Encore Capital Group's (ECPG) CEO Ken Vecchione on Q3 2016 Results - Earnings Call Transcript

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About: Encore Capital Group Inc (ECPG)
by: SA Transcripts

Encore Capital Group Inc (NASDAQ:ECPG) Q3 2016 Results Earnings Conference Call November 9, 2016 5:00 PM ET

Executives

Bruce Thomas - VP-IR

Ken Vecchione - President and CEO

Jonathan Clark - EVP and CFO

Ashish Masih - President, Midland Credit Management Business

Paul Grinberg - Group Executive, International and Corporate Development

Analysts

David Scharf - JMP Securities

Mark Hughes - SunTrust

Robert Dodd - Raymond James

Michael Kaye - Citigroup

Bob Napoli - William Blair

Hugh Miller - Macquarie

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Encore Capital Group's Third Quarter 2016 Earnings Conference. [Operator Instructions] As a reminder, this conference is being recorded.

Now I'd like to welcome your host for today's conference, Mr. Bruce Thomas. Please go ahead.

Bruce Thomas

Thank you, Operator. Good afternoon, and welcome to Encore Capital Group's third quarter 2016 earnings call. With me on the call today are Ken Vecchione, our President and Chief Executive Officer; Jonathan Clark, Executive Vice President and Chief Financial Officer; Ashish Masih, President of our Midland Credit Management Business; and Paul Grinberg, Group Executive, International and Corporate Development. Ken and Jon will make prepared remarks today, and then we’ll be happy to take your questions.

Before we begin, we have a few housekeeping items. Unless otherwise noted, all comparisons made on this conference call will be between the third quarter of 2016 and the third quarter of 2015. Today's discussion will include forward-looking statements subject to risks and uncertainties. Actual results could differ materially from these forward-looking statements. Please refer to our SEC filings for a detailed discussion of potential risks and uncertainties.

During this call, we will use rounding and abbreviations for the sake of brevity. We will also be discussing non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are included in our earnings presentation, which was filed on Form 8-K earlier today.

As a reminder, this conference call will also be made available for replay on the Investors section of our website, where we will also post our prepared remarks following the conclusion of this call. With that, let me turn the call over to Ken Vecchione, our President and Chief Executive Officer.

Ken Vecchione

Thanks Bruce and good afternoon everyone.

In the third quarter Encore enjoyed another solid quarter of capital deployment in an increasingly favorable domestic environment. We believe we are seeing a turn in our industry cycle in which pricing and supply are improving. In addition, our consumer centric liquidation programs are contributing to better returns.

Our financial results for the quarter are clouded by non-cash charges associated with our thorough review of all of our European pool groups. Unlike typical allowances which are driven by reduced expectations of collections, our revised collection curves resulting from our review our forecasting more expected collection but the timing of the collection is delayed due to factors I will describe in a moment.

It is important that we provide a clear picture of the events that led up to the charges and why we are confident that we resolve the issues with the actions we took in Q3. In addition to covering the highlights from our business in the third quarter, some investors and analysts have also asked us to discuss an outline of the new proposed rules from the CFPB and we have a bit more detail to add on that topic.

So let me start with the domestic business. Our U.S. market for charged-off receivables is coming in increasingly attractive market for us and continues to show signs of improvement. Supply in the U.S. is on track to rise 15% in 2016, accompanied by meaningful declines in price from last year.

Our consumer centric liquidation improvement programs continue to improve our collections performance, while simultaneously increasing consumer satisfaction. Newly committed forward flows are being booked at higher returns for 2017 than they were for 2016, a continuation of the trend we've been seeing for approximately the last 12 months.

Encore is well-positioned in this market as we judiciously deploy capital along with other large debt purchases. Our liquidation improvement programs are generating strong results and our strategic cost management initiatives continue to lower our cost-to-collect. All these actions contribute to the rise in the current and future returns.

Incremental capital being deployed at higher money multiples and are higher IRRs for the last few years. IRRs for our 2016 vintage are nearly 40% higher than in 2015. As capital allocated is nearly 90% of Encore shareholder capital is designated for deployment in the U.S. market excluding our subsidiaries Cabot and Baycorp which was self funding.

Our expectations for the coming domestic cycle are different then for prior cycles. Capital inflows by opportunistic outside participants are limited by the regulatory environment, the need for substantial compliance investment and the absence of sophisticated operating platforms. We believe investments and compliance and operations have ensure that the mode to protect our business continues to get lighter and deeper.

The domestic market issuers have now caught up with our documentation request to support our legal collection efforts. We do not see this as a problem going forward and indeed the improved documentation is enhancing our legal collections.

Although we had encountered delays in both collection and expenses, we're beginning to ramp back up to more typical collection run rate and expect to be fully ramped as we enter 2017. Legal collections delayed in 2016 will be shifted to 2017 with no material impact to revenue.

Strategic cost management initiatives implemented at the beginning of this year have produced very strong result as operating expenses declined by $23 million in Q3 and $53 million year-to-date. Of these totals we reduced expenses due to documentation delays by $5 million in Q3 and $8 million year-to-date.

Some of these expenses will be shifted into next year as we ramp up legal collection efforts in 2017. Higher deployment in the U.S. market combined with our continued focus on expense reduction should result in lower cost-to-collect over time.

Rise in consumer receivables to pre-2008 recessionary levels should support the current pricing and supply environment. In addition to improve pricing of the U.S. market, several recent indicators of credit growth lead us to conclude that supply is poised to increase further. Consumers are increasingly taking on higher debt low as one item We've heard from several large CEOs who are including in their earnings commentary that delinquencies are expected to rise followed by charge-offs and higher recoveries including debt sales which will help mitigate the rise in charge offering.

Outstandings have grown to pre-session levels. Average households credit card debt has also grown to pre-recession levels. The improved returns we're seeing from our U.S. business will take some time to offset the lower returns from portfolios purchased in 2014 and 2015. Consequently the full impact will not be realized immediately, however as we approach this crossover points, we will continue to aggressively invest in the improving U.S. market and to opportunistically deploy capital at attractive returns in other regions.

Let's turn our attention to Cabot now. The largest of our international businesses is Cabot Credit Management headquartered in United Kingdom. With a long history of solid collection performance and over 1400 unique portfolios among their asset, Cabot has become the largest debt buyer in Europe with a sizable advantage in estimated remaining collections over their next largest competitor.

Cabot continues to build upon it leading market positions in the U.K. and Ireland and has expanded into businesses in Spain, France and Portugal. These markets offer attractive returns on capital deployment.

Cabot buys in services secured and unsecured debts, sales will continue to expand the capabilities of their servicing, and BPO businesses. Cabot's long collection curve is driven by a high concentration of payment plans and lower affordable payment amount provides steady collections and long-term sustainable revenue streams.

In October Cabot redeemed it's £265 million senior secured notes due 2019 and replaced them with a new £350 million senior secured offering due 2023 with a reduced coupon. In addition Cabot increased the size of its revolving credit facility from £200 million to £250 million and extended its maturity at a reduced interest margin. After these actions Cabot's liquidity stood at approximately £250 million reinforcing our expectation that Cabot has the appropriate liquidity and capital to continue its growth.

Before we turn our attention to the European allowance chart, I would like to take a moment to touch upon our accounting practices. Since 2008 Encore has consistently applied a prudent approach to revenue recognition. Over this period of time, Encore has not taken any portfolio allowance charges for portfolios purchased after 2008 other than a single charge related to the CFPB consent order. Because of our approach, it will take a fairly unusual event such as a significant regulatory change or an isolated issue related to a single portfolio to trigger a material allowance charge.

Given our long history of consistently applying this approach to our purchases, we have strong confidence in our reported ERC. During our last earnings call, we announced that Encore and Cabot teams are undertaking a thorough examination of our European pool groups. After completing this exhaustive study and calculating revise curves based upon our analysis, we've recorded a growth consolidate allowance charge of $94 million of which $37 million represent Encore's share after-tax.

The allowance charge was a result of two factors. First, uncertain pool groups, we had increased our expectation and raised IRRs under U.S. GAAP based upon collections over performance and expected uplift from operational initiatives. Second, these uplifts were delayed and tempered primarily due to revise regulatory requirements and operational initiatives which did not fully materialize.

Size of this allowance charge was driven mainly by the largest pool group in Encore’s European advantages, the Cabot acquisition pool group. This pool group is approximately 10 times larger than more typical pools for Cabot and contains all the historical Cabot pool groups from pre 2002 up through 2013 when we acquired Cabot.

The ERC associated with our 2013 European vintage, which contains this pool groups is more than $900 million, and reforecasting these pool groups, we have revisited our expectations going forward to a methodical analysis and now have full confidence that we comprehensively concluded the review of all of our European pool groups.

Unlike more typical allowances, the charges we've taken today are largely the result of delayed collections, not reduced collections and in fact we expect to collect more from these pools over time. We now expect to generate greater collections in a more consumer friendly fashion, but have incurred an allowance charge due to the timing of these collections.

Regulatory changes in recent years drove changes in business practices, which Cabot incorporated into the collection practices over time. The cumulative impact of revised regulatory expectation eventually offset some of the upside we were anticipating in the near-term, ultimately delaying, but increasing collections over time. In the face of these influences, plan liquidation initiatives were not as affected in generating near-term collections as we had predicted.

Pursuant to Cabot policy under IFRS, Cabot's ERC as reported is a rolling snapshot of expected collections over the next 10 years, pursuant to Encore’s policy under the U.S. GAAP, Encore’s ERC as reported was derived from a static 10 year window with this beginning fixed at the time of purchase for international portfolios.

Beginning in Q3 2016, Encore lengthened Cabot's ERC as calculated under U.S. GAAP to 15 years in order to reflect the longer duration of these curves and better capture the full collection expected over time. We believe this change will improve the accuracy of the ERC by accounting for years 11 to 15, which now comprise a meaningful portion of the total expected collection, both accounting policies have as its starting points, forecast that originate at tasks.

Based upon our ownership share and applying the appropriate U.K. tax rate, the reduction in the basis resulting from the portfolio allowance charge reduced quarterly earnings in the third quarter by approximately $0.11 per share after-tax. In connection with our review of all the European poll groups we also undertook a thorough review of Cabot's deferred court costs, which represent the portion of incurred costs we expect to recover through litigation.

This review cause us to reexamine the timing and estimate of Cabot's court costs recoveries. The cumulative impact of regulatory changes also had a negative impact on our recoveries from litigation efforts, when combined with changes in the types of asset we were litigating we’ve reduced our expectation for recovering court costs. As a result, we made an $11 million adjustment to Cabot’s deferred court costs after accounting for non-controlling interest, the non-cash deferred court costs adjustments for Encore was $4 million after-tax.

Before I hand the call over to Jon, I’d like to remind everyone that we are entering on the last phases of the CFPBs formal rulemaking process. When we spoke about this a quarter ago, we acknowledge that the new rules were going to create a level playing field for participants in the U.S. markets that the outline of proposed rules aligns well with Encore's current practices and that we were pleased that many of the proposed rules were consistent with our own recommendations or current practices. Because of this alignment, we believe we are well positioned and in fact far ahead of others in the industry as these new rules are rolled out.

Our substantial investments of time and resources we've made over the last several years have developed our compliance category and given us a competitive advantage. I like to add that we continue to have thoughtful dialogue with the CFPB on several areas of the proposed new rules where we expect a small subset of the current proposals may lead to unintended consequences for consumers.

We continue to cooperate with the CFPB in this way and I'll provide statistical support to the issuers we believe have the most - to have most important - statistical support to the issues we believe to be the most important to the industry as we navigate our way to expected new rule implementation sometime in 2018. Once these rules are finalized, we can measure their intended and unintended impact on the consumer and on our U.S. business.

At this time, I will turn it over to Jon who will go through the financial results in more detail.

Jonathan Clark

Thank you, Ken. Before I go into our financial results in detail, I would like to remind you that, as required by U.S. GAAP, we are showing 100% of the results for Cabot, Grove, Refinancia and Baycorp in our financial statements. Where indicated, we will adjust the numbers to account for non-controlling interests.

The non-cash portfolio allowance and the adjustment of our deferred court costs reduced Encore's revenue by $94 million and increased operating expenses by $11 million in the third quarter. GAAP net income and EPS declined $41 million and $1.57 respectively while ERC rose $296 million. Due to the timing of collections, allowance charge is warranted when future collections are discontinued at current monthly IRRs even though the total ERC increased.

Turning to Encore's results in the third quarter, Encore included GAAP loss from continuing operations of approximately $1.5 million or $0.06 per share with results heavily impacted by the $41 million non-cash allowance charge in the quarter. Adjusted income was approximately $3.6 million or $0.14 per share.

Deployment totaled $206 million in the third quarter. In the United States the majority of our $142 million of deployments represented charged-off credit card paper over 80% of which was comprised of fresh accounts. And as Ken mentioned earlier, excluding self funding subsidiaries nearly 90% of Encore shareholder capital deployed in Q3 was invested in the U.S. markets reflecting our commitment to capturing the improving returns available in the United States.

U.S. year-to-date purchases and commitments now total over $530 million for 2016. Pricing having peaked in 2015 projected returns from our 2016 deployments continue to exceed those from last year. European deployments through Cabot and Grove totaled $43 million during the third quarter with the majority attributed to portfolio purchases in the U.K.s and Spain.

We deployed $22 million in other geographies in the third quarter including purchases in Australia and to a lesser Latin America. Worldwide collections declined 4% to $407 million in the third quarter. In constant currency terms collections grew 1% in the quarter.

Our collection this quarter represents the most geographically diversified stream of collections in the company's history. Encore's international collections received benefit in the year-over-year comparison from the addition of Baycorp, our subsidiary in Australia and New Zealand.

In the third quarter we generated $245 million of adjusted EBITDA, a decrease of 7% compared to the third quarter of 2015 primarily due to the $11 million adjustment we made during the court costs. In constant currency terms adjusted EBITDA decreased 2%. On a trailing 12 month basis we generated adjusted EBITDA of $1.57 billion which was up 2% compared to the same period a year ago.

Revenue in the quarter was $179 million net of the $94 million portfolio allowance charge. Domestic revenues were down 2% compared to same quarter a year ago as we continue to see the impact of higher multiple portfolios rolling off our books.

International revenues outside of Europe grew compared to the third quarter last year to the Encore's addition of Baycorp in Q4 of 2015. We recorded $3 million of domestic net portfolio allowance reversals in Q3. In the third quarter we increased domestic yields primarily in the 2012 and 2013 vintages as a result of sustained overperformance by pools within those vintages.

In the third quarter, Encore generated $38 million of zero base revenue compared to $29 million in the same period a year ago. Encore's prudent accounting approach can generate zero basis revenues. Zero basis revenues are highly predictable and provide Encore with a valuable long-term collections stream.

During the cost of courts - including acquisition related and other costs, our overall costs collected in third quarter was 41.1% compared to 39.2% in the same quarter a year ago. This increase of 190 basis points year-over-year reflects the impact of the adjustment to Cabot's deferred court costs and was partially offset by improved cost-to-collect in the United States which benefited from our strategic cost management program.

Without the adjustment to Cabot's court costs reserve, our European cost-to-collect would have been approximately 31% and our overall cost-to-collect would have been approximately 38.3%. We expect our European cost-to-collect to return to its normal run rate closer to 30% in Q4.

Our estimated remaining collections or ERC at the end of the third quarter was $5.7 billion an increase of 1% compared to the end of September a year ago. In constant currency terms, our ERC grew 9% on a year-over-year basis.

It is important to understand that Encore and Cabot account for ERC differently. In accordance with U.S. GAAP Principles, encore's ERC represents our best estimate of future collections and as Ken mentioned, we're now migrating to a 180 month ERC for Cabot pool groups beginning of the time of acquisition.

Cabot ERC has reported its revise for each pool groups each quarter. Cabot's adjusted ERC based on collections from the most recently completed quarter either up or down and it is done on a formulated basis. Unlike Encore Cabot ERC is based on a 120 months window - a rolling 120 month window.

Because of these differences and because Encore's European vintages and Cabot's vintages are constructed from different combinations of pool groups, Encore's ERC is not directly comparable Cabot's ERC for any given vintage. Additionally all collection curve and forecast for Cabot pool group originated Cabot.

