Encore Capital Group Inc (ECPG) 2004 Q2 法說會逐字稿

At this time I would like to welcome everyone to the Encore Capital Group conference call. (Operator Instructions). Thank you. Ms. Conlon, you may begin your conference.

Good afternoon, and thank you, operator. We'd like to welcome everybody to Encore Capital Group's second quarter conference call. Today's webcast is being accompanied by a slide presentation which is available at www.EncoreCapitalgroup.com on the event calendar under the investors page.

With us today from management are Carl Gregory, President and Chief Executive Officer, Barry Barkley, Chief Financial Officer, and Brandon Black, Chief Operating Officer. Management will discuss the second-quarter results and company developments and will then open up the call up to your questions.

Earlier today, Encore Capital Group filed its 10-Q for the second quarter. This is a complete report of Encore's results and I encourage you to read it thoroughly because it contains a great deal of useful information.

Before we begin, I would like to refer you to slide two which addresses forward-looking statements. I would also like to note that certain statements in this conference call and slide show constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements involve risks, uncertainties and other factors which may cause actual results, performance or achievements of the Company and its subsidiaries to be materially different from any financial results, performance, or achievements expressed or implied by such forward-looking statements. For a discussion of these factors, we refer you to the Company's quarterly reports on Form 10-Q and to the Company's annual reports on Form 10-K for the year ended December 31st, 2003, filed with the SEC. Forward-looking statements speak only as of the date the statement was made. The Company will not undertake and specifically declines any obligation to publicly release the results of any revision to forward-looking statements to reflect events or circumstances after the date of such statements, or to reflect the occurrence of anticipated or unanticipated events, whether as a result of new information, future events, or for any other reason.

With that I would now like to turn the call over to Carl Gregory. Carl?

Thank you, Moira, and good afternoon to all of you.

Encore enjoyed another good quarter. Our collections, revenue and net income all increased. In addition, we closed a terrific new loan with J.P. Morgan Chase that dramatically lowers our cost of borrowing, increases our flexibility, and should result in better financial returns for Encore.

Finally, just after the end of the quarter, we closed the biggest purchase we've ever made on terms we considered quite attractive. We are very excited about our industry and its future, but most importantly, Encore's ability to excel in the future.

Barry will go into detail about our results in a moment, but I would like to share with you the highlights shown on slide three. Compared with the second quarter of 2003, our collections were up 23 percent, revenue increased 54 percent, pre-tax operating cash flow was up 84 percent after the exclusion of the onetime benefit in Q2 of 2003, and net income grew by 69 percent.

Continuing on to slide four, the most noteworthy accomplishment in the quarter other than our strong financial results was the closing of our new loan. It is a material improvement over our previous arrangement and it provides the flexibility the Company needs for the remainder of 2004 and beyond. The financial terms are better in two key areas.

First, we had the choice of tying our investments to either prime plus zero or Euro dollar plus an applicable spread, which can vary between 200 and 300 basis points. Our old loan had a base rate of prime plus 200 to 300 basis points depending on the amount outstanding. As nice as this improvement is, the most important difference is that the new loan has no contingent interest feature, or any other participation feature. All other things being equal, the absence of future contingent interest expense will contribute to a big improvement in Encore's financial results.

Encore recorded contingent interest of $16 million for all of 2003 and $17 million in the first six months of this year. To put this in perspective, if you could completely eliminate contingent interest in the first half of 2004, our earnings per share would have been 94 cents, or 88 percent higher. Although we will continue to pay contingent interest on those portfolios financed with our secured financing facility, it will decrease rather rapidly. In 2005, we expect it to be only 60 to 65 percent of the 2004 amount, and in 2006 only about 25 or 30 percent of the '04 expense, before it completely goes away, which could in effect double our net income over this period before factoring in any underlying business growth.

Our industry has seen a great deal of change in the past four years, most notably there has been a recognition that the disciplined, long-term players have produced excellent returns. That recognition has brought new capital into the market. Many of these new entrants are attracted to a return expectation without understanding the complexity of the business. They tend to rely on the conventional methods of collection, often working exclusively through collection agencies. Our principal planning assumption is that this business is constantly evolving.

