Bad Loans Rising

After skyrocketing gains, Rentcash investors reel from a surprise disclosure.

Over the phone at Rentcash Inc.'s headquarters in Edmonton, Gordon Reykdal actually sounds winded. It's no wonder. The CEO of the country's only publicly traded payday loan company – which wowed investors last spring and topped our Investor 500 chart with a one-year return of 1,084% – has just had an exhausting week. After a surprise $8.9-million “administrative allowance” in fourth quarter results, released Sept. 8, and a conference call five days later that caused even more confusion, investors yanked their money out of Rentcash. The share price ( TSX: RCS) plummeted from an open of $28 on Sept. 9 to a close of $11.45 on Sept. 20 – in fact, the share price dropped about $4 on the day of the conference call alone. “It could have been better, no question,” says Reykdal.

Rentcash had lured investors with a tantalizing business model: it acted as a broker of small loans for people who live hand-to-mouth, those who only need to borrow a couple hundred dollars or so to cover them until payday. These are people who have nowhere else to turn for money, don't qualify for traditional loans and are therefore desperate enough to pay steep interest and brokerage fees, which add up to charges that well exceed the 60% annual interest limit set in the Criminal Code.

As investors knew it last spring, there were three major ways that Rentcash makes money. First, it derives the bulk of its income from brokerage fees, which are charged at a rate of 20% of the loan amount – a standard rate in the industry. Second, until last January, Rentcash offered customers the option to roll over their loan up to four times – i.e., customers paid that same 20% fee, plus interest accrued to date, to put off repaying the loan when it came due – which allowed Rentcash to charge up to four times the fees for the same loan. Third, and most genius of all, Rentcash is not technically a lender, and therefore should not be on the hook for loan losses. But as it turned out, that wasn't the case.

Bowing to political pressure, Rentcash stopped allowing rollovers in January, as did the other 34 members of the Canadian Payday Loan Association (whose members account for 750 out of about 1,100 payday loan stores nationwide). Customers didn't like it. The company that used to foster more of a “nurturing” relationship with its customers – as Darin Coutu, Rentcash's CFO, calls it – now effectively became a collection agency. Some customers took their business elsewhere, but many simply defaulted. In fact, Rentcash reported an increase of 4% in loan loss volume in Q4. “We really underestimated the impact of the no-rollover policy,” says Reykdal.

When Rentcash investors saw the $8.9-million charge on the balance sheet, for “the company's future share” of bad loans, they wanted an explanation. Rentcash, after all, did not get any handouts from its lenders: It payed them interest – and at a fairly steep rate. One of its lenders, Avenir Diversified Income Trust ( TSX: AVF.UN), collected 12% interest in 2004 plus a 4% financing fee on a subordinated debenture of $3 million.

So, why the handout? “The lenders are still responsible for the bad debt on the loans,” says Reykdal. “What we've got to do is make sure that the lenders remain viable to ensure they provide funds for our customers. They've got to still make a profit.” It sounds like the deal is a guaranteed moneymaker for lenders, if not for Rentcash.

How will the company fare? Lenders' loan losses are forecasted to be 18%­24% of total broker fees for fiscal 2006 (they were 16% this fiscal year, according to Reykdal). Rentcash has yet to haggle with lenders over who will be shouldering what percentage of that loan loss burden for the coming year.

The fact that Rentcash is taking financial responsibility for an increasing proportion of loan losses may also weaken its defense against three class-action lawsuits targetting payday loan companies, including Rentcash, though the lawsuits are still in their infancy. Add to the mix political pressure, dissatisfied customers, confused investors and a frenetic pace of expansion that would see eight new stores open each month in 2006, and it's enough to make any CEO sound winded.