The projected ERC always starts with Cabot and Cabot management. Importantly we believe the reported ERC in both Encore's and Cabot's financial disclosures so different is correctly represented given each company's respective accounting policies.

In the third quarter we recorded a GAAP net loss from continuing operations of $0.06 per share which resulted largely from the European allowance charge partially offset by tax adjustments. In reconciling our GAAP net loss to our adjusted net loss, adjustments included $0.15 related to acquisition integration and restructuring costs, $0.12 related to the non-cash interest and issuance costs associated with our convertible notes, $0.10 related to settlement fees and related administrative expenses, followed by $0.02 for the amortization of certain acquired intangible assets related to our contingency collections business.

After applying the income tax effect of adjustments and adjusting for noncontrolling interests, we end up with $0.14 per fully diluted share and our non-GAAP economic EPS was also $0.14. Because our shares traded at an average price below the initial conversion prices of our convertible debt during the quarter, we did not exclude any shares from our calculation of our economic EPS.

I'd like to mention here an important point about our tax provisions for the third and fourth quarters which are explained in more detail in income tax footnote in our Form 10-Q. A large disparity in tax rate between the U.S. and Europe normally reduces our effective tax rates but because of the Q3 law centered in European operations this quarter, is that increased our effective tax rate.

Since the effective tax rate expected for the year will also be much higher due to the same factors but tax expense for the fourth quarter is expected to be approximately $10 million higher than our normalized rate.

Our consolidated debt-to-equity ratio in the third quarter was 4.56 times. Considering this ratio without Cabot our debt-to-equity ratio is 2.18 times which is less than half of the consolidated ratios. It is important to remember that we fully consolidate Cabot's debt on our balance sheet because we have a 43% economic interest in Cabot and we control their board.

Nonetheless Cabot's debt has no recourse to Encore. Consequently Encore is far less levered than a quick review of our financials would indicate. Available capacity under Encore's revolving credit facility subject to borrowing base and applicable debt covenants was $188 million as of yesterday not including the $195 million additional capacity provided by the facility’s accordion feature.

With that I’d like to turn it back over to Ken.

Ken Vecchione

Thanks Jon.

To summarize, the U.S. charge off receivables continues to be favorable with a few remaining qualified large debt volumes. Pricing leverage is shifting from sellers to buyers and we believe based upon year-to-date performance we are approaching a positive turn in the market. We expect future debt services to continue at these lower prices.

As to this increasing supply and the benefits we’re seeing from our consumer centric liquidation programs and it's clear that returns are rising for us in the U.S. The Encore team is also driving improved returns by reducing costs to our emphasis on cost management initiatives around our global operations. With the comprehensive review of our European pool groups, we are highly confident in our ERC and the accounting curves that support that. We continue to be focused on improving shareholder value by judiciously deploying capital, improving liquidity and managing our costs.

At this time operator we are happy to take some questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question is from the line of David Scharf with JMP Securities. Please go ahead.

David Scharf

Good afternoon. Thanks for taking my call. Maybe two things, one just focusing on your commentary on the U.S. market Ken. Just curious a topic that came up earlier in the week regarding one of your competitors what was with the concept of you know changes to some of the rules regarding consumers disputing claims and some of the documentation that has to be produced for that. And they had commented that it both elongates the recovery process and in some cases it may impair the value. Are you seeing an impact from any of the changed rules regarding the dispute?

Ken Vecchione

I am going to toss that over to Ashish who is sitting here who runs that operation. Go ahead Ashish.

Ashish Masih

Okay. Thank Ken. So it’s a good question, it did come up earlier. So it will help just step back and let me given a context and give a comprehensive picture on kind of what the change was in the rules and what's happening. So as you can imagine due to the nature of our collections business there are always some consumers who will dispute the debt and including in our call centers whey they speak to our account managers. Now through training we've been able to ensure that consumers truly understand the origin of their debt and not disputed.

So we’ve found dispute volumes in our call centers very much in control since the consent order went into effect earlier this year. Now that said, there are some consumers who still feel the need to dispute and we have a process, we've always had a process actually to pause collections temporary while we investigate the dispute reasons. And this temporary pauses is not a new process for us, we’ve always had this.

What is new to your question is since the consent order when consumers dispute are now required to send the documentation to the consumer. And what we found is over the last several months about half our disputed accounts or cases we have the documentation ready and we’re able to respond to the consumer within two or three days and in a very timely manner and put that account back into connection so there's no delay.

For the remainder, we’re able to go back to the issuers and sellers and in majority of cases obtain their documentation it takes a month or two but for majority we’re able to that.

Now just keep in mind for more recent purchases and for all future purchases, we receive full documentation on all accounts in a portfolio. So over time this minor issue will become even smaller overtime.

And in terms of collections impact we’ve actually not seen any negative impact of these disputes on our collections and we also have staffed up well in advance of the March deadline, implementation deadline that we had. So our current expenses also full reflect that staffing ground.

I hope that answers the question in a somewhat comprehensive way.

David Scharf

Yes, that does, it’s very helpful. Maybe I’ll just finish up with some questions on the allowance, I know others are probably going to have some as well. A couple of things, first of all in terms of this concept of a 15 year life for average collection lifetime how much of the increase in ERC just sequentially was related to your purchase activity less collections in the quarter versus adding five more years to the life of these European assets.

Ken Vecchione

Try that question again David for me.

David Scharf

I am trying to understand, my understanding is that you raised – that some of the increase in your ERC is related to increasing the life, the collection life of those Cabot assets to 15 years. Did I hear that correctly?

Ken Vecchione

Correct. We shifted out years one and pushed four into years 11 through 15.

David Scharf

Great. So what I was trying to understand is, when I look at how your ERC improved from Q2 to Q3, how much of that was related to your purchasing activity in the quarter versus how much of it was related to this lengthening the light of those existing assets to 15 years?

Ken Vecchione

The improvement when we went through the study on the European pool groups added $300 million in the longer term, so $296 million there about $300 million was added. And you don't fully see it recognized in the total ERC because of the exchange rates. But if you would've normalized for exchange rates you would've seen our ERC be about $6.1 billion in change and that where you would've seen the total ERC rise. But the exchange rates tampered some of the rise that we saw when we did our study on the European poor groups.

David Scharf

Got it. And Ken was the $94 million allot, was that entirely on the 2013 vintage at Cabot?

Ken Vecchione

No. So basically three vintages, ‘13, ‘14 and there was just a little bit in ’15. Most of it is in ’13.

Jonathan Clark

Yes, the vast majority it’s in ’13.

David Scharf

So if I add…

Ken Vecchione

David, I am sorry. David, I’d just about $76 million in ‘13 million, ’30 million in the ‘14 vintage and under $5 million for the ’15 vintage.

David Scharf

And in I apologize because I don’t have the Q in front of me but you know the unamortized balances of those three vintages combined I mean what percent of a write-down is this in effect the 94?

Ken Vecchione

About 10%, little less than 10%.

David Scharf

Okay. In my calculation - just trying to get a feel - the $37 million which is your 46% after-tax impact. If I just - that’s an after-tax, if I just divided that by your share count I am trying to get a sense for how to think about sort of run rate, quarterly run rate earnings. I mean is there a way ex the allowance charge after tax, is there a way to think of it as that ‘14 adjusted EPS plus?

Ken Vecchione

David, in the slide deck we have it's on Page 11 but a quick answer for you is it’s $0.11 per share for the allowance charge going forward.

David Scharf

Got it. Okay thank you.

Operator

And our next question comes from the line of Mark Hughes with SunTrust. Please go ahead Mark.

Mark Hughes

Thank you. And just to make sure I understand your last point. The earnings in the quarter if we take your $0.14 economic EPS, do we simply add back if we wanted to do this adjusted for the allowance charge, we just add back the $37 million divide by the number of shares, is that the…

Ken Vecchione

There are a few different add backs I would I direct you to but first is the add back of about $1.52 for the allowance charge, I'd add back about $0.16 for the deferred call it costs receivable reserve adjustment, $0.09 for different compensation issues that related to this charge and then the tax impact was about $0.40. When you reverse engineer which is where you're going, had we not had the allowance charge, our earnings would've been about $1.33 – not about our earnings would've been $1.33.

Mark Hughes

Okay. And then on a go forward basis $1.33 be reduced by the $0.11 or is that already incorporated in the $1.33?

Ken Vecchione

No, it would be reduced by the $0.11.

Mark Hughes

So that would be a $1.22 would be the run rate.

Ken Vecchione

And throwing an extra penny for the cost receivable adjustment. So its about $0.12 court costs receivable adjustment. So its about $0.12 EPS going forward.

Mark Hughes

Right, okay. The $0.11 and that you would add $0.01 of headwinds so to speak for the court costs adjustment is that what you’re saying?

Ken Vecchione

Yes. That’s correct.

Mark Hughes

Okay. You had given a number of 40% increase in IRR, was your comparison period 2015 to 2017?

Ken Vecchione

No, no. The comparison period is 2015 to 2016. So 2016 on average our IRR are being listed by 40%. And what you're seeing – I’ll just add – I’ll touch more color on that. For what you’re seeing is a combination of the three things actually coming together.

Really there are three general levers you can pull to improve IRRs liquidation programs and since the beginning of 2014 we've been talking about our on this journey to improve our first-year liquidations by 50%. That was a very large audacious number and we continue to track against that goal which we should hopefully accomplish by the middle of 2017.

So one, we’ve controlled some of our liquidation improvements by the programs we put in place. Two, we’ve worked on our cost structure which you heard us talk about, you see that our CTC is also declined/

And then the third which we don't necessarily have full control of but you could see the marketplace is responding to higher supplies, but the debt purchasers certainly large ones are distributing or using their capital in a more judicious way, which is forcing pricing to come down because people are being disciplined.

And I think those three things together for us have led to this increase year-over-year in IRRs. What I'm also saying is based upon our forward flow as we sit here today going into 2017, the 2017 returns will be higher at this moment than the 2016 that we’re booking.

Jonathan Clark

And Mark, when Ken refers to the 40% improvement he’s referring to new investments obviously flows that were entered into 2015 that continue into 2016 at the same return the new investment though are 40% higher.

Mark Hughes

Okay. And then your point about your projections – the projections to start with Cabot, are your projections now the same as Cabot other than you're using kind of different pools and may be different period but are they – the underlying projection essentially the same?

Ken Vecchione

I would say that everything starts with the same collection assumptions and they all are generated by the Cabot management team, because Encore and Cabot operate under two different accounting policies. They produce two different estimated remaining collection expectations. Okay.

One, Cabot just uses a 120 month rolling ERC projection, Encore as we just told you uses a 15 year fix time period. Encore looks forward and relies on judgmental approach when forecasting estimated remaining collections. Cabot uses a formulaic accounting approach.

Whereby, whatever the improvement in current performance is for that quarter, they extrapolate that to their ERC. So if performance was better by 2% they would extrapolate that all the way out, so total ERC would be better by 2%.

So, yes, we both thought with the same assumptions but the accounting policies and the approaches for the accounting get us to two different numbers. So that's why its very possible – not possible as why we – as we increased our – we been Encore, as we increased our expectations, we are now taking an allowance charge against an increased expectation while Cabot is achieving their expectations because they didn’t have to put in those estimated judgmental improvements to the operating initiatives that I have alluded to you before. Does that make sense to you?

Mark Hughes

It did. I was thinking it would be great to see sort of a written down maybe the accounting language one versus another. It's a complicated topic and probably hard to absorb at one setting. So I think I understand the general idea, but I could certainly use some additional detail if that were possible and we can do that off-line, certainly.

Ken Vecchione

We’ll get you an example. I think the example would work best.

Mark Hughes

Yes. That would be appreciated. One final question, the legal collections impact, I think you suggested you did had some impact from that that you are getting back up to the full speed now. Can you speculate as to what that might have been say in the third quarter? What headwind from legal related to the new processes?

Ken Vecchione

I’ll kind of phrase it this way. I think all in we’re moving about $40 million of collections out of 2016 into 2017 that will pick up in round numbers, okay. But as I said, it won't impact our revenue recognition.

Mark Hughes

And that would've been 40 million over the Q2, Q3 and Q4?

Ken Vecchione

Yes, primarily. Yes.

Mark Hughes

Okay. Thank you.

Operator

And our next question is from the line of Robert Dodd with Raymond James. Please go ahead.

Robert Dodd

Hi, guys. Just want to clarify on the allowance charge in Europe and from the U.K. This and then the regulatory you mentioned that you made in relate to that. Does that relate to the process with the FCA in getting certified over there or is there still something deceptive going on that front?

Ken Vecchione

It's the result of the cumulative effect of a lot of regulatory changes that have taken place over the last few years as Ken described in his prepared remarks. We increase the expectations from certain operational initiatives that we had, and overtime the impact of the regulatory initiatives resulted in those initiatives, the collections from those initiatives getting delayed over a longer period of time which resulted in the expansion occurred, the ERC coming in at a later point in time. So wasn’t specifically that one point in time approval of the FCA was a cumulative impact of a lot of different changes over the course of time, primarily in the U.K.

Robert Dodd

Right. Got it. And then just on the competitive front. Obviously, I mean the U.S. seemingly much improved with IRR’s up substantially I mean, you’re talking about forward flow agreements also coming in. Are you seeing a greater and greater reliance on forward flow and but obviously we certainly saw that some 15 to 16 in terms of coming into the beginning of this year was a lot more volume locked in up and forward flow already. Do you expect that to continue shifting? Is that going to be a continuing trend given the consolidation in the U.S., obviously as we go forward and have even greater visibility in earnings as you get into – as you lock up these longer-term deals?

Ken Vecchione

Yes, you know a lot of that is driven by the issues. A lot of that is driven by their own level of defaulted debt charge-offs and how they want to manage their earnings. So we have a fair amount that comes through forward flows. We’ve got a fair amount that some issuers just want to get that sold in bulk sales on a particular quarter, we’re happy to accommodate both, we stand out ready to accommodate both. Right now obviously what we have going into 2017 is all forward flow related, but we see a mix of both the forward flows and on and the bulk deals.

Robert Dodd

Got it. And then last one if I can. I think it’s fairly obvious question. In the U.K. and you may have mentioned it but I missed it if you did. Have you seen any shift in the competitive landscape and the IRR’s that you are getting in the U.K. market?

Ken Vecchione

Yes. So in the U.K., I would say, U.K. is looking a little bit like the U.S. was about 18 months ago. Still elevated pricing returns are down to touch. There are some competitors that we clearly don't understand their pricing. So we at Cabot, we've shifted to trying to do smaller off market deals in the U.K. to circumvent large competitive pricing transactions and that's why we’ve also moved into Spain, France and Portugal where we see returns in excess of those in the U.K.

So we kind of look at our credit facility that Jon alluded to over there, allows us to go seamlessly between countries. So we’re just reallocating capital away from the U.K. into Spain, Ireland I should say as well France and Portugal. So I am going to wait for the U.K. to back a little bit back to a more reasonable returns or more reasonable pricing.

Our approach in Cabot is the same in is in Encore which is if we can't usually figure out how to make it work it’s one thing if we lose a deal like 5 or 10 basis points but we’ve lost some deals by hundred of basis points and we can’t see how those deals work. And over time it’s our projection that those buyers will have to pay the price for paying such a high price in buying the debt.

Robert Dodd

Okay. I appreciate it. Thank you.

Operator

And our next question comes from the line of Michael Kaye with Citigroup. Please go ahead.

Michael Kaye

Hi, thanks for taking the question. So pricing, in the U.S. pricing supply is clearly improving but I just wanted to get your thoughts if pricing continues to improve some like it is now is there any risk that some insurers could pull back from selling maybe perhaps opt to keep some more and just use third-party agencies instead of selling to third party debt buyers?

Ken Vecchione

So I think that’s a well thought out question and we’ve wrestled with that as well but I’ll tell you where I think the market is going. The proposed CFTV rules which has been there contacting consumers six times a week. We believe that agencies will not be able to figure out that puzzle. We are well on our way to figuring it out and I think our decision science support is world-class.

So if the largest issuers are going to move money over to the agencies I don't think the agencies are going to fulfill their expectations, that’s one. Number two, the issuers are attached to the earnings stream. So they may be getting a little less than what they previously got as a high but they do like those the sales because they roll at a charge-off rate as their recovery rate go up.

