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The Trouble With Payday Lenders

While regulatory scrutiny and consumer protection measures are par for the course for any financial institution, payday lenders are particularly vulnerable because of the nature of the business. Legislative and regulatory hostility is not a nuisance or an extra legal expense; the CFPB settlement demonstrates that it is an existential threat, and one that the market doesn't appear to have fully priced in.

Regulatory risk exposures aren't payday lenders' only problem. Innovative competition from lean online microlenders and peer-to-peer lending platforms are emerging, threatening to cut into the more established players' bottom lines in the long term.

But for some payday lenders, there is a silver lining. While the consumer lending segment of the industry is suffering, the pawn lending side of the business continues to thrive. Pawn shops issue collateralized loans, and so face lower losses and collections expenses.

In addition, this portion of the business is not as tightly regulated or legislated against, and is generally not seen as predatory by consumers because the high effective rates are somewhat obscured by the fee structure.

Strategy Overview

The difference in the prospects of these two sides of the business is apparent in the performance of Cash America's stock versus that of First Cash.

Traditionally, the investment community considers both companies to be a part of the same industry. But upon examination, it's apparent that their recent strategies are very different.

While Cash America made a bet on expanding its e-commerce division, its fastest-growing segment, First Cash concentrated on the core pawn operation responsible for 93% of its revenue steam.

In other words Cash America is walking right into head-to-head competition against the emerging industry of mobile micro lending startups and peer-to-peer lending platforms, facing potential margin contraction and international regulatory scrutiny with no end in sight.

First Cash, on the other hand, is steadily expanding and solidifying its pawn lending operations in the U.S. and Latin American markets, its core business.

Important Factors

While the commentary of some analysts has stoked fears that falling gold prices will hurt pawn operators, we feel those fears are unfounded for several reasons:

1. Many pawn operators don't have a large portion of their merchandise tied up in precious metals. FCFS' Mexican shops, for example, hold 88% of their pawn merchandise value in electronics and other merchandise.

2. Most pawn merchandise isn't held for more than two months and about 75% is redeemed, which limits gold price risk exposure. In addition, a 5 to 20% service charge provides extra padding against gold price volatility.

3. The portion of the value that jewelry derives from the precious metal of which it's composed is relatively small, so the delta on the price of jewelry relative to gold is much less than 1 to begin with.

Conclusions

Our research shows that regulatory headwinds and emerging competition are the biggest problems for the payday lending business, while pawn shop operations provide predictable and steady growth. We recommend choosing investing positions accordingly.

At the time of publication the authors had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Stock quotes in this article: CSH, WRLD, FCFS 

- Written by Igor Zhitnitsky and Victor German

To contact the authors of this article, click here.

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