Thomas Brown of hedge fund Second Curve Capital recently filed a 13G/A in Encore Capital Group (NASDAQ:ECPG) declaring a position of greater than 17% of the company. (A 13G filing occurs when a large investor [usually a hedge fund or mutual fund] owns more than 5% of a company, and I monitor such filings for investment ideas.) Encore purchases charged-off consumer debt and provides bankruptcy services to the financial industry. Encore’s strategy and business are focused on purchasing assets at a deep value. As evidence, since the company began managing its own capital, it has invested $583 million to purchase about $22.1 billion in debt at face value. This represents slightly less than three cents on the dollar. Obviously the company doesn’t even come close to recovering the entire face value, but if it recovers just a couple of cents on the dollar, it can still turn a very significant profit.
Why would a bank or credit card company sell bundled debt at pennies on the dollar? Simply put, rather than waste resources trying to locate and recover from debtors, the company can sell the debt at a premium to what they’d likely receive. Because companies like Encore specialize in the field, they have the tools necessary to collect a greater percentage of the debt than could the financial institution.
The company has several call centers (San Diego, Phoenix, and St. Cloud) from which account managers locate debtors and advise them how to pay off their debt with alternative financing such as home equity lines of credit. In addition, the company uses lawyers who are compensated on the basis of how much they are able to recover rather than on a per-case basis. Plus, the company’s 52 years inside the industry have given it many contacts, so it occasionally has the opportunity to sell a basket of debt to another buyer at a premium to the original cost.
The company’s stock has fallen 22% during the past year due to what I believe are temporary issues. For example, there were concerns regarding the methods of accounting the company should use for acquired loan portfolios. While this is certainly an issue, I don’t think it has hurt the company’s reputation among bundled debt sellers.
At current levels I think the stock is cheap. Currently the stock fetches 2.6x tangible book, 11x earnings and a 22.3% return on equity. This compares to 2.5x tangible book value, 15x earnings, and an 18% return on equity at AACC and 3.6 tangible book value, 17x earnings, and a 21% return on equity at PRAA. While this is obviously a simplistic valuation, I have been unable to create a realistic discounted cash flow or LBO model because of the naturally volatile operating characteristics of the industry, namely inconsistency in ability to acquire receivables and collect on the debts.
According to a recent Barron’s Online article, Thomas Brown thinks Encore will announce a takeover by a private equity firm within the next couple of months at around $17-18 per share. While it’s never good to rely on another person’s valuation, I believe Brown deserves some credit for his long (and profitable!) experience in picking values in the financials sector. In addition, as shown above, the company seems pretty cheap on a ratio versus comparables basis.
ECPG 1-year chart: