Description

Encore Capital trades at 8x EPS and has started exploring “strategic options”. I think it could get sold for $15 easily (+40%), though its largest competitor could pay over $20 and still see EPS accretion.

Encore is a company that collects charged-off assets. This business was great five years ago, when you could buy credit card receivables at 2 cents and collect 10 cents worth, for IRRs in excess of 100%. However, an improved credit environment (reduced supply), combined with a surfeit of capital (think: hedge funds, prop desks) looking for returns (increased demand), has competed IRRs down to a more reasonable level—I estimate mid-teens, unlevered.

Encore was backed by Triarc, which is now managing the sales process. The company has, in my opinion, the most sophisticated approach to buying and managing these receivable pools, with a much more data-intensive structure than its peers. It has been penalized in the last six months due a combination of lack of execution and telling the truth. While their competitors kept talking about a rosy environment, ECPG warned investors that it was more difficult to buy assets that met their return hurdles, and that they were pulling back on their purchases until the environment improved. Most recently, they reported costs that were higher than expected as they ramped up an Indian initiative designed to allow them to collect lower balance receivables as well as a few other initiatives that were undisclosed for competitive reasons.

The company is trading at 8x eps of $1.35 for 2007, though I would note that this number was in excess of $2.00 before recent disappointments. More importantly, there are good reasons for a competitor to buy this company. First, the obvious removal of corporate overhead. Second, the superior systems and collection initiatives alluded to above. Third, competitors PRAA and AACC both have net cash on their balance sheets, as they have been unable to buy sufficient assets to put their cashflow to work. Buying ECPG would allow them to buy a large portfolio of assets, capture a forward-flow agreement for future assets, and lever up the balance sheet modestly in addition, thus enhancing their returns. I think PRAA could pay $15 and have over 10% eps accretion with modest cost savings—this is likely quite conservative, as a $20 price is still immediately accretive also. AACC would see slightly less accretion than PRAA. Note that NCOG (another competitor) recently announced an MBO at 14x earnings.

As a corollary, I think that Portfolio Recovery (PRAA) makes a good pair against this investment. PRAA trades at 16x earnings and 4.5x book, and has remained above the fray in investors’ minds. I think this is temporary—the company has been bailed out by residual collections on older, more profitable portfolios—and the company will start reporting results that are more in-line with economic reality. That said, since PRAA is a likely acquiror of ECPG, this could be good or bad for the stock depending on how the deal is spun and the potential accretion.

Catalyst

resolution of strategic process