Encore Capital Group Inc (ECPG) 2006 Q3 法說會逐字稿

Good afternoon ladies and gentlemen, and welcome to the Encore Capital Group third quarter 2006 earnings conference call.

[OPERATOR INSTRUCTIONS]

I would now like to turn the conference over to Tony Rossi of the Financial Relations Board. Please go ahead.

Thank you operator. Good afternoon and welcome to Encore Capital Group's third quarter 2006 conference call. With us today from management are Brandon Black, President and Chief Executive Officer, and Paul Grinberg, Chief Financial Officer.

Management will discuss third quarter results and then open up the call to your questions. Earlier today, Encore Capital Group filed its 10-Q for the quarter ended September 30, 2006. This is a complete report of Encore's results and we encourage you to read it thoroughly as it contains a great deal of useful information.

Before we begin, I'd like to note that certain statements in this conference call 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 SEC filings, including its annual report on Form 10-K for the year ended December 31, 2005.

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 reflect the occurrence of anticipated or unanticipated events, whether as a result of new information, future events, or for any other reason.

In addition, as most of you know, the company announced on June 5, 2006, the formation of a special committee of the board of directors to consider strategic alternatives. The special committee has retained JP Morgan Securities, Inc. and Deutsche Bank Securities, Inc. as its financial advisors.

The company announced that it does not intend to disclose developments or provide updates on the progress or status of the strategic alternatives review process, or of any strategic alternative under consideration unless and until the board of directors has approved a specific transaction. As such, the focus of today's call will be on the company's third quarter 2006 results. Management will not discuss or answer any questions related to the company's consideration of strategic alternatives.

With that, I would now like to turn over the call to Brandon Black. Brandon?

Thank you Tony and good afternoon. The third quarter was another solid quarter for Encore. During the quarter, we saw the continuation of many of the trends we experienced last quarter, most notably normal, seasonally adjusted collections, continued progress with our new liquidation strategies, and the acceleration of up front expenses required to support the development of these new initiatives.

We also began to see the impact of these new strategies on our ability to purchase portfolio. Before I review the quarter in more detail, it is important to note that many of this quarter's metrics are not favorable as compared to the prior year because of the significant purchase volume in the second quarter of 2005, which included the $2.8 billion portfolio that we purchased from Jefferson Capital.

In the second quarter of 2005, we spent $121.9 million on new portfolio, compared to 21.3 million in the second quarter of 2006. Since our highest level of collections on newly purchased portfolios occurs in the first few months immediately after the purchase, the Jefferson Capital transaction drove significantly higher collections in the third quarter of 2005.

Our purchasing strategy will, from time to time, cause a variability in our quarterly results, therefore, we continue to guide investors to look at returns over a longer period of time and not focus solely on any particular quarter's results. Taking this into account, let me focus on our 2006 third quarter results.

Gross collections were $75.8 million. Given that we are at the beginning of the slower part of the annual collection cycle, these results were in line with our expectations. Earnings per share for the third quarter were $0.22, down from $0.33 in the third quarter of 2005.

There are a number of expense items that impact the year-over-year comparability of our earnings per share, including approximately $0.04 per share related to stock option expenses, $0.02 related to the full quarter impact of increased amortization expense resulting from the Ascension acquisition and $0.02 per share related to the costs associated with our strategic alternatives process.

We continue to see positive results from our new liquidation initiatives as well as our developing operations in India. As a result of the collections from our new legal strategies, for the first time in our history, the legal channel contributed more collections than any other channel in the quarter.

We are clearly seeing the incremental portfolio liquidation that we envisioned and we expect to see improved, long-term results as we expand the use of these strategies to a broader set of portfolios. This is most visible when you look at our 2005 vintage, which now includes $24 million of estimated remaining collections as of September, 2006, from these strategies.

A significant portion of the cost of these initiatives, however, is front end loaded while the collections occur over time. This has a negative near-term impact on our expense levels. We are optimistic that our continued success will allow us to increase the estimated remaining collections and the IRRs on other portfolios of our existing portfolio in the future. In addition to providing lift on our legacy portfolios, these strategies give the company additional pricing flexibility when bidding on new portfolios.

Turning to our investment in India, we continue to scale these operations and add it to our workforce during the quarter. Gross collections continue to grow at this site and reached nearly $500,000 in the month of September. While this amount may initially seem to be insignificant, when you consider that the account balances collected in India are predominantly less than $300, we consider this to be a huge accomplishment.

Again, we emphasize that this is a liquidation strategy, not a cost play. Previously, we would have had limited strategies to collect on these types of accounts, and now consider this to be a competitive advantage and an integral part of our overall collection strategy. The success we have seen in India is also allowing us to bid more aggressively on portfolios with a significant portion of very low balance accounts.

Moving to our bankruptcy servicing business, as expected, Ascension Capital had a revenue decline this quarter to 3.4 million from 6.2 million in the second quarter. As we indicated on our last call, we expect Ascension's revenue for the fourth quarter to be at levels similar to the first and third quarters. While Ascension will generate little contribution to our bottom line in 2006, we continue to believe in its long-term prospects and are making the necessary investments to win new customers and grow the business.

Finally, turning to purchases for the quarter, we invested $32 million to buy approximately $1.1 billion in face value of debt. While the pricing environment in the third quarter remained elevated, we continued to find good value in alternative asset classes such as telecom, consumer loans, and other deficiencies, which comprised of both of our purchases during the quarter.

We also continue to gain traction in the healthcare receivables market and have closed another purchase in this area. The healthcare market continues to develop and we look forward to expanding our footprint in this asset class.

Of note in the third quarter, we fully in-sourced the collections on our large initial healthcare purchase made in September, 2005. Our healthcare team in Phoenix is fully staffed and is handling the entire portfolio.

As we go forward, collection agencies will be part of our collection solution, but we believe optimal liquidation can be achieved only when we apply our analytics to the daily operating decisions. Overall, we remain steadfast in our disciplined approach to purchasing, buying only those portfolios that meet or exceed hurdle rates.

Incorporating our new initiatives into our valuation process is opening new purchasing opportunities for Encore. Of the 32 million spent in the third quarter, approximately 13 was spent on portfolios we would not have been able to pursue prior to developing our new liquidation initiatives. As such, we believe these strategies will have positive, long-term implications for both collections and purchasing, which are key components of building a strong foundation for future growth.

With that, I'll turn it over to Paul to review our results in more detail.

Thanks Brandon. Let me begin with the results from our debt purchasing business. Gross collections in the third quarter of 2006 were $75.8 million, a decrease of 10% from $83.9 million in the third quarter of 2005.

As Brandon mentioned, the impact of the large portfolio purchase from Jefferson Capital makes year-over-year collection comparisons difficult. As such, I will focus my comments on the collection trends we experienced within the third quarter of 2006.

Legal collections represented 40% of our total collections, which reflects the continued growth of this channel. Collection sites represented 38% of collections and outsourced collection agencies represented 16%. The remaining 6% of collections came from portfolio sales.

Our revenue from receivable portfolios in the quarter was $57.2 million, a decrease of 2% from $58.2 million in the same period of the prior year. Revenue recognized on receivable portfolios as a percentage of portfolio collections, was 76% in the third quarter, compared with 69% in the same period of the prior year, and 75% in the second quarter of 2006.

The increase in the revenue recognition rate year-over-year was primarily attributable to the strong collections experienced in the third quarter of 2005, following a large portfolio purchase from Jefferson Capital which had the effect of lowering the revenue recognition rate in that quarter.

Looking ahead to the fourth quarter, we would expect our revenue recognition rate to trend slightly higher, primarily due to the seasonally slower collections that we generally experience in the last quarter of the year. However, as we said previously, the revenue recognition rate is also dependent on the level and timing of purchases in the quarter.

Finally, with regards to revenue from receivable portfolios, netted in revenue recognized for the quarter was an $814,000 allowance charge spread across five pool groups, four of which related to older pools of assets purchased in 2002 and 2003, where we continue to expect to generate nearly four times our original purchase price.

