Oct 10, 2013

$QCCO – Deep Uncertainty – A Value Trap

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The Sword of Damocles

The Sword of Damocles

Overview 

At first glance QC Holdings Inc. (Ticker: QCCO) gives every indication of being cheap, its underfollowed, small, and subject to grave uncertainty. And yet to the best of my understanding it still seems to have a generous valuation.

QC Holdings Inc. management divides their business into three segments – below I break them down by revenue for FY 2012:

  • Financial Services = ~82%,
    • (Payday loans ~66%  & other financial products ~16%)
  • Automotive = ~13%
  • E-Lending = ~4.4%

QC derives roughly two-thirds of its revenue from the financial services segment. And 66% of total revenue from the payday loans business. This is a problem for the firm because the payday loan business looks to be in danger of going extinct.

Payday Regulation

For those who don’t know, a payday loan is a loan secured by the personal check of an individual. These are dubbed payday because the loan is usually structured to mature on the date of the individual’s next paycheck. Because these loans have a high rate of delinquency, and associated costs, the interest rates charged are substantial, if not astronomical.

Unfortunately for QC, the business is under attack on multiple regulatory fronts. The first of which is from potential ballot initiative in the state of Missouri. This initiative would effectively outlaw payday lending throughout the state. As one-fourth of the companies’ payday stores are located in that state, and their activities generated 33% of gross profit in 2012 – that would be a big problem. Not only because of the loss of revenues and profit but also from the costs of closing approximately 100 locations.

At present the initiative is still in the process of gathering the necessary signatures to be placed on the ballot in 2014. A similar initiative was submitted in 2012 but failed to accumulate enough signatures to be put to a vote. What’s required is signatures totaling 8% or more of the number cast for governor in 2012, in six of Missouri’s eight congressional districts. That comes out to about 162,000 signatures, depending on which districts you pick. I haven’t found any way of monitoring initiatives accumulated signatures so it’s hard to say how likely it is that this initiative will pass but the possibility is real.

The other threat to payday lending is new legislation at the federal level. The Dodd Frank act created the Consumer Financial Protection Bureau (CFPB) to protect customers from unfair lending practices. The act gives the CFPB broad powers to regulate finance companies. Unfortunately for QC, payday loans appear to be low-hanging fruit for the young agency looking to justify its existence. So far the agency has only produced a white paper on the subject but it has made clear its intention to take some action soon. No one knows what that action will be but from my reading of the white paper, a best guess is that they will limit the number of repeat uses by individuals and/or mandate a cooling off period between loans. This is better than an outright cap on interest rate levels, which would effectively stop the business in its tracks. But it can still have a significant impact on profitability and the specifics of it will matter.
Taken together, I think it’s fair to assume that regulation of some form will adversely affect QC’s core business in the near future. Whether this is a 50% decline in profitability or an 80% decline is very difficult to say but the danger is there.

Other Businesses

In 2011 QC purchased Canadian based E-Lending underwriter for $12.4 million. Though the company’s management seems optimistic about the acquisitions prospects, and the Internet lending business has been exploding, the segment has yet to generate a profit. Further evidence that the business is not performing up to expectations was the failure to achieve the performance target of an earn out payment in 2012.

In 2009 the company entered the used care sales and financing market by purchasing several pay here, buy here locations. In essence, these locations help less creditworthy borrowers afford used cars. This would seem like a logical place to leverage the companies underwriting expertise. However, this segment also failed to produce an EBT profit in both 2011 and 2012.

Though QC’s efforts to diversify its product offerings make sense strategically, they have yet to prove worthwhile for shareholders. Lacking any special insight to either business’ prospects, I can only assume they will continue as they have thus far.

Valuation

At $2.35 per share and ~ $41 million in market-cap QC is trading at 50% of book value and 75% of tangible book value.  At first blush this seemed attractive, but when you consider the costs of closing businesses and paying off the non-cancelable leases, (I estimate ~$ 20 million) the margin of safety quickly dissipates.

On the earnings front, the company is trading at ~7x last years earnings. This is cheap but not cheap enough for a company that could see its profitability greatly diminished over the next twenty-four months.

Conclusion

When I started looking QC I expected that the company would be cheap. When I started writing this article I thought it would be too. It took days to get over my biases and realize that it actually isn’t. For me it just goes to show that even in the darkest corners of the market, things can be expensive.

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