Encore Capital remains one of our favorite ideas on the short side as debt collection companies have historically been the worst performing subsector in all of Financials in the late cycle period. Beyond this, the company has been using what we would characterize as a loophole in GAAP (it's legal, but we think it's sketchy) to inflate its earnings over the last two years by buying companies and allocating a large share of the purchase price to goodwill. Under interest method accounting, this has had the effect of boosting revenues and earnings. It's our view that the late cycle dynamics are a strong riptide against which longs are swimming and the artificial pull forward of earnings through these acquisitions over the last few years will turn into a RoC headwind in the NTM.
For these reasons, we still think Encore is a great idea on the short side over the intermediate to long term. However, in the short term, it's possible that some good news could cause the stock to go up. Two potential catalysts are the return of select large issuers (JPM / C) who've been on the sidelines due to regulatory issues of their own and Encore getting out from under its own regulatory investigation by the CFPB.
It looks like one or both of those positives is getting more likely based on a flurry of recent CFPB settlement activity.
Encore reports earnings on Monday and we think they'll likely talk positively on both of these fronts.
There have been three recent CFPB enforcement actions in the debt collection space.
Recent CFPB Enforcement Actions
- On July 8, the CFPB announced a $216 million enforcement action against JP Morgan Chase for selling debt that was not legally collectible to third-party buyers and for robo-signing affidavits to sue consumers for unverified debt.
- On July 21, the CFPB announced a $700 million action against Citi, $23.8 million of which was related to an expedited payment fee that Citi charged and failed to properly disclose to customers when collecting overdue debts.
- On July 22, the Bureau announced an $18.5 million action against Discover for overstating minimum payments, misrepresenting interest paid, making early morning and late night collection calls, and failing to provide adequate notice to debtors whose debt it had acquired from Citibank.
Possible Effect on the Debt Collection Industry
As the CFPB concludes more investigations, the go-forward environment will become more defined, and issuers like JPM and Citi may become more comfortable developing plans to return to consumer debt sales. If those issuers do return to selling charged-off consumer debt, it would increase the debt supply available to Encore and decrease some of the upward pricing pressure on that supply.
As mentioned by management on recent conference calls, Encore is in ongoing discussions with the CFPB regarding past practices that could result in a settlement and one-time pretax charge in excess of $35 million. Given the recent high frequency of CFPB settlements with major institutions involved in debt collection, a resolution with Encore seems likely to materialize sooner than later. Most likely, a settlement would be a positive, as it would dissipate one of the clouds hanging over Encore.
Maintaining the Short Call
In spite of these possible developments, we are maintaining our short recommendation. Although the return of large suppliers and/or the resolution of CFPB negotiations may be speedbumps for the short case, the credit cycle remains late cycle. Jobless claims hitting their lowest level since 1973 a few weeks ago is further evidence of the credit cycle at/near its peak. As the cycle heads in the other direction, we expect Encore’s ability to collect on its purchased debt to suffer. Additionally, some regulatory uncertainty will remain even after the slew of CFPB settlements slows down. The Bureau has yet to complete its broad debt collection rulemaking and currently has pre-rule activities scheduled for December 2015.
These observations are not a waiver from the short thesis but a “heads up” in regards to a few speedbumps that may materialize in the short to intermediate term.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT