Describe in more detail your interest in debt-recovery firm Encore Capital.
WN: If you look at a chart of total household debt as a percentage of GDP over the past 60 years, it’s downright scary. From around 25% in 1950, that number went over 100% in 2007 and is currently at 101%. That’s a very big problem on any number of fronts, but one way to respond to that as an investor is to look for companies that may benefit as some of those excesses get worked off. We put Encore Capital in that camp.
The company buys distressed portfolios of mostly credit card receivables and small personal loans from banks and other lenders. The loans have typically been written off and the banks put packages of them up for bid in order to clean up their balance sheets. Encore’s business is fairly simple: it makes money on the spread between what it pays for the loans and what it can eventually collect on them.
What does it take to be good at that?
WN: The first thing is that you need sophisticated models, based on long experience, to analyze what you’re getting and what to pay for it. The most obvious risk is that you end up overpaying for the loans, but Encore has proven to be disciplined and smart in how they bid.
As for collecting on the loans, Encore has also been adept at categorizing borrowers early on to determine the most efficient way to deal with them. In its initial research the company focuses on both the willingness and the ability of the borrower to pay. Those who are willing but unable, for example, will be treated differently than those who are able but unwilling. Someone deemed able but not willing won’t get more cajoling calls or letters, except as part of the detailed legal-remedy process Encore has defined. Another efficiency effort that is starting to pay off is the outsourcing of parts of the collection process. Collection rates at their center in India, which opened in 2007, now rival those in the U.S. and are done at a significant cost savings.
Couldn’t one argue that a lousy credit market and flagging economy will make it that much harder to collect on bad consumer loans?
WN: The loans Encore is collecting on today are to borrowers who were in trouble well before the credit crisis hit. What Encore is seeing is nothing it hasn’t seen before, and we believe they use that experience well to know how much they can collect and how to collect it. One positive dynamic is that the prices Encore is paying for loans has come down fairly significantly. The marginal competitive buyers in recent years have been hedge funds, many of whom are exiting the market as their performance and funding sources fall off. Estimated recovery ratios – what Encore expects to collect over what it has to pay – have risen from roughly two times 12 to 18 months ago to the 2.5x-to-3x range today.
The stock, currently at $13.50 [Editor's note: As of publication, the stock sits at $9.98], has been all over the place in the past year. Why?
WN: We started buying in the summer of last year at $10-11 per share, so our timing wasn’t initially great. The company had a couple quarters of disappointing earnings, partly due to a strategic decision to more aggressively pursue legal remedies earlier in the collection process. In the short term, that resulted in higher legal costs hitting the P&L before the increased collections followed. The stock got as low as $6 earlier this year and we were buyers on the way down.
As increased collections have come in, earnings in the most recent quarters have improved and the stock has rebounded. But we still don’t think the market is recognizing the earnings power of the company, which should have the wind at its back for years. The mountain of consumer debt out there means that this period of unwinding and deleveraging is going to go on for a long time.
How do you see that translating into earnings and share-price upside?
WN: We estimate the company will earn $1.45 per share this year, $2 next year, and could increase earnings at 10%-plus for years. In this economy, how is the market going to value a story like that as it becomes better known? Even at 10x next year’s earnings, which I’d argue is too low for a company with this growth profile, that would give us a $20 stock.
Another way to value the company is on its estimated remaining collections, which for Encore today is $990 million. Historically the stock has traded at an enterprise value that was around 0.9x those remaining collections. Today the shares trade at only 0.6x. Based on that measure as well, we can imagine at least 50% upside in the shares.
This is somewhat of an aside, but we like the fact that one of Encore’s largest shareholders is the J.C. Flowers private-equity shop. We respect them as savvy investors and believe they’ll have a lot to contribute to Encore’s navigation of the distressed-debt markets going forward.
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