These four pools have high IRRs as a result of our initial conservative outlook and subsequent increase in the forecast over time. While still performing well, as a result of the high IRRs, lower collection levels in the near term will result in an allowance charge, even if there are greater collections expected over the life of the pool group.

Moving on to Ascension, servicing fees for the quarter were $3.4 million in line with our expectations of lower than last quarter. As we mentioned in our last quarterly conference call, the results for the second quarter reflected the impact of the large volume of Chapter 7 placements we experienced immediately prior to bankruptcy reform in October of 2005.

We recognized revenue from our Chapter 7 placements at the end of the average life of the placement, which is seven months. Our results for the third quarter were negatively impacted by the significant drop off in bankruptcy filings following bankruptcy reform. This trend of lower filing volumes has started to reverse and bankruptcy filings continue to increase each month. Industry experts expect that bankruptcy filings will return to the levels experienced prior to bankruptcy reform by early to mid-2007.

At this lower level of revenue, Ascension generated a net loss of $1.1 million following a profit of $1.3 million last quarter. Included in the loss were approximately $1 million in non-cash amortization charges relating to the amortization of intangible and other assets established in connection with our purchase accounting for Ascension. And again, we caution that Ascension's revenue for the fourth quarter will be impacted by lower placement volumes following the spike in late 2005.

Turning to expenses, our total operating expenses for the third quarter of 2006 were $45 million, compared with $37.6 million in the same period last year. Excluding stock option expense of approximately $1.5 million and Ascension, which is a fee-based business, as a percentage of collections, operating expenses increased to 51% in the third quarter of 2006, from 43% in the third quarter of last year, and 49% in the second quarter of 2006.

This increase was primarily the result of the lower level of portfolio sales in the quarter, which generally have a lower cost structure than other collection channels, and the continued investment in our new liquidation strategies.

As we have indicated previously, a significant portion of the cost associated with our new strategies are incurred up front, particularly in the legal channel. As these initiatives ramp up, we continue to see our legal cost as a percentage of collections from the legal channel higher than historic trends.

We would expect this ratio to decline over time to a normalized level, however, during periods where we are ramping up these strategies, these costs could increase. Beyond the recently discussed newer initiatives that are being implemented, we continue to invest in other R&D projects that can produce additional liquidation strategies in the future.

For example, we are adding analytical resources that enable us to conduct comprehensive tests to determine how to optimize the liquidation of portfolios across asset class, balance, age, and credit quality.

In addition, during the quarter, we built up our internal healthcare receivable collections staff to accommodate the return of most of our healthcare accounts that were previously outsourced to a third-party collection agency. As our new collectors complete training and increase their productivity, we would expect a positive impact on our expense to collections ratio.

We incurred approximately $750,000 in expenses related to the company's evaluation and strategic alternatives in the third quarter. This equates to approximately $0.02 per share after taxes. Taking into account the commitment we made to invest in new liquidation strategies in 2006, our expense levels are tracking in line with our internal expectations.

Our total interest expense was $6.7 million in the third quarter of 2006, compared to $8.5 million in the same period last year. Consistent with our expectations, our level of contingent interest expense continues to decline. The contingent interest component of interest expense was $3.8 million in the third quarter of 2006, compared with $5 million in the same period last year.

Our tax expense in the quarter was $3.7 million. Our effective tax rate was 41.5% compared to 40.7% in the prior year. This rate is slightly higher than the 40 to 41% range we expect in the future due to the impact of some permanent book tax differences during the quarter.

Our fully diluted earnings per share were $0.22 in the third quarter of 2006, compared to $0.33 in the same period last year. For comparison purposes, excluding expenses related to stock option compensation, increased amortization resulting from the Ascension acquisition, and costs associated with our evaluation of strategic alternatives, earnings per share would have been approximately $0.30 for the third quarter of 2006.

Our adjusted EBITDA was $35.6 million in the third quarter of 2006, which reflects net income before interest, taxes, depreciation and amortization, stock based compensation, and portfolio amortization. As expected, this was down sequentially as we enter the seasonally slower part of our collections cycle and it is not entirely comparable on a year-over-year basis because of the Jefferson Capital portfolio purchase. We nonetheless continue to profitably liquidate portfolio and generate strong cash flows.

Moving to the balance sheet, our cash and cash equivalence increased more than $6 million from the second quarter of 2006, and our debt increased by more than $8 million. We had built up our cash position and increased borrowings on our credit facility in anticipation of certain portfolio purchases that we expected to make late in the quarter. These purchases were subsequently completed in early October.

These balance sheet variances were more timing related than a change in our leverage philosophy. We continue to expect that during times of solid cash flows, when we do not invest in large amounts of portfolio or new acquisitions, we will continue to pay down outstanding debt.

Before we open up the call for questions, I'd like to turn the call over to Brandon for some additional remarks.

Thanks Paul. As we wrap up today, I would like to say that we feel confident in our business and the approach we are taking. We continue to see excellent growth opportunities in the stress consumer debt industry, but to capitalize on them, we need to operate differently than we have in the past.

We believe we identified fundamental changes in our industry at a very early point in time. These fundamental changes will force companies in the distress consumer debt industry to rethink virtually all aspects of their operating strategies from the assets they purchase to the techniques they use to collect on them.

To effectively compete in this new industry in the future, it isn't a matter of if a company adopts a new operating model, but when. This will be a significant transition and we are well under way in this process and are seeing very encouraging results. Our focus on innovation helped drive the company's tremendous success in the early part of this decade.

We believe the initiatives we have developed and rolled out over the past year, coupled with the new strategies we expect to develop through our ongoing R&D projects, will ultimately position the company to once again produce industry-leading returns in the coming years.

We will now be happy to answer any questions you may have.

Thank you.

[OPERATOR INSTRUCTIONS]

Our first question comes from Jeff Nevins with First Analysis. Please go ahead.

Good afternoon guys. I've just got one or two housekeeping and then a broader question. I'll do the housekeeping first. Was there an allowance charge in the quarter? I heard you talking about it, Paul, and I think I may have missed it.

There was. It was approximately $800,000.

Okay, thanks. And then the amortization rate or the revenue recognition rate, the level that you're at now, does that seem to be more of a normalized level going forward? And I'm just thinking back to the March quarter of this year where it was a different level, but that seemed to be kind of a different time with the Jefferson Capital stuff rolling out pretty quickly. Should I think about the amortization rate going forward, more about where we've been at in the last two quarters?

Well, as we've mentioned before, Jeff, it's going to be very dependent upon seasonality and periods where we have higher collections, like the first quarter, the rate, the revenue recognition rate is going to be lower in periods where we have lower collections like the fourth quarter, though it will be higher, depending upon purchase levels in the quarter.

That will affect the rate also, so you really need to consider all those factors when evaluating what the rate is going to be in any given quarter.

And I assume then the question of, you saw cash collections decline year over year. Going forward, that trend is going to be dependent upon your purchases obviously, right?

That's correct.

And subsequent to the quarter, did you make big purchases? I mean, could you comment on the magnitude of those?

Typically. we don't talk about the level of purchasing in quarters until we've completed that quarter.

Okay. My final question is, this is my broad question I was going to try and get through, was or is, are you guys seeing any change in the sophistication of the consumer? And where this question comes from is the legal channel has been very successful for a lot of companies for a couple of years now and it's been a huge growth factor including with yourself, and I know you're doing -- you're looking at other liquidation strategies.

But I imagine at some point the legal strategy is not going to be as attractive as the consumer just becomes better at understanding what their options are and things like that. Have you -- is that something that you've thought about or am I just coming up with my own theories here?

From our standpoint, I think the legal strategy, the way we apply it, we apply to those consumers who we think have a high capability, but a lower willingness. I think any customer who wants to -- that has options that wants to explore them with us, we'd prefer to talk to them on the phone and work out an arrangement without having to pursue litigation strategy. So we again, I'm not sure kind of the sophistication of the consumer would impact that.

