Description

Debt buyers are cyclical businesses, or perhaps more illustrative, countercyclical businesses. At the part of the cycle in which credit card issuers are managing through above trend gross charge offs, companies like ECPG are able to accelerate growth at higher than average returns which should lead to very strong earnings growth. But nothing is ever that simple. The environment in which charged off paper becomes more plentiful and less expensive for the debt buyers is generally correlated with collections getting tougher for those same debt buyers. As such, investors have a needle to thread of buying the stocks when growth prospects are on the ascent and expectations have digested some near-term collection headwinds. It is likely we are nearing that sweet spot in the cycle. US revolving debt balances now exceed their pre-COVID high by over 10% with credit card balances growing the fastest. Meanwhile,  card delinquency rates, which were dampened dramatically by stimulus, have been increasing consistently on a year-over-year basis (actually every quarter as well save the seasonal downtick during tax return season) and will soon exceed pre-COVID levels (delinquency dollars already have), despite the fact that employment remains near historical lows. Further, ECPG has taken “changes in recoveries” writedowns for five consecutive quarters totaling a little over $4.00/share after tax. In other words, most of the pain has been recognized and most of the earnings growth from record purchases is in the very near-future.    

Further, the competitive environment for this cycle appears to favor buyers of defaulted loans relative to sellers. The last time credit card charge-offs peaked coming out of the GFC, there were dozens of pools of capital competing to purchase paper. In addition to numerous dedicated debt buyers, financial sponsors could buy paper with the expectation of outsourcing collections and then perhaps flipping their portfolio to another investor. The CFPB changed that dynamic. While the agency certainly imposed restrictions on how companies could collect outstanding debt, they also severely curtailed who could effectively operate in the business. They did this by holding card issuers responsible for the actions of their outsourced partners from a compliance perspective. While issuers would still seek the highest price for their defaulted loans, they had to limit their potential buyers to those operations they had fully vetted and audited from a compliance perspective, limiting the pool of potential buyers to only the most institutional players. Further, the transmission of compliance violations back to the issuer effectively eliminated the practice of financial buyers purchasing paper because the seller would have to approve the buyer. As it can take years to extract full value from a portfolio, there are very few financial sponsors willing to deploy capital without the ability to exit.       

The anticipated cycle is coming on the heels of disappointing results for the debt buyers. ECPG had to adjust down their expected collections of the vintages of charge offs they bought in 2021 at the peak of stimulus. It seems that borrowers that defaulted when consumer liquidity was historically high were below average prospects for willingness to settle debt. This should certainly be viewed as a blotch on the record of the buyers for not recognizing this tendency and adjusting their pricing accordingly.

It is important to note that what I have described above references the US market. Encore also has significant European operations. For Encore, Europe is primarily Western Europe (UK the biggest by far, then Spain and Ireland) and represents 25-30% of collections in a given year. The market for paper is currently more competitive than in the US. Encore expects a shakeout as their European competitors employ significantly more leverage and are hampered by higher interest rates. And the expectation should be that until that happens, they will be focused on deploying capital in the US and would expect the share of revenues from Europe to shrink. 

At the top I will acknowledge that valuation is tricky. Accounting makes reported results very volatile and different assumptions for the purpose of revenue recognition makes relative comparisons on traditional earnings metrics difficult. I have attempted to normalize for these factors by focusing on two measures of value that, at least over time are not determined by accounting or assumptions. 

First, I calculate an adjusted EBITDA. The significant adjustment I make is to add back collections applied to principal balances (total collections less revenue). This eliminates revenue recognition differences between companies. While earnings and traditional EBITDA metrics vary greatly between the two significant public debt buyers, their multiple of this adjusted EBITDA multiple has remained in a relatively tight band and is much more comparable.   

To be clear, this is a flawed metric as a debt buyer would be rewarded with higher adjusted EBITDA even if it was recklessly over-overpaying for paper. As such, it is important to keep the buying environment in mind when considering the right multiple. The market seems to do so as the multiple on this measure appears to peak out at 4x or a little higher when the perception is that purchases are coming at attractive pricing. Conveniently, this is exactly the environment for which we are playing.

At 4.0x NTM adjusted EBITDA on my current projection, Encore is fairly valued at $66 today (assuming the market all of a sudden awarded them the high-end of the range multiple, which of course it will not until there is evidence they actually are in the sweet spot) and $76 twelve months from now. As a check, the $66 target implies an 8.4x multiple on my 2024 GAAP EPS multiple which is reasonable in a buyers-market for paper.

The other approach to cutting through accounting volatility and revenue recognition assumptions is to look at book value growth over a long enough period of time that accounting converges with cash and the companies have a chance to earnback book value per share declines from above book buybacks.

The two significant companies – ECPG and PRAA - have remarkably similar average book value multiples over time despite the fact that ECPG has consistently grown book value at a roughly twice the pace of peer PRAA. Unsurprisingly, both companies achieved the high end of their BV multiple range when purchases were ramping and the low-end when they were slowing. This probably has more to do with the perception of pricing when purchases are increasing than enthusiasm over simply buying more paper. 

Both companies trade well below their average book value multiple, with PRAA trading at a historical low. For reference, the $66 target for ECPG implies a 1.16x multiple a year from now, while the $34 target for PRAA implies a 1.03x multiple a year from now. After speaking with both management teams I have a significant qualitative preference for ECPG management.

One note worth making. Both companies have made acquisitions and carry a significant amount of goodwill. Despite this, in everything I’ve read so far, analysts and investors focus on book value rather than tangible book value. For both companies the goodwill have been steady throughout the measurement period so the comparisons should still be reliable. 

•  Base case- Achieves a 4.0x adjusted EBITDA valuation on solid, but not off the charts  ERC growth at returns in-line with historical averages. $66 represents a 36% total return. At 1.16x book and 8.4x my 2024 earnings estimate this valuation is well within historical norms.  
•  Upside- Growth opportunities exceed expectations which would by definition come at higher than projected expected returns. Higher collections drive operating efficiency up 300bps to 50% (still below where they have operated in prior to 2022. Applying the same 4.0x adjusted EBITDA suggests $85. Note: Upside based on multiple applied to NTM adjusted EBITDA 12 months from now, while base case is based on NTM results.
•  Bear case- Growth does not materialize and collections disappoint. After taking charges to write down ERC, the revenue yield falls to a cyclical low and the company suffers negative operating leverage. $38 or 22% downside. Equates to 8.0x a 2024 EPS estimate that is 38% below the base case. 80% of book assuming ERC writedowns net of earnings did not degrade book value per share. 

Catalyst

Credit normalization