So I don't think they're going to be able to move and what I'm saying here is really this is a different story here. As we talk about there is capital that’s being deployed in a constructive way by the debt purchaser but the other story is capacity and we don't believe that some of the larger issuers have the ability to ramp up their capacity, we don't believe that the agencies can ramp up their capacity in a way that will be effective given where the new proposed CFPB roles wind up. Even if those new rules go from six times a week to a greater number we still don't think that there's going to be as effective. And I think that's why we’re comfortable that debt sales continue to occur at the pace that they've been occurring at.

Paul Grinberg

And a significant turns are driven by our improvements to our liquidation so it's not just pricing that's driving our returns. A material part of the return is driven by all of the effort we’ve had in improving how we collect in a consumer friendly manner.

Ken Vecchione

Paul makes a very good point here. Let me just say that to-date on majority of our returns are more in our liquidation programs than they have been in price reductions. So as price reductions continue with a higher set of liquidation expectations our return should rise overall.

Michael Kaye

Okay. Got some great answer. I really appreciate that. Just want to talk a little bit about your cap last year. I know you have if I am not mistaken some convertible notes that's due next November. Just wanted to understand your plan with that, your plan to refinance that, you plan to be able just paid off somehow.

Jonathan Clark

Yes, good question. It is 12 months off. We’ve given this a lot of thought. We’ve a number of alternatives available to us. You can either do something in the convert market or other markets to generate cash. I think we’ve a number of alternatives and we’re just going to select the one at the end of day that’s the most cost effective but I don’t lose a whole lot of sleep over that one.

Michael Kaye

Okay. It sounds like the supply environments, doing much better and you are very well positioned but how do you feel, obvious the larger shores did come back hypothetically and just even ex them supply continues to improve. Do you have enough capital to take advantage of these opportunities?

Jonathan Clark

Sure. We’ve got – I mean today in the U.S. we've got almost $190 million of availability. Right, that’s just standing still not exercising and accordion and then internationally we’ve got now €250 million. So we’ve got plenty of liquidity.

Michael Kaye

I mean, that $199 could you actually know you is that really available for you to pull now or is that like subject to conditions that are real.

Jonathan Clark

Technically subject to conditions but the way we define it here is kind of write a check for that today and the answer is yes.

Michael Kaye

Okay. That's it. I really appreciate answers. Thank you.

Operator

And our next question is from the line of Bob Napoli with William Blair. Please go ahead.

Bob Napoli

Any thoughts on the election and what that mean that might mean for your business and the CFPB and regulations and things like that?

Ken Vecchione

Yes I think the Trump presidency is not 24 hours yet, but it’s always the news, it’s not 24 hours old. But I would say in a general sense his stance on taxes are favorable for us that’s one. He had said that he wants to see less regulations so every rule that's written he wants two rules to be removed. That would be favorable for us.

I think you know there's been regulation out there for the CFPB any way to move from director model to a panel of four or five like the SEC so that's out there. Also for having the Congress also control more of their capital expenditures their budget. So all those things are in general favorable for us and we’ll later meet Obama on Thursday and we'll go from there Bob.

Bob Napoli

Okay thanks. Thank you for commenting. I thought that you might not but the….

Ken Vecchione

That’s okay.

Bob Napoli

Let’s see, the pricing discipline question was a good one but so you haven't seen any other banks pull out of selling. I think one of the concern is always – there are several banks that haven’t been selling. You haven't seen any new bank that has stopped selling, that have been consistent sellers?

Ken Vecchione

No, those that have been selling have been consistent. There is always the mix and match approach. Some tend to favor more bulk, some tend to favor more forward flows. They take a position on where pricing is. If you thought pricing was going to continue to rise you may be more forward flow oriented. If you think pricing is going to go down you may want to do bulk sales in order to lock it in.

So that they come up with their own whatever equation works for them and we work either way very uncomfortably whether it be forward flow or more bulk sale.

Bob Napoli

Okay.

Ken Vecchione

But we do and I want to say this. Regardless of which one it is we do have higher return expectations and we are pricing to our higher return expectations. And I think the issuers are now after the last couple of months fully digesting that and see that as a trend not as a one-off event.

Bob Napoli

Did they possibly hold back some volume to see if that was a one-off event and then you are seeing more flow in the fourth quarter or?

Ken Vecchione

Hard to say so I can't. Really hard to say but we've done, we’ve deployed, either deployed or have committed to deploy a fair amount of money this year very consistent with prior years. I will say they match our return expectations so we’re happy that we’re deploying money at higher return levels. We don't go for the deployment at any return.

Bob Napoli

My last question just on the legal collections and the regulatory changes and I you missed part of the call. Was there a change over the last - and it seems like your collections from legal when your competitors collections from legal took a - declined by a faster rate in this quarter and the last quarter. And now you're suggesting that you're going to get caught up and was there something that changed just over the last quarter or two, or is it just the yearend and how confident are you that 40 million, why are you so confident you're going to get that those missed collections back?

Ken Vecchione

So we are going to break this up. First, I'm very confident and now Ashish is going to tell you why I'm very confident.

Ashish Masih

Okay. There was a change and the change was in the consent orders for us and for our competitor back effective in March. And the change was requirement for certain documents to always be attached and included in this suit process and litigation process. Previously in some states you required other, others you didn’t require it in the beginning, you could need it later on. So when that requirement came for all the accounts in the inventory and backlog, we needed a huge number of documents, which always - we would always get but we just needed them quickly from the issuer.

