’t a guaranteed buy.  Smart investors will first ask themselves “Why does this company trade at a discount to book ?”

There is a salient reason why stocks trade below book:  the market is pricing in the risk of asset impairment.  If one wrench is thrown into WRLD’s gears, its stock could go to zero.

WRLD tangible book value is supposedly $275 million, but its main asset is $460 million in net loans receivable.  In order for the common shareholder to get anything at all from WRLD’s “book” value, over 40% of those loans would need to be repaid in full.  It is the opinion of Citron that in runoff or with any regulation that forces changes to WRLD’s loan offerings, it would be impossible for this company to collect even 20 cents on the dollar.  As its own financials clearly show, the only reason a huge portion of these folks enter the store and make payments is the hope that they can get another loan.

If payday is sub-prime that is collateralized by a paycheck, then this is the sub-prime of sub-prime … with no collateral.  Not a good loan book to own in the face of regulation.

Just a few months ago, Henry Coffey, the Sterne Agee analyst whose work on WRLD is referenced above, wrote that the incoming administration’s intent to regulate payday lenders “is clearly unambiguous.”  At the time, WRLD was trading around $16, and he had a “neutral” recommendation on it.  Citron asks: “What has fundamentally changed?”
http://www.cashadvancepaydayloansusa.com/news/sector_snap_payday_lenders_fall_on_obama_proposal.html

Conclusion

Citron strives to present stories detailing business risks, which are, to date, being ignored or denied by the subject company and its analysts, always backing up its opinion with factual links.  It believes caricaturizing critical opinion as “fear mongering” is foolish, and savvy investors ignore risks at their own peril.

Investing is a two-way street, and the strength underlying our markets is that investors are free to choose potential risks and potential rewards as they assess them.  Ultimately, it’s an exercise in separating appearance from reality.  Reality has a way of taking care of itself.

Citron stands by its opinion that in the case of WRLD, undisclosed risks to its business model may be catastrophic, and are not priced into the stock as currently evaluated by its cheerleader analysts.

Cautious investing to all.