2023-08-03 17:08:44 ET
Summary
- Encore Capital Group's stock had a mixed performance because of a sudden compression of their EPS in the last year.
- The company is deploying capital at attractive returns, which will result in higher collections, earnings, and cash generation in the next few years.
- Encore has significant liquidity and flexibility to continue investing in higher-yielding assets, and the market is excessively bearish on the company. We estimate an upside of around 20%.
We already covered Encore Capital Group ( ECPG ) in August 2021, assigning a strong buy rating, and since then the stock had a mixed performance. First, it rose to an all-time high above $70, increasing more than 50% since our article. However recent challenges on profitability drove the price back to the same levels as our first publication. But we are still very confident about this company’s prospects and we will explain here why.
We believe that Encore Capital Group is currently deploying capital at very attractive returns at record speed. This will result in higher collections, earnings, and cash generation in the next few years. Right now the company is facing some temporary headwinds as higher funding costs impact the EPS while the collections are sitting at historically low levels. We think this is set to change in 2024, as the capital allocated in the last two quarters will start to be collected at significantly higher valuations.
Overview: purchases today generate cash tomorrow
Just as a quick recap, Encore is in the business of buying distressed credit and debt at a deeply discounted price and recollecting the due amount for a gain on the difference. There are many similar players, but Encore is one of the few pure plays that are publicly traded.
Encore has been investing more than $200 million per quarter since the beginning of 2023 now. These allocations are happening at very generous pricing given that the environment of distressed credit is normalizing after years of uncommon behavior. This was caused by zero interest rates and massive government spending that caused a strong reduction in charge-off rates and default rates, negatively impacting players like ECPG.
This is a snapshot of what the allocations (purchases) look like over the last years. As we can see, the quarters between Q2 2020 and Q2 2022 have been characterized by an extremely low new capital allocation. Thankfully, the increase in interest rates is benefiting ECPG in terms of creating an attractive pricing environment that benefits new purchases, as we see in 2023.
Eventually, these allocations generate future earnings and cash flows.
This chart is indeed representative of that mechanism. Those higher collections between 2020 and 2022 were the results of the 2019-2020 purchases. And for the same pattern, the lower collections in 2022 and 2023 are the outcome of the lower purchases shown in the 2020-2022 period. Basically, there is a direct correlation between purchases and collections that however is subject to a delay of a couple of years. This is why we think that going into 2024 we will see a pick up of cash generation due to a normalization of the credit environment taking place since early 2022.
We also note that ECPG just reported earnings yesterday, and we can gather a good understanding of what management is expecting. From the call transcript :
Importantly, as pricing continues to improve, we expect to collect more for every dollar of capital deployed. The portfolio supply pipeline for the remainder of 2023 is expected to remain favorable and MCM will continue to focus on maximizing returns in this environment.
The CEO confirmed the better pricing environment is the main driver of the allocations as they are able, in the future, to collect “more for every dollar deployed”. Meaning higher-than-average returns in the future. And then goes on confirming that they will continue to buy at max capacity for all of 2023. But what’s the “purchasing power” of Encore (i.e. its liquidity and capital position)? Let’s see.
A look at their funding profile: contained leverage and high flexibility
To finance the purchase they “use a mix of debt and equity”, because they deploy their own cash but also tap their credit facilities. In particular, their debt and maturity profiles look like this:
The bonds are in dark blue, and the big purple facility is a revolver. As one may expect this last form of debt is at a variable interest rate, which means increased interest expense as rates go up. However, here’s again Encore’s competent management kicking in: there are an overall $880 million of rates caps purchased between 2019 and 2021 that thus significantly limit exposure to increases in rates. These caps are in place for the entire 2023 and expire between June and September 2024, leaving some hopes that rates may come down in the meantime.
We also note that the leverage profile, especially in terms of debt-to-equity, is significantly below the historical average. And this is despite (1) a reduction in EBITDA in the short term, and (2) massive allocations that drained out liquidity in the last months.
Leverage Profile (Latest Presentation)
We conclude that there is significant room for expansion in the upcoming months, and the company has close to $500 million between debt and cash to allocate.
Risks: Encore’s weakness lies with the macro environment
The main risks around Encore are macro-related. We saw exactly what happened during the Covid liquidity bonanza: there were no interesting assets to acquire and the pricing environment was totally out of line. Were a similar situation to occur again, and for a more prolonged period of time, the business model of Encore itself could potentially collapse. We saw that the result of the reduced investing activity between 2020 and 2022 yielded depressed EPS. If any future “liquidity bonanza” was to last for more than 2 years, the company would probably be forced to restructure and/or downsize.
However, we are confident that this risk is limited because it would require an extreme policy environment with zero rates and absurd fiscal spending that lasts for a prolonged time. Given the recent experience with spiraling inflation, we doubt that the policy makers will be ever willing to do so. But still, it is a non-zero probability risk.
Looking ahead: estimated collections and shareholders' remuneration
As we discussed, we are expecting higher collections ahead. As we enter 2024, the return profile of the 2022 and 2023 deployments should be clear to the market, and ECPG will likely experience a higher valuation (and stock price). But we also think that the shareholders' remuneration policy is the key to making a re-rate of the valuation as generous as possible.
And if we look at distributions to shareholders in the form of buybacks, we remain assured that it is up there on the management’s agenda. Indeed, between 2021 and 2022 the company bought back shares for a total consideration of around $500 million. This is almost 40% of the current market cap of Encore.
ECPG Historical EPS (Seeking Alpha)
We think that given the deployment of cash taking place in 2023, we should expect a normalization of EPS above $5 in 2024, as a result of the collections. We would also point out about valuation.
This is the historical P/E ratio that the market assigned at ECPG. As one can see, it has been consistently above 10 for many years and then decreased to around 5 in the most recent years as the market understood it was operating under extraordinary circumstances. We believe in a fair multiple that is around 12 times earnings, given (1) the consistency in earnings/collections and thus the efficiency of the company, (2) expansion of the EPS happening in cycles, and (3) better prospects of returns ahead because of higher long-term rates.
If we add together the estimated EPS of around $5 for 2024, and the P/E multiple of 12, we get to a fair price of $60, with an upside potential close to 20%.
Conclusion
Encore Capital is deploying cash at a record speed, and we think that this will translate into much higher EPS in 2024 and beyond. The company has significant liquidity and enough flexibility with its own cash reserves and their debt facility to continue to invest in higher-yielding assets throughout the end of 2023. We think that the market is excessively bearish and that the company presents an upside of around 20% from the current price.
For further details see:
Encore Capital: Deploying Capital At Attractive Returns At Record Speed