Summary:
As expected, the third quarter saw a continuation of the same dynamics impacting last quarter; that is, the collectability of Encore's current receivables portfolio, particularly in the United States, continues to be enhanced by government and lender responses to the pandemic, as well as the physical limits on discretionary spending. Collections in the United States grew +18% y/y to a record $391M, with call center & digital collections up +32% y/y. In the U.K., collections trends continue to improve, down -6% y/y due to pandemic restrictions hurting litigation-related collections while call center & digital collections were effectively flat year-over-year.
Higher-than-expected collections drove an incremental +$30M in revenue, providing a +9% boost to revenue from receivables and accounting for 7.5% of total revenues. Based on the positive changes in expected and future recoveries reported in 2Q and 3Q, +$66M and +$30M, respectively, the company has effectively wiped out the -$109M charge it took in 1Q at the onset of the pandemic. However, new charge-off supply remains low, despite improved pricing in both the United States and Europe. The United States accounted for 83% of quarterly purchases, with the $171M third quarter total down -35% y/y, led by a -65% y/y decline in European purchases with domestic purchases down -18% y/y. Consistent with the commentary from bank earnings season, Encore's management indicated that the timing of its expectations for increased charge-off supply had shifted from the back half of 2020 / early 2021 to the back half of 2021 and beyond.
While management did not opine on the potential for regulatory regime change in the United States under a new administration, they shared their content with the newly finalized CFPB debt collection rules which provide long sought-after clarity, are largely consistent with what was rolled out in a draft version 18 months ago, and do not bear a significant operational cost of compliance for the company's US operations.
With $650M in dry powder, improved and greater access to capital, and a global reach, Encore remains in a unique position to take advantage of the forthcoming phase transition in the credit cycle, even if that transition, as suggested by Capital One's Richard Fairbank, has been moderated rather than delayed.
Adding back the $0.59 per share impact from the $19M in expenses associated with the establishment of the company's new funding structure, Encore posted adjusted EPS of $2.90, giving it an annualized core earnings run-rate of $8 to $9, which at ~$34/share amounts to a current P/E of ~3.8x. As we have previously argued, not only are earnings poised to grow very substantially in the next 24 months, but the long-term (last 17 years) forward earnings multiple has averaged 9x, implying upside of >100% with no earnings growth.
ECPG shares remain a Best Idea Long.
A Closer Look at the Quarter:
Encore Capital Group (ECPG) reported 3Q20 diluted GAAP EPS of $1.72, up +40% y/y from $1.23 in the prior year quarter based on higher revenue and improved operating margins. Adjusting for the one-time payment of $15M to the CFPB, adjusted EPS, which did not add back the expenses related to the implementation of the company's new funding structure, came in at $2.31, up +41% y/y and exceeding the average street estimate of $2.14 - as well as the top-end of seven street estimates ranging from $1.98 - $2.28.
Revenues of $404M were up +13% y/y, driven by a $30M positive adjustment to expected future recoveries related to a pull-forward in the timing of the company's estimated remaining collections. Recall, in 1Q20, the company recorded a -$109 million non-cash charge related to changes in the company's future collections forecast caused by the COVID-19 pandemic. Underlying Encore's revised future collections estimates from last quarter were expected delays of 12-21 months on collections for Q2-Q4 2020 in the U.S., and delays over a number of years on collections for Q2-Q3 2020 in Europe, due in part to the nature of long payment plans in Europe. However, reported collections trends for April, the second quarter, and July show global cash collections outperforming the company's expected collection curves in both the United States and Europe. Accordingly, as of the third quarter, the company's estimated remaining collections forecast is back to 100% of pre-pandemic levels reported in 12/31/2019, with the first quarter revenue charge of -$109 million having now been fully offset by positive revisions of +$66M and +$30M in 2Q20 and 3Q20, respectively.
It is clear that lock-down measures, together with government stimulus and widespread lender forbearance programs in the firm’s two largest markets, the U.S. and the UK, saw the collectability of Encore's current book of business greatly improved with consumers taking advantage of government transfer payments, enjoying relief from mortgage & auto loan deferrals, and prioritizing debt repayment by virtue of having their discretionary consumption effectively halted.
Operating expenses of $261M increased +6% y/y, with the increase entirely driven by the $15M payment made to the CFPB to settle a complaint filed in September. As a result, operating margins expanded nearly +5 pts to 35.3% from 30.4% in the prior-year quarter. Although expenses were lower-than-expected in part due to pandemic-related spending constraints, Encore continues to show a trend of strong cost management as exhibited by its improving collection costs in its domestic business.
Meanwhile, the company is seeing some of the best purchase multiples in years, with multiples steadily improving in spite of lagging incremental supply. As we've highlighted in our past work, debt collectors experience operating margin expansion in tandem with improving portfolio purchase multiples.
Encore has expanded its revolving credit facilities and is generating increased cash flow from the improved collectability of its current book. Between it’s borrowing capacity and cash on hand, it now has $615M to deploy.
