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Avoid This 1 Financial Services Stock!

Before I get into this analysis, I’m warning you that even though a stock looks good on the surface doesn’t mean that it’s a good investment.

The company I am referring to is goeasy (TSX:GSY), a financial company based in Mississauga, Ontario. The company derives its revenues in one of two ways.

First, it operates easyfinancial, the subprime borrower division of the company. These loans are high interest to offset the risk.

Second, it operates easyhome which sells furniture, electronics, computers and appliances on a rent-to-own model.

Its net income has increased from $20 million in fiscal 2014 to $53 million in fiscal 2018. Despite its net income suggesting that goeasy is a growing business, the industry that it operates in and its negative operating cash flows make it a company to stay away from.

Precarious industry

Not too long ago, the subprime mortgage industry wreaked havoc around the world. The aftermath was so bad that Lehman Brothers – at one point one of the largest banks in the United States – declared bankruptcy.

The event I’m referring to is the 2008-2009 recession that decimated stock markets around the world. One country that was hit particularly hard was Iceland.

In October 2008, all three of Iceland’s largest banks defaulted on $62 billion of foreign debt. As the country was heavily invested in the subprime mortgage industry, the recession took a toll on Iceland’s economy.

goeasy derives its revenue from high-interest loans to subprime borrowers, exposing the company to significant risk that could jeopardize its future success.

Although there’s no evidence to suggest that the ramifications will be as severe as Iceland, there’s every indication that the subprime mortgage industry is directly correlated with the economy. When times are good, goeasy will benefit, when times are bad, it won’t.

This instability is not a good sign for investors, especially amid rumours that suggest a recession is on its way.

Negative operating cash flows

The company experienced negative operating cash flows in three of the past five fiscal years.

This is problematic for investors as operating cash flows are indicative of the success of the company’s main line of business.

A negative operating cash flow suggests that the company does not generate enough cash internally to service its obligations. Given that the company raised $203 million of debt in fiscal 2018, it will need to return to positive cash flows in order to make payments on interest and principal.

The company’s issuance of debt also exposes it to leverage risks, putting the company at risk when business slows down but its debt payments are still required.

Summary

I generally shy away from companies that operate in precarious industries.

As goeasy derives its revenue from loans to subprime borrowers, the company is exposing itself to massive risk when the economy inevitably goes into a recession.

Learning from history, the 2008-2009 recession taught investors that companies such as goeasy are not prudent investments, as success is entirely dependent on the success of the economy as a whole.

With negative cash flow from operations and the continued issuance of debt, goeasy is a company that I would definitely avoid.

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Fool contributor Chen Liu has no position in any of the stocks mentioned.

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