We have listed the three most important likely changes on slide five; they are -- better capitalized competitors, smarter sellers, and greater diversity in the types of assets available for purchase.

We believe our business model is especially well-suited to this changing environment. Specifically, our business model emphasizes customer-level rather than portfolio-level analytics, innovative and flexible collection processes and conservative accounting.

The keystone to everything we do is customer-level analytics -- understanding the individual customer and his changing ability to pay. Prior to purchase and throughout our ownership, we analyze the individual customer's ability and willingness to pay. We are always asking the same question -- can this particular customer pay us all or some of what he owes now? By focusing on the customer and information about him, we are able to move comfortably across various asset types as well as the portfolio ages or time since charge-off. In this process, a score is generated for every single account we own and the score is refreshed quarterly to ensure that it maintains its accuracy.

The second major aspect of our business model is our use of innovative collection strategies that are driven by the underlying collectibility score of each customer. In other words, to fully benefit from the new information we are generating about the individual customers, we have to be able to apply different collection strategies as appropriate, or at least be able to apply the traditional approaches in new ways that will be more effective.

We now have eight unique revenue channels that each contribute more than $1 million per month in collections, including direct mail, balance transfer, external legal, and our recently developed agency outsourcing strategy.

Finally, we are committed to conservative accounting. We're willing to push the envelope on analytics and process, but not accounting. Recognizing that much of what we were doing was new and untested, we decided to report as fully and clearly as possible about what we had accomplished, but not assume any more about the future than our experience to date would permit.

And now, Barry will walk through our second-quarter financial results.

Thanks, Carl.

As you can see on slide six, the second quarter of 2004 was a very strong quarter with gross collections of 57.4 million, up 23 percent from the second quarter of 2003. Revenue amounted to 43.6 million, an increase of 53.5 percent, while operating expenses increased 39 percent to 25.4 million. This resulted in income before taxes of 9.3 million, up 67.8 percent over the prior year's second quarter, while net income rose 69.1 percent to 5.6 million.

Slide seven further examines gross collections. The $10.8 million increase in gross collections reflects continued leveraging of our additional collection channels that do not require commensurate increases in the number of employees. As I stated earlier, we had a 23 percent increase in quarter-over-quarter collections. During the same period our total employees increased only 13.3 percent, from an average of 670 people in Q2 of 2003 to 759 for the quarter ended June 30th, 2004.

Our high collector retention rates, coupled with our innovative alternative collection strategies, resulted in an increase of 8.6 percent in the monthly average collections per employee, to 25,200 from 23,200 during the quarters ended June 30th, 2004 and 2003, respectively. As we have discussed in prior calls, it is our goal to continually improve the overall productivity of each employee in the Company instead of just focusing on our collectors.

Another noteworthy fact in the second quarter was growth in collections despite the relatively small amount of portfolio sales. Sales have the effect of increasing cash collections in the period when the sale takes place, but lowering the multiple -- the purchase multiple we recognize over time. Therefore, we only sell when we believe we can significantly improve our position. This quarter sales were only 8 percent of total collections, compared to 14 percent in the same period last year.

Total revenues grew 15.2 million to 43.6 million, or 76 percent of total collections. This compares with 61 percent of total collections in the second quarter of last year. The increase in revenue recognition is a function of two continuing positive trends, shown on slide eight.

First of all, zero-basis revenue on portfolios which no longer have a book value grew 241 percent, from 3.3 million in the prior year's quarter to 11.1 million in the second quarter of this year. Second, our performance on portfolios with a remaining book basis continues to be stronger than our adjusted forecasts. The result is that we are seeing the natural transition to higher accretion percentages given our conservative initial revenue recognition. Our life-to-date accretion is still very conservative at 63.4 percent. I would refer to the new vintage (ph) analysis table in the quarterly report filed with the SEC on page 48, which shows you collections by year of origination.

