Investment Thesis:

 I believe Encore Capital Group is currently undervalued at a 50% discount despite providing significant growth potential. Negative perceptions of debt collectors by consumers and the general media compounded with impending industry regulatory changes contribute to Encore’s discount. Furthermore, a complex industry revenue recognition method confuses some investors, allowing for the mispricing to occur. Finally, due to the fact that Encore has the industry’s best cost structure, an industry leading analytic platform, and also the fact that the company recently divested an underperforming service unit and acquired a tax lien business, the company is poised to grow significantly over the long run.

Overview:

 Encore Capital Group is one of the largest public debt collectors in the U.S. The company buys charged off debt from the nation’s largest credit originators and collects on the accounts through multiple channels. From inception through December 31, 2011, the company has purchased $2.1 billion accounts with a face value of $66.4 billion or 3.16% of face. The company utilizes multiple channels to collect on these accounts which include: a large internal call center operation, a vast network of external attorneys, a growing internal legal department, and in some cases third party collection agencies. The company’s main public competitors are Portfolio Recovery Associates (PRAA) and Asset Acceptance Capital Corp (AACC).

The company also recently announced that they would acquire Propel Financial Services, a Texas based tax lien acquisition business. Propel operates solely in Texas and provides commercial and residential property owners with property tax financing. Essentially, Propel will pay down a homeowner’s delinquent property taxes to the government, which then transfers the tax rights to Propel. The company will then develop a monthly payment plan with the consumer under which interest rates are usually 13-14%.

Analysis of Thesis:

Negative Perception & Regulation:

Encore has faced a string of lawsuits and investigations by consumers and the attorney generals of multiple states in recent years. In 2008, the company faced a class action lawsuit titled Brent v. Midland Credit Management, Inc. The lawsuit alleged that Midland (an Encore subsidiary) used flawed affidavits in their collection process. The case lingered into 2011, a time when mortgage companies also received attention for their affidavit processes. Then in mid 2011, the Texas Attorney General filed a complaint similar to the allegations in the 2008 Brent case. Later in early 2012, the West Virginia Attorney General’s office filed a lawsuit against Midland, which was similar to the two prior events. I believe that these factors in conjunction with impending regulation from the FTC and CFPB have suppressed Encore’s share price for a large portion of 2011 and still cause the shares to be trading at a discount to its intrinsic value (despite trading near a 52 week high). The FTC and CFPB are two of the largest regulatory entities governing the industry. Both are currently still in a “research” phase, but more regulation in the industry is inevitable. However, tougher regulation may prove to be beneficial in the long run if it provides a sufficient barrier to entry.

ASC 310-30:

 Encore’s revenue recognition method is complex and requires numerous managerial estimates. Because of this factor, I believe the company is undervalued by some investors. Under ASC 310-30, whenever the company acquires portfolios of charged off debt, they must aggregate them into static pools with common risk characteristics. If the company can reasonably estimate the timing and magnitude of the future cash flows of a portfolio, the interest method is used. Under the interest method, the company must find the rate of return that equates the future cash flows to the purchase price of the portfolio. This IRR is applied against the portfolio’s book value each quarter to determine “revenue” generated. If the company cannot reasonably estimate the timing and magnitude of the future cash flows of a portfolio, the cost recovery method is used (no revenue is earned until the portfolio cost is recovered).

However, I believe that this methodology of recognizing revenue is not indicative of the company’s underlying economic performance. As such, cash collections on the company’s portfolio are a better indicator of performance. To determine the company’s core earnings, I have adjusted the GAAP numbers for this consideration (among others) to create an adjusted earnings metric, which better summarizes Encore’s operating performance for the past few years.

Adjustments include:

1. Cash collections: Instead of revenue accrued on investment receivables, I have included cash collections.

2. Salaries & employee benefits: Removed one time severance charges in 2007amounting to $1.4 million.

3. Cost of legal collections: Removed $1.7 million of court cost reversals in 2010 due to a supplier’s settlement with the FTC.

4. General and admin expenses: Removed $1.7 million and $5.3 million of legal expense in 2010 and 2009, respectively relating to one time litigation.

5. Interest expense: Removed the amortization of convertible bond discounts for fiscal years 2007-2010 and contingent interest expense in 2007.

6. Gain on repurchase of convertible notes: Removed accounting gains relating to the repurchase of the notes amounting to $3.3 and $4.8 million in fiscal 2009 and 2008 respectively.

7. Provision for income taxes: I assumed that the company’s GAAP tax rate for each respective year would apply to the adjusted income before income taxes number.