If anything, it would allow us to collect from those people sooner, potentially in a voluntary fashion, but I don't see much of an impact there in terms of our ability to use the legal channel.

Okay, thanks.

Thank you. Our next question comes from Mark Hughes with Suntrust. Please go ahead.

Thank you very much. Where you do use the legal channels where you're developing new strategies, to what extent are those, in-house people, in systems that you're utilizing, or like then are they outsourced or partners or commission-based parties that you might be using?

The work around -- the selection of which consumers to push through the legal strategy is all done internally. We do have a network that we maintain with a team here of outside law firms who do work on a commission basis when we choose to push accounts into the legal channel.

All right. And you decide and then they execute?

That's correct.

Okay. Great, thank you very much.

Does that answer your question?

It does, thank you.

Thank you. Our next question comes from Brian Gonick with Corsair Capital. Please go ahead.

Good afternoon. Could you quantify in sort of absolute dollar terms net of any revenues you've recognized in the quarter, what the cost would be if all these initiatives, these new investment initiatives to collect incremental portfolio?

Other than in the legal channel, where we've given the specific cost to collect there, it's (prided) on something we would comment on, for example, the amount we're investing in India or the cost to ramp up the healthcare group, so it's -- I hear your question. I don't think it's something we want to kind of put out there.

Okay. Well, let me ask you this. When you say that you expect to get to a -- I think your words were a normalized level of expenses eventually, does that mean back to that 44%, 43% as a percentage of collections? Is that what you expect to get back to at some point?

It's a -- it's on like strategies. We expect the cost to come down over time. However, it doesn't mean we will not introduce other strategies that may have a higher cost to collect if it's generating incremental returns.

So rather than give you kind of where the number I think ends up, it's our belief we will trend back down towards numbers on a historical basis for a portion of the collections, but it's our belief we will add in incremental collections that may have a higher average collection but increase the total net collections for the company.

Okay, okay. And I don't know if this is the right way to look at it, but if I went back to last year where you had 43% and just applied that rate to your Q3 collections, right, and said, okay, that's sort of what expenses would have been if it was status quo. The different in expenses is like north of $5 million. Is that a flawed analysis?

It's not flawed. There's a piece that you should probably look at which is the amount of sales done in the quarter, which have no cost, so some of that is that we have dollars in this quarter that have costs associated with it, where we may have a year ago, had collections that didn't have any cost associated with it.

Can you tell me what that was?

Does that make sense?

Yes, I know. Can you tell what -- just year-over-year what the sales were?

The sales were $8.4 million last year.

Okay.

In Q3.

Right. Needless to say, it sounds like your investments are a couple of million bucks at least.

But there are certainly up front costs associated with some of these initiatives, Brian, and there are initiatives that are incremental liquidations as well, so I think your math is correct.

I wouldn't say that everything that we're doing today is not incremental, so some of it is going to be at a higher more general cost than our historical collections, so there is a mix.

Right, fair enough. And can you give a sense for when you would expect to see "a more positive bottom line impact?"

No, that's going to depend on interest in growth and purchasing because as we add more portfolio, we will also apply this strategy more broadly, so it's hard to give you a specific quarter where you're going to start to see a big pickup.

But we believe that it's -- we're at a point where we are adding to the revenue for the company and the cost, so it's starting in there now, but it's hard to give you the exact numbers.

Right, okay, great. Thanks a lot.

Thank you.

[OPERATOR INSTRUCTIONS]

Our next question comes from [Vic Kumar[ with [Sound Plus Partners[. Please go ahead.

Hi guys, good quarter. I know you don't want to talk about the strategic process, but one high level question, are there parties interested in and actively looking at the company? If so, how many?

I think that's probably too specific of a question to answer.

Okay. That's it then.

Thank you. At this time, I have no further questions. I would now like to turn the conference back to management for closing remarks.

Thank you everybody and we'll speak with you next quarter.

Thank you. Ladies and gentlemen, this concludes the Encore Capital Group third quarter earnings teleconference. Thank you for your participation. You may now disconnect.