Turning now to page nine. Total operating expenses were 25.4 million, or 44 percent of gross collections, compared with 18.3 million, or 39 percent of gross collections in the second quarter of 2003. This five percent increase in our expense ratio is a function of three things -- first, increasing employee benefit costs, including health-care; second, additional corporate compliance costs for Sarbanes-Oxley implementation and SEC filing costs related to our Form S3; and third of all, lower sales volume for the quarter.

Other variances were largely related to the increased volume of collections and reflect the growth in the costs of our external legal collection channel and the continued growth in our agency outsourcing channel. Despite the increases in the second quarter, we expect our cost per dollar collected to fluctuate around our 40 percent target, depending upon the mix of revenue sources in any one period.

The bottom line can be seen on page 10. Income before taxes as a percent of gross collections increased 67.8 percent to 9.3 million. Net income increased 69.1 percent to 5.6 million, as compared to the prior year's quarter. On a fully diluted earnings per share basis, we earned 24 cents in the second quarter, an increase of 41 cents -- 41 percent -- excuse me -- over the prior year.

We run the business on a cash basis, and our strong improvement is highlighted on slide 11. Pre-tax cash flow from operations increased 84 percent, from 8.1 million to 14.9 million. This excludes the 7.2 million litigation settlement recovered in the second quarter of 2003. The Company exhausted its federal and state tax net operating loss carryforwards in the fourth quarter of 2003 and began to make income tax payments in 2004.

Turning now to purchases. As you can see on slide 11, our investment in portfolio continues at a good pace. During the second quarter of 2004, the Company spent 19 million to purchase approximately 759 million at face value at a blended purchase price of 2.51 percent. Credit card portfolios represented 67 percent of the total purchases in the second quarter, and non credit card portfolios represented the remaining 33 percent.

Not included in the second quarter purchase is the $13 million acquisition of a portfolio representing approximately 421 million at face value that was negotiated in the second quarter and closed immediately after the end of the quarter. Approximately 84 percent of this portfolio consists of non credit card accounts.

Taking into account our $13 million acquisition, our year-to-date investment in portfolio through July 2004 of 53.4 million is slightly ahead of the 50.6 million investment in portfolio through the prior July year-to-date. On a year-to-date basis, credit card represents 51 percent of the purchases, while alternative paper has risen to 49 percent.

Thanks, Barry.

Purchasing is, obviously, quite important, and I believe we do it very well. However, we approach it differently than most. When meeting with shareholders, analysts and lenders, we invariably spend a significant amount of time discussing the purchasing environment. Because there has been so much focus on it lately, I'm going to ask Brandon to talk about our recent experiences.

Thanks, Carl.

Without question, there has been a general upward pricing trend for unsecured consumer receivables. However, as mentioned in prior calls, those increases vary with the age of the portfolio and the product type. The largest increases appear to be in older paper with less pressure on fresh paper. We have two unique strategies for managing through this rising price environment, and they are listed on slide 13.

First, our consumer level evaluation process allows us to identify those portfolios with the largest spread between expected return and market-clearing price. Our internally developed statistical models take into consideration data provided by the sellers, our historical performance on similar accounts, and data we purchase from third parties. This is a substantial competitive advantage because we believe we are one of the few, if not the only company, focused on valuing individual consumers, not portfolios.

Second, over the past three years we have successfully broadened our sources of paper along three dimensions -- age, paper type, and seller. In any given month, we are evaluating transactions in many different asset classes regardless of age or seller. This has allowed us to identify significant opportunities in the various markets, which is critical to maintaining a disciplined purchasing philosophy. The portfolio acquisition we announced in early July was a direct result of this diversified strategy. We worked closely with the seller to negotiate a transaction on terms that we believe are quite attractive, without it going out for competitive bid.

