Still reeling from the financial crisis of 2008, many low-income Americans are still struggling to gain traction and rebuild their savings. Getting away from a paycheck-to-paycheck lifestyle has been an uphill struggle, and lender World Acceptance Corp. (Nasdaq: WRLD) has done this demographic no favors.

According to a series of reports by investigative journalists at Propublica.org, World Acceptance has engaged in a series of predatory lending practices.

Key highlights from that report include:

• The company targets distressed consumers (often near military bases) and after fees, the firm charges interest rates that can exceed 100%.

• Unlike payday loans, which are usually paid back in a short time, WRLD focuses on installment loans with long payback periods, encouraging consumers to continually refinance such loans to let interest charges pile up and principal balances go untouched.

• When consumers begin to fall too far behind in their growing loan balance, their personal possessions are at risk of being repossessed, leading to a further downward financial spiral.

• WRLD sells a range of insurance policies to protect against further financial distress, though such policies rarely pay off for consumers.

In WRLD’s 10-K, you can get a clear sense of how clients become trapped in a debt spiral. “In fiscal 2014, approximately 83.9% of the company’s loans were generated through refinancing of outstanding loans and the origination of new loans to previous customers. A refinancing represents a new loan transaction with a present customer in which a portion of the new loan proceeds is used to repay the balance of an existing loan and the remaining portion is advanced to the customer.”

#-ad_banner-#Although the Propublica report first appeared more than a year ago, the Consumer Financial Protection Bureau (CFPB), created by the Dodd-Frank Act in 2010, belatedly looked into the issue in March 2014. That’s when the bureau issued what’s known as a Civil Investigative Demand, which according to the company, “contains broad requests for production of documents, answers to interrogatories and written reports related to loans made by the company and numerous other aspects of the company’s business.”

Although that investigation is ongoing, short sellers remain convinced that World Acceptance will end up paying massive fines and perhaps be forced to radically alter its business model.

Too good to be true

One of the perils of being publicly-traded is the chance for the public to see just how profitable a company’s operations are, and World Acceptance’s numbers are truly stunning.

In fiscal (March) 2014, the company generated $238 million in free cash flow, on a sales base of around $600 million. Any industry that garners those kinds of returns typically attract more players, though most financial services firms wisely steer clear of this unsavory style of doing business.

Still, regulators don’t go after consumer-facing businesses simply because they are wildly profitable. Instead, any questions likely focus on the clarity of terms spelled out in such loans. In other words, the CFPB can’t stop consumers from making bad choices, but they can stop deceptive sales practices.

The CFPB has begun to take action against payday loan firms, delivering indictments against the industry’s most egregious players. With that process well underway, short sellers think that installment loan firms, like World Acceptance, will soon be in the spotlight as well.

To be sure, the wheels of justice have been turning quite slowly. Though the CFPB has been investigating World Acceptance for nearly half a year, no actions have been taken.

“I’ve been led to believe that this process can take quite some time… it would be very nice if they would finish their review within the six months and go on to a different project,” said CEO Sandy McLean in a July 2014 conference call.

It would be unrealistic for management to simply assume that this investigation will go away. The issues raised by Propublica.org and others are simply too damming. The question then becomes: what kind of legal enforcement should the company expect?

At a minimum, look for a set of changes for the installment loan industry that reduces interest rates on loans and new policy thresholds that make those loans harder to obtain. World Acceptance may also be on the hook for hefty fines.

What would the impact of lower interest rates, restrictions on loan rollovers and a higher threshold for loans have on WRLD’s financials? That’s hard to quantify right now, but this lender would no longer be in a position to earn $10-to-$12 a share every year as consensus forecasts for fiscal (March) 2015 and 2016 suggest.

But short sellers aren’t targeting this stock on expectations of a drop in EPS. Instead, they suspect that the CFPB’s investigation will deal a mortal blow. Short-seller Whitney Tilson noted on his blog, “Simply put, this business should not exist.”

World Acceptance’s most recent quarterly results reveal a year-over-year sales decline. The company may have already begun the process of throttling back its aggressive predatory lending practices. Yet that won’t be enough to satisfy the CFPB. Considering this investigation has already been underway for nearly half a year, enforcement action could come soon

Risks to Consider: As an upside risk, the CFPB could issue a watered down decree that discourages but doesn’t prohibit such predatory lending practices.

Action to Take–> Short sellers often seek out “terminal shorts,” those companies that may face threats that put them out of business. In the case of World Acceptance, regulators may levy such heavy fines and restriction on the company that the business model proves untenable. At a minimum, it is increasingly clear that the company will lose its ability to exploit distressed consumers to the same extent as in the past, which was the source of the company’s remarkable financial metrics. In such a scenario, short sellers may be looking at 30% or 40% downside as profit forecasts are lowered. If you are looking for vulnerable stocks to provide a hedge in your portfolio, then World Acceptance looks to be a sound candidate for a short sale.

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