The results are shown below:

Misleading Growth:

Since 2007, Encore has grown significantly. Cash collections grew at an annual compounded rate of 21.10% while income before income taxes grew at a rate of 28.38%. While these may be impressive numbers, they can also be misleading. In general retail stocks will show significant increases in revenue and income due to expansion of new stores.  Ceteris paribus, to increase cash collections and thus profits, Encore only needs to purchase more portfolios. In retail a same store sales metric is utilized to measure performance of stores in operation for over a year. For Encore, I have developed similar metric entitled same portfolio collections growth. This metric measures all cash collections on portfolios older than one year—in other words, cash collections on portfolios purchased in the most recent fiscal year are excluded. The results are measured below:

Cost Advantage:

Unlike its competitors, who primarily operate domestic call centers or contract with third party agencies, Encore operates a large scale Indian call center. This allows for Encore to differentiate itself as a cost leader in the industry. As of 12/31/2011, the company’s Indian employees amount to 1,426 or over 64% of its workforce. Of this amount, 1,005 employees are account managers (collectors). While originally developed as a call center, the Indian operation has also expanded its capabilities and now manage a part of the company’s IT infrastructure while handling complex analytics and providing back office support.

While it may seem obvious for debt collectors and collection agencies to set up call centers in India or other countries with cheap labor, there are a few challenges. One is a geographical challenge. Under the FDCPA, consumers may only be contacted from 8 a.m. – 9 pm. local time. This means an offshore call center must essentially operate during the graveyard shift. Furthermore, to collect from consumers, a debt collector needs to be licensed in many jurisdictions. A lot of states and municipalities will not license offshore collectors—this pertains to third party collection agencies. For most jurisdictions, a company owned off shore call center can be licensed as a branch of your domestic location.

 Furthermore, in the first quarter of 2012, Encore began operations of its near shore Costa Rican call center. While this does not provide short term cost savings due to the collector learning curve (usually one year or longer) and numerous capital expenditures, it will provide significant future cost savings in the long run, especially if Encore decides to expand the work force there.

Another (and often undervalued) advantage of operating a call center in Costa Rica is the utilization of bilingual account managers. Many call center managers and collection agencies consider bilingual account managers to be very important, with Spanish being cited as the most popular and important.

With these factors in consideration, Encore has among the highest adjusted income before income tax margins in the industry as compared to its main competitors:

While it may seem PRAA produces consistently better margins, a few factors should be taken into consideration. First, a large portion of PRAA’s portfolios and collections are comprised of bankruptcy debt. This asset class requires relatively less labor and costs to generate collections compared to core portfolios (non-bankrupt debt). For the fiscal years 2007-2011, bankruptcy collections comprised 10.3%, 17.39%, 23.47%, 35.25%, and 39.18% of collections for PRAA, respectively. Second, Encore is more aggressive in utilizing litigation in collecting accounts, which produce lower margins. For the fiscal years 2007-2011, legal collections comprised 47.58%, 48.47%, 47.7%, 44.12%, and 49.59% of total collections, respectively. In comparison, PRAA’s legal collections as a percentage of total collections for fiscal 2007-2011 was 34.20%, 28.43%, 23.56%, 23.77%, and 24.37%, respectively.

Industry Leading Analytics:

As mentioned previously, Encore has arguably the best cost structure in the industry and one of the highest margins as well. The cause of this success is the firm’s superior analytical capabilities to identify undervalued portfolios and collect on them. Because of their advanced analytics, Encore enjoys the highest collections multiples in the industry. The results compared to the company’s top two public competitors are shown below:

The collections multiple measures a vintage’s total cash collections to date (as of 12/31/2012) divided by the purchase price.  For example, the 2010 data point represents all collections in 2010 and 2011 for accounts purchased in 2010 divided by their cost.

To further develop its analytical capabilities, Encore also launched the Consumer Credit Research Institute (CCRI) six months ago. They will research the distressed consumer in collaboration with leading institutions in the nonprofit and academia sector to gain understanding to the growing group and to help improve the firm’s operations and valuation/purchasing efforts. While most studies are in the concept and planning phase, a few have reached the experimental phase and will hopefully improve the company’s operations.

Leverage:

Leverage is important for companies in the debt collection industry to not only fund normal ongoing portfolio purchases, but also to take advantage of good deals when they come by. An example of the latter case is Encore’s most recent purchase of a competitor’s portfolios as discussed in the next section. Encore recently amended its revolving credit facility, allowing for a total loan commitment of $555.5 million, of which $314 million was outstanding at the end of Q1 2012. This compares to PRAA’s $407.5 million credit facility and a $357.5 million facility that matures on 12/20/2014 and AACC’s $95.5 million and $175 million credit facilities. Taken these factors into consideration, Encore has a huge purchasing power advantage.

