When times are tight and cash is hard to come by, companies who specialize in short-term loans to sub-prime borrowers can generate a lot of business.  Such is the case with First Cash Financial Services, Inc. (FCFS).  The company operates 278 pawn stores and 182 payday advance stores throughout North America.  And while the industry may be somewhat unsightly and off the radar for many investors, the business model can be very profitable and lead to strong investment gains.  The ZachStocks Growth Model currently holds a position in the stock which has performed quite nicely over the past month.

The payday loan business is a traditionally highly regulated industry which is likely to face more scrutiny with the current administration in power.  This is probably a good thing socially as fair lending standards should be available no matter what size the loan is or who is applying for capital.  But the idea of more regulation has led to some losses for investors in recent months.

But the tide appears to be turning as First Cash (along with rival Cash America – CSH) have seen stock prices advance sharply over the past month.  Part of the increase is due to the overall market rebound, but there is some industry specific strength that adds validity to the current run.

Late last week, Cash America stunned the street by adjusting guidance for their first quarter profits.  The company now expects to make 76 to 78 cents for the quarter compared to its prior guidance of 61 to 65 cents.  For the full year the company expects to make $3.10 to $3.30 per share.  The news caused quite a stir with the stock vaulting 20%.

The strength was largely a function of growth in the pawn shop business as customers raise cash through pledging whatever assets they can round up.  While this business should remain healthy, the payday loan side of the business will likely have difficulty comparing with last years results.  This is due to the sharp rise in 2008 business which centered around the Bush stimulus checks.  Many customers took an advance from FCFS and then repaid the loan when the checks arrived.  Still, regardless of the second quarter comparables, the business model appears solid and should remain healthy.  After all, people will always be in need of short-term financing.

While businesses in this sector enjoy healthy margins, the loans are not without risk.  As the economy continues to struggle in its recovery and unemployment remains high, the risk of loan losses remain a serious concern.  With debt now at roughly 50% of book value, FCFS will have to be very careful with its own capital in order to stay out of hot water.  But management has a strong track record of operating wisely and the company is now sitting on 7 straight quarters of earnings growth ahead of its first quarter report.  I expect that when the company announces earnings next week it will show continued strength similar to Cash America.

Even after rallying 35% from its low in March, the stock still looks very attractive from a valuation standpoint.  Earnings are expected at $1.37 for the current year which means that the stock is trading with a multiple of roughly 12.5.  With a strong cash-flow positive business like FCFS runs, I wouldn’t be surprised to see this number move closer to 18 or 20 which would represent a healthy return over the next several months.  Volatility will likely remain, but I believe this stock will hold up better than most for the majority of the summer.

FD: Author has a long position in the ZachStocks Growth Model
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