Editor's Note: Financials analyst Josh Steiner is presenting an update to our short thesis on Encore Capital Group (ECPG) Friday December 15th at 10am. Email sales@hedgeye.com for access. A brief overview of the bearish thesis follows below.
overview
Encore Capital Group (NASDAQ: ECPG), one of the largest publicly traded debt collection companies in the United States, has been a short-side best idea since late 2014.
A distressed consumer debt fund primarily targeting U.S. charged-off credit card receivables, with a sizable presence abroad as well through its 43% stake in U.K. debt collector Cabot Capital Management, Encore is a cyclical name that performs best in early-stage, post-recessionary, economic rebounds, with fundamentals that slow into both economic downturns and the latter stages of economic expansions as collections deteriorate in the case of the former, and in the case of the latter, purchase multiples (EGC/purchase price) contract.
Having significantly participated in the post-election financials rally, ECPG is up +60% YTD despite the absence of any meaningfully improved fundamentals.
Given the near binary trajectory of the economy –that is, an extended expansion or an eventual slowdown, the cyclical headwinds that await ECPG are clear. Accordingly, we are excited to restate our bearish view on Encore, offering incremental analysis, insights, and a robust framework by which investors can easily understand and measure changes in the fundamentals of Encore's business.
Key Points of Discussion
- Fundamental progress of late: While ECPG's 2016 vintage has, both at the firm-level and stratified across the constituent U.S. and European vintages, demonstrated a marginal improvement in collections, the majority of the vintages defining the firm's estimated remaining collections (ERC) have largely failed to exhibit a similar feat. Moreover, in the absence of material efficiency gains, and even after adjusting for a lower future U.S. tax rate, our analysis concludes that Encore is still largely unprofitable at its current ERC-weighted, firm-level estimated gross collections / purchase price multiple –a result consistent with the inevitable realization of the aforementioned cyclical headwinds set to befall the debt collection practice.
- A review of the regulatory landscape and potential legal catalysts on the horizon: Undoubtedly, a large share of the post-election financials rally has been driven by eager expectations for favorable regulatory reform out of the Trump administration. Given the recent structural headwinds faced by U.S. debt collectors following an increase in regulatory scrutiny over the last few years, share pricing among rival debt collectors has suggested that future financial regulatory reform will have targeted benefits for the debt-collection industry. While targeted regulatory relief would be a true structural tailwind for ECPG, we view this as an unlikely catalyst that is inconsistent with the intended nature of deregulation efforts and would, in any case, fall among the lowest set of objectives in future financial reform initiatives.
- Developments abroad: With the failed fourth-quarter IPO attempt of ECPG's joint venture European initiative, Cabot Capital Management, the "Smart Money" collective has signaled its concern regarding the future of the European debt collection landscape. With free-cash-flow negative, leverage-fueled competitors like Arrow, Intrum, and Lowell pushing purchase multiples increasingly lower, the European landscape is very unlikely to emerge as a source of growth for Encore, irrespective of how its current European vintages fare.
- Ambitious expectations: Moreover, having fully reversed the prior allowance on its European vintages, the firm's management has ambitiously projected a rate of collections decay across its European portfolios that is aggressively inconsistent with the statistically-robust, average rate of vintage decay.