Interpreting quarterly purchase price fluctuations is more difficult to address, and is probably the biggest red herring in our industry. Purchase price does not translate into collection returns. To use a sports metaphor, it is a measure of the degree of difficulty of the dive, but does not give an investor the ability to predict future collection returns. These returns are ultimately driven by the collection capability of the company and how closely actual collections correlate to assumptions in the business model.

We believe there are two more accurate measures of future success -- they are inventory turnover ratio and estimated remaining amortization period. These two metrics are detailed on slide 14 and are valuable measures of the quality of receivables on the balance sheet. They can also provide a good indication of whether a company is paying appropriate prices for portfolios.

The inventory turnover ratio is calculated by dividing the existing receivables inventory at the beginning of the period, plus any new purchases, into collections for that same period. For example, if we started the year with a $10 investment in receivable portfolios, and we spent another $10 buying new portfolios in that year, our total portfolio balance would be $20. Now, if we collected $30 in that same year, our annual portfolio turnover ratio would be 1.5 times.

You can take the analysis a little further and calculate the duration of the estimated remaining amortization period. You start with the receivables balance at the beginning of any period, and you divide that by an appropriate historical amortization rate to obtain the amount of future collections required to bring the balance to zero. For example, if you begin the year with investment of $10 in receivable portfolios, and had an amortization rate of 25 percent in the prior year, then you would need to collect $40 to reduce the existing book value to zero.

Finally, you divide the average monthly collections into the total collections to determine the estimated remaining amortization period. In this example, if we assume average monthly collections of $5, it would take eight months to amortize the balance. In reality, collections are not constant and tend to decline over time. Therefore, the longer it takes to amortize the balance, the greater the risk of not achieving the forecasted collection targets.

To take this from the hypothetical to the actual, please turn to slide 15. Encore's inventory turnover ratio using annualized purchase and collections was 1.5 at the end of the second quarter. It is worth noting that this metric has been relatively stable over the past year, during a period of time when there has clearly been some pricing pressure in the marketplace. We would caution you against tracking fluctuations on a quarter-to-quarter basis, as inventory turnover can be impacted on a temporary basis by a quarter where there is a lot of purchasing activity or a quarter where there was a lot of collections, such as the seasonal impact we see in the first quarter of the year.

The bottom half of the slide calculates the estimated remaining amortization period for our receivable portfolios' balance on June 30th, 2004. Using the average monthly collections for the first six months of the year, we would need just over four quarters to fully amortize the current balance. We believe these calculated metrics are industry-leading and provide good evidence of the disciplined approach we have been using for purchasing, and the conservative nature of our accounting. They can also be used to compare companies in our industry and are easily computed using publicly available data.

In summary, we are comfortable our purchasing philosophy will continue to yield sufficient volumes of profitable portfolios, and believe all will be well served by focusing on the two new metrics I introduced instead of the average price paid for portfolios in the quarter.

Thanks, Brandon. The metrics we discussed today hopefully give you a clear picture of how well the Company is doing. When viewed along with the traditional measures of financial performance, we think an investor can get a more complete understanding of Encore's performance.

In summary, we had another good quarter. Our new loans should be a big boost to earnings, and we are encouraged about the future of the business.

We would be happy to take your questions.

(Operator Instructions). Richard Shane, Jefferies & Company.

A couple of questions. One is, on -- there was a lot of fluctuation this quarter on the cost, operating expenses per dollar collected. And Barry, you had made the comment sort of as you were going through that that you expected it to normalize at about 40 cents on the dollar collected. Can you give us some explanation of why it was down so much in the first quarter, popped up this quarter, and then sort of help us understand why it stabilizes in the back half of the year around the 40 percent level?

The other question is, it looks like during the quarter your lifetime collection expectation on the existing pools increased. Can you talk us through what the ratio is going forward, or what your expectation is going forward?

On the expenses, a couple of things occurred. Obviously, the first quarter has in general on a seasonally-adjusted basis the strongest quarter in terms of collections, and therefore the ratio, other things being equal, would be lower. We had some, and we will continue to have in the third quarter, some nonrecurring expenses related to the implementation of Sarbanes-Oxley, as well as our S3 filing costs. And while we, obviously, can't say that we won't do additional S filings or 33 F. filings, we don't see any more in the near future. And there is clearly -- this was a filing which the Company had to pay all of the registration costs under the registration rights.

