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The following segment was excerpted from this fund letter.
During the second quarter, I sold a substantial portion of our shares in goeasy, and in July exited our position entirely, altogether at a significant loss from our weighted average purchase price.
Just seven months ago, I wrote about how goeasy is a business that I’d hoped to own for many years to come, while regularly challenging my thesis in the months and years ahead. In the six months since, goeasy has engaged in a rapid series of strategic developments, faster than I had imagined, which together have increased my perception of long-term risk, beyond comfort. A number of these developments include:
- Expanding rapidly into non-prime indirect auto financing, already over $100MM or 5% of the company’s total loan book, with an intention to continue growing this book to $250-300MM+, despite a lack of experience in this segment and lending at a time of elevated car prices.
- Almost completing a ~$200MM acquisition of a U.S.-based non-prime consumer lender in Q1, but ultimately calling off the deal because goeasy intended to issue equity, its share price had fallen, and the deal no longer became accretive. In July 2022, goeasy appointed Jonathan Tétrault to its Board of Directors, in part in order to “help guide our future investments, acquisitions and international expansion plans,” suggesting continued appetite for M&A.
- Entering in June 2022 into a strategic commercial partnership with Canada Drives, a Canadian online-based used car dealership whose business model is similar to Carvana (CVNA) and Vroom (VRM). Key details of this partnership included a guaranteed minimum volume of non-prime loan originations from Canada Drives and a $40MM convertible debenture investment from goeasy in Canada Drives. Canada Drives generates negative EBIT and 100% of loans are digitally underwritten.
- Announcing pilot tests, with rollout beginning as early as this year, of a new goeasy smartphone app that allows existing customers to be cross-sold new loans, and could potentially allow brand new customers to receive loans, using 100% digital underwriting with no branch-based contact.
From 2011 to 2021, goeasy’s easyfinancial was a branch-based lender whose loan book was 97-100% comprised of unsecured and secured loans that required in-branch servicing for all customers living within 40 kilometers of their nearest branch. This business model had worked terrifically, as goeasy compounded its earnings per share at a rate of +25% from 2011 through 2019.
But, fast forwarding to today, through various product introductions, acquisitions, and partnerships, goeasy has shifted from offering 2 products through 1 main customer channel to offering 6 products through 6 separate customer channels, with more products and channels intended. While I expected management to continue innovating new products and creating new avenues for growth, I expected these shifts to occur over a much longer time frame than has transpired. Instead, change has occurred at what I’d argue is an aggressive pace, and has been worrisome.
One main area of concern here has been the increasingly digital nature of goeasy’s underwriting, a clear pivot from their successful roots. Historically, goeasy’s customers who have been required to visit a branch to complete the loan approval process have incurred significantly lower charge-off rates than customers who haven’t been required to, suggesting the company’s face-to-face approach it has mandated for years has worked well, and has served as a competitive advantage over digitally-based lending peers.
But recently, goeasy’s new initiatives for continued growth have shown an increasing willingness to embrace fully-digital lending without a face-to-face element, including to new customers whose charge-off rates have historically been meaningfully higher than for repeat customers. This represents a shift away from goeasy’s successful model of the past and towards a new era that has yet to be proven.
The other main area of concern has been what I believe to be poorly-designed management incentives, which I fear may be driving goeasy’s willingness to enter new, adjacent lending markets through fast-paced underwriting and M&A. When goeasy’s current CEO was appointed in 2019, executive compensation was restructured such that management stood to maximize future bonuses if each year they compounded the company’s EPS at a +30% CAGR over the preceding 3-year period.
At face value, this compensation structure appears more thoughtful and shareholder friendly than most. But, where this structure can fail is when handed to an executive team that adds undue risk in the pursuit of overambitious growth targets.
Looking at recent events, goeasy continues to enter adjacent markets beyond areas of core competency, is still integrating a large acquisition from last year, was very close to completing another acquisition this year in a new country, and is piloting new, lower quality digital origination channels, all while heading into a possible recession. I don’t think management believes they are adding any undue risk. In fact, I think management is convinced that all of this is prudent strategy, and it may be.
But, I can’t help but think that justification to enter a new lending vertical, or to acquire a new company, becomes subtly easier when that action would also go a long way towards unlocking substantial compensation if things go as planned.
Esteemed investment manager Allan Mecham once remarked to his partners, which I find apt to this situation, that, “Our concern is not that the aggressive forecasts won’t be met, but rather that they will, at any cost! Earnings growth should be a consequence of sound strategy, not the object of it.” I still believe in a successful version of this management’s vision, one that is executed with prudence, and I admire the talent and rigor of the CEO.
However, as of now, the likelihood in my view that this next iteration of goeasy experiences a major hiccup due to credit quality issues has grown uncomfortably large beyond my expectations, and therefore we have sold our shares.
This investment has taught me valuable lessons. For one, beware the power of management incentives and pay close attention to how management incentives can create conflicts of interest between shareholders and executives, even for relatively thoughtful and shareholder-oriented compensation structures such as this one. Compounding EPS at +30% annually would be extremely friendly to shareholders, but only if done while taking appropriate risks.
Additionally, monitor valuation multiples relative to their historical ranges and embed this within one’s margin of safety framework. In hindsight, I should have considered trimming our position when shares were priced near $218 in September 2021 as they carried a 15-year high trailing P/E multiple of 21x based on trailing normalized earnings, with a lower bound of 7x over that time frame. Despite my forecast of +20% annual future free cash flow growth which implied a price still at a significant discount to intrinsic value, the company’s rich valuation multiples left little implied margin for error.
Looking ahead, my extensive studies of goeasy have educated me on the resilience and strength of nonprime consumers, which have helped me to identify what I believe to be misunderstood opportunities in similar industries, some of which I am exploring today.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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