And the issuer had to reengineer their processes and to get out of a way to get us a document and that took a few months. They have now completely caught up and they're giving us - they've given us all the documents for these backlog accounts and so we are ramping up the litigation process and that's why we are very confident that the collection will catch up and so will expenses catch up in next year as well.

Going forward anything new we buy issuer give us full documentation as I said earlier for the purchases at the time of the sale, so there is no waiting, there is no delay. We have full documentation available to pursue any kind of collection activity, any channel collection activity that we would want to.

Bob Napoli

Great. Are you seeing that already in the fourth quarter?

Ashish Masih

Yes, in fourth quarter our legal collections and suit process or litigation process will ramp up and so will expenses and collections.

Bob Napoli

Great, thank you very much.

Operator

And our next question is from the line of Hugh Miller with Macquarie. Please go ahead.

Hugh Miller

Hi, thanks for taking my questions. I guess one on the - follow-up on the court cost, did you say that, that operating expenses in the third quarter benefited from about $5 million worth of push out legal cost, legal placements in the quarter? And that should obviously been ramp up in second quarter?

Ken Vecchione

Yes, that's correct.

Hugh Miller

Okay. And so I guess we should think about that in terms of the one rate analysis that you guys did on the breakout that should likely than the considered as well that was not considered in the breakout of the analysis that you guys provided?

Ken Vecchione

No, you're right.

Jonathan Clark

You're right.

Hugh Miller

Thank you. That's helpful. The other, I certainly appreciate some of the color you gave on the U.K. market and the differences in the bidding and the returns, would you say that the rational type of pricing that you're seeing from time to time? Is that really solely in the U.K. market?

Ken Vecchione

Remember we're predominately - Cabot is predominately in the U.K. We've entered into Spain and just entered into Portugal and same thing with France. So my color is predominately about the U.K. Spain, there just seem to be more attractive pricing and we see more volume coming up both in unsecured and SME deck.

Hugh Miller

Got it. A last question and the second, but would you say then that given the improvement in liquidation rate you're seeing in the U.S. and some of the improvement in pricing. Would you say that you are now as you head into 2017 buying to better returns in the U.S. relative to the U.K?

Ken Vecchione

Yes, I'd say that. We are not only buying the better returns but I think our cost programs are also picking into as we go forward and that's going to help.

Hugh Miller

Sure. I mean that would be included in your expectations for next churns - one of the drivers, yes. And then obviously we've seen some of your peers in Europe talking about very strong supplies coming to market in the fourth quarter in various jurisdictions, but Spain in particular being one of those areas. Can you provide any insight into kind of as you think about supply coming from the direct issuers versus maybe some of the financial buyers that are exiting the market? How much of an opportunity is there in the resale market to be coming to market aside for just the general in a direct market?

Ken Vecchione

We are seeing portfolio was offered from issuers and from resellers. And all I'll say as we look at both and we value them appropriately. So we have at least in Spain you've got two sources of supply which is good. In the U.K. for example you got many resellers that are coming up. It's not like back in the U.S. a couple of years ago where you could buy directly from issuers and you could buy some of the resellers as well.

Hugh Miller

Okay. That's helpful. Thank you.

Ken Vecchione

Operator, I think we have time for about one more call, one more answer the question.

Operator

Thank you. Next question comes from the line of Mark Hughes with SunTrust. Please go ahead.

Mark Hughes

Yes, thank you. The cost of legal collections was actually 14% of the total collections in the quarter which is higher end of recent range, you are lower in the second quarter and low in the first quarter, but compared to the third quarter it seems like you are a fairly full run rate. In the historical terms would - is that $5 million will you be layering on legal expenses, so you'll be above the recent trend on a go forward basis?

Ken Vecchione

So I think if you're looking at the consolidated statements, you'll have Cabot in there as well and what you don't see is the Midland.

Paul Grinberg

In the Q we break out the cost to collect for the legal channel for the quarter and for the nine months separately. So you’ll see that it's much lower for the third quarter - for the cost of legal collections for that channel as a percent of that channel's collections. Overall numbers, U.K. - I mean European numbers are also a part of them.

Mark Hughes

All right, okay. Got it. And then the tax item I think Jonathan you'd suggested another $10 million in higher taxes, is that to say we would take whatever our assumption for taxes would be at $10 million which is roughly $0.40 per share and that's what the impact out of these the extra $0.40 from that related to these items?

Jonathan Clark

You’re right. It's basically what you expect and then you add $10 million. And just the people understand and it just with the loss we took right as I explained earlier cut both ways, so we lost money in the low tax rate jurisdiction that pushes up your effective tax rate for the year. If you look at the three months ending September 30, it looks like a very low tax rate and that's because we've already paid, we've already accrued taxes in period one and two to get to period three you just effectively treating up to get to where you need to get to right and you just had incurred a big loss.

So you end up having a what I'll call somewhat understated number, but the fourth if you look at the nine-months number, Mark, you'll see that's 53% for the last nine months and you can have a tax rate for the year of something in the mid-to high 50s.

Mark Hughes

And then the tax rate for next year on a run rate basis?

Jonathan Clark

It will be caught mid to low 30s.

Mark Hughes

Mid to low 30 okay. All right. Thank you very much.

Ken Vecchione

Okay. Thank you all for joining us today and we look forward to spending more time with you on our Q4 earnings call. Thanks again, everyone.

Operator

Ladies and gentlemen, this concludes our program for today. You may all disconnect. Have a wonderful evening.