Second of all, there were some increases in the medical and healthcare costs that we're working very actively on. We, essentially, by June of next year, will have in place a plan that we think will give the employees a great deal of incentive to actively manage their costs. So we will probably continue to see the effects of that for the next couple of quarters. But most of all, the sales being the lowest component of the total collections in this quarter -- sales are a very low-cost channel for us, so when they are there, they are there with a very small cost; and when they're not there, the small cost is gone but a bigger amount of collections are gone, so it dilutes the ratio. And then on the lifetime collection expectations (multiple speakers)

What we did this quarter, this is our third quarter of revaluation of portfolio. And each quarter, the amount of revaluation continues to decline, meaning that we are picking up less and less, as we had anticipated we would. Our impact on this quarter was about $3 million in revenue and about 900,000 on contingent interest expense. So all-in-all, not a hugely significant ratio. The multiples that we see going forward are probably now just to 2001 -- the years 2000, 2001 -- in our financials. In the back of the Q, there is a table on, I think, page 48 that shows the multiples. So hopefully that helps.

I'm looking at that table; so somewhere between -- closer to three times as opposed to 2.7 historically?

Probably closer to 3.5 I would say.

And there was one thing that you said that I'm not sure I understand. I understand how the revaluation would affect the revenue recognition, but I'm not sure I understand how it impacts contingent interest expense, because I thought that was actually based on dollars collected, not revenues recognized.

It's based upon the back end of the portfolio. And essentially, if you recall, Rick, prior to the fourth quarter of last year, we kept shortening our portfolios. We kept the original (inaudible) of the curve, so we shortened the average life from 54 months down to around 31 months. And now we're going back the other way, and essentially we are adding collections back and increasing the total amount under the curve. So we are ending up about 41 months, I think. We are actually sharing residual collections here, which is as we increase the back-end, about 30 cents of every dollar on the back-end goes to (indiscernible).

But the accrual for the contingent interest is based on the lifetime expectations from the portfolio. So as we increase the amount we expect to collect lifetime, we are increasing our accrual.

Got it. That makes sense. I was looking at it on a cash basis; I wasn't looking at it on an accrual basis. Thank you, guys.

Richard Eckert, Roth Capital Partners.

Just a quick question, probably more for Barry. It seems that the revenue from retained interest grew sharply to 810,000, and yet I believe that that has amortized down to zero. Can you explain that?

In essence, Rich, we covered all the book value of the retained interest, and so we're now getting approximately a couple of $100,000 a month. And every dollar that we get is recognized as revenue since we have no more basis to recover. So it's essentially zero basis income.

Audrey Snell, Brean Murray & Co.

Nice quarter, gentlemen. Can you give us some help on how the other line item in revenue servicing fees and related income is looking over the next few quarters? Is that tailing off on a consistent basis or what?

We only service a small amount. It's a legacy portfolio, and it -- we actually gave all of the portfolio back to the owner 18 months ago, I believe. And so the only amounts that we're continuing to service are those that are in active Qs or in litigation. So this amount should runoff in the future. Because some of it is in litigation, it could take awhile for it to run off completely.

Carl, eventually will it get to zero?

I think so.

The other question is collection and legal costs shot up markedly in the quarter, about 1.2 million sequentially. Can you explain that or give us a little help on that one?

The big change was legal recoveries shot up substantially and the ensuing cost went up also, but the cost per dollar collected went down in the quarter from that channel from about around 40 percent to about 38.5 percent. But that was strictly volume-driven and it improved as a ratio of the dollars collected.

Can that improve further, based on volume increases?

You know, as we've said in the past, it's about where it can possibly go. So you will see it move up and down as the numbers change, but I wouldn't expect much improvement.

Justin Hughes, Philadelphia Financial.