Recent Purchases & Implications:

In the last few quarters, Encore has been accelerating their portfolio purchases. For the TTM, they have purchased $426.6 million of portfolios with a face value of $11.7 billion. Furthermore, the company recently announced a substantial purchase (>$100 million) of an unnamed competitor’s portfolios due to the competitor’s exit from the market. This will allow for substantial value to be realized over the next 12-18 months. The competitor’s exit from the market is nothing new and may in fact be a trend. All three of the largest public debt collectors (PRAA, ECPG, and AACC) have witnessed consolidation within the industry. More and more medium and small competitors are pushed aside due to inefficient operations, lack of affordable capital, and inferior underwriting capabilities. I believe these factors will continue to drive growth for Encore in the long run.

Propel Financial Services:

The purchase of Propel presents a tremendous growth opportunity for Encore. The acquisition allowed the company to diversify its investment in asset classes. While detailed financial data for Propel have not yet been released, the company holds a $140 million portfolio of tax liens, earning interest at 13% and higher. The Texas tax lien market is large with $7-$10 billion of new tax liens sold each year. This market is currently largely untapped with about a 20% market penetration—the entire industry is only funding $200 million in delinquent taxes each year. Of the market that is penetrated, Propel dominates with a 37% market share with their largest competitor far behind at 16%. Because of these factors, I believe Propel will also be a significant growth driver for Encore in the long run.

Valuation:

To determine the intrinsic value of the company, I utilized a discounted earnings model by forecasting Encore’s adjusted net income for fiscal 2012 to fiscal 2015. The discount rates used range from 8% to 13% and the terminal value growth rates for net income range from 2% to 6.25%. Overall, I believe my estimated income statement numbers and terminal growth rates are very conservative. To improve the accuracy of the results, I removed three data points due to the fact that the difference between discount rate and the terminal growth rate produced an inflated terminal value. Under the assumption that each discount rate and terminal value was equally likely to occur, I computed an average intrinsic value of $240.06 per share. However, this is based on adjusted GAAP earnings. Since 2007, adjusted net earnings have ranged from 3.56-3.89 times GAAP earnings (except in 2008 where it was 7.41 times GAAP earnings). Utilizing a range of multiples from 3.58-4.06 times GAAP earnings, I estimated an intrinsic value of $59.12-$67.12 per share. The lower bound value represents an approximate 52.9% discount to the market price of Encore’s shares as of 7/25/2012. The results are shown below:

Summary:

Overall, I believe Encore Capital Group is a company that is significantly undervalued with the potential to produce large returns. Lawsuits and investigations have kept the company’s stock price suppressed for much of 2011 and impending regulatory changes also contribute to the discount. Despite these factors, the company has a history of profitable growth. This will likely continue for the long term through the company’s India and Costa Rica locations, through the CCRI, and through the recent acquisition of Propel.

When to Sell:

I believe that if any of these events were to occur, a more detailed investigation should be pursued to determine if you should sell the company’s shares:

Purchases decrease significantly or stagnate: Without ongoing purchases of receivables, the company’s cash collections and earnings will suffer in the long run. Take AACC, one of Encore’s competitors, for instance. In 2007, the company purchased $245.7 million of charged off debt while in 2011, they purchased $216.9 million. Cash collections on receivables in 2007 amounted to $371.2 million and $350 million in 2011—in other words, throughout that period AACC essentially did not grow.  Note, a temporary decline in purchasing activity is not always bad, especially if the pricing environment is too high.

Margins decrease significantly: As mentioned previously, one of Encore’s competitive advantages is its efficient cost structure, which has allowed it to decrease the cost per dollar collected and thus increase margins significantly over recent years. If margins were to decline significantly, it would be a red flag to conduct further research to determine if the competitive advantage is lost.

The company repurchases stock or pays a dividend: I believe that Encore should under no circumstances redistribute cash to shareholders. Their collection activities are extremely profitable and consistently generate returns above what most investors can obtain elsewhere. Such a distribution may indicate a lack of profitable investments for the company.

Catalyst:

1. Time to pass for people to forget the recent lawsuits against Encore.
2. Continued cost savings from India and future cost savings from Costa Rica.
3. Operational efficiencies to be gained from the CCRI.
4. Collections on large portfolios purchased recently.
5. Integration of best practices at Propel.
6. Penetrating the untapped tax lien market in Texas.