I just wanted to ask about the revenue per dollar collected. That's gone up quite a bit, and I know part of it is the impact of the zero-basis portfolios. But this quarter you actually had less from the zero-basis portfolios and your ratios still went up higher.

Yes. They're really, as you have indicated, Justin, they're two moving parts. We had less but we still had $11 million on total collections of 56, where last quarter we had about 12 on the collections of about 64. So clearly, zero basis is continuing to be a strong part of our income. The other part is, if you go back to our business model where we pay $100 for a portfolio, and we set it up initially on $270 of collections, and prior to the fourth quarter of last year we had not increased the amount under that curve. As a result of that, on well over half of the portfolio is we were through most of the book value. And then on probably about a fourth of the remaining ones, our book value was very small. So as a result of that, any increases in future collections will end up making the ratio very high. In other words, let's say we had gotten through 250 of the $270 of collections -- if we had another $50 of collections, you would be spreading that -- as a percent of total collections it would be a very high percentage, which is one of the reasons that we showed the -- pardon the sirens in the background -- which is one of the reasons we showed the cumulative percentage of accretion to total collections, and will continue to disclose that as we go forward, at 63.5 percent for all portfolios.

Okay. Is that where you expect to trend back to over time?

I think as we buy more portfolios and the mix changes, both as zero-basis diminishes and as we have gotten through pretty much of our upward adjustments out of the existing portfolios, as the mix tends to shift in favor of new purchases, we would expect it to go back down into the low 60s.

Okay. How many more quarters do you expect to be revaluing the portfolios?

Well, essentially we will revalue them every quarter, but we would expect the impact of the revaluation to be a fairly small amount as we go forward in future quarters.

What was the EPS impact this quarter?

It would be about $2 million pre-tax (inaudible) would be about a million, would be about (multiple speakers) five cents.

Five cents? Okay. Last question. One of your competitors this morning kind of talked about their collections by month. And they said that April and May were very strong, and then they said they saw a noticeable drop-off in June. And they think that maybe that the big gains and the strengthening of the economy are slowing down. Did you see a similar thing in your collections for the quarter?

Frankly, we don't discuss the collections by month, but we have not seen any material change in collections, relative to prior months or relative to our model.

(Operator Instructions). Audrey Snell.

Barry, with regard to this new lending arrangement with J.P. Morgan, do you have the option of choosing the LIBOR or the prime-based rate more than once? In other words, can it be changed month by month or quarter by quarter? How does that work?

It essentially is -- yes, we can. And we have, I think, 30 buckets in which we can place LIBOR related debt. So if we for example look at what -- put what amount of loan will be outstanding over a six-month period, we can put that in a six-month LIBOR bucket; and depending upon our forecast of rates, we may want to pick a shorter bucket or a longer bucket depending on whether we think rates are going up or down -- or down or up rather. So we have an enormous amount of flexibility in this credit. So essentially we will probably borrow at prime base to begin with until we accumulate a bucket of indebtedness. And for example at the end of the July, we are anticipating that we're going to -- in the next week we're going to roll that over into a LIBOR-based bucket -- probably a 60-day LIBOR, and then we will accumulate collections during the quarter.

Will you hedge that at all?

You know, we are looking at that. We haven't made a decision yet. I do think that the trend of rates, obviously, is up. And at some point -- I think right now the hedge rates show the effect of that already. So if we think it's going to go up even more than the forecast, then we probably will hedge. We're having some conversations with the Banc One folks -- J.P. Morgan banking.

Do you have the option of fixing that rate during the course of this agreement?

Yes. Fixing that through hedges, yes.

But not without the hedge?

But not without the hedge, correct.

And one last question. What is the term of this, three years?

Three years.

And it's 75 million; can you increase that amount?

Yes. It's an expandable -- it has an accordion feature that will allow us to go to 100 million.

(Operator Instructions). There seem to be no further questions. Please go ahead with your closing remarks.

We had another excellent quarter and we are excited about the rest of this year. We appreciate you tuning in to our conference call. Thanks very much.

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