Encore Capital Group Inc Q2 FY2022 Earnings Call

Thank you, operator. Good afternoon and welcome to Encore Capital Group's second quarter 2022 earnings call. Joining me on the call today are Ashish Masih, our President and Chief Executive Officer; Jonathan Clark, Executive Vice President and Chief Financial Officer; Ryan Bell, President of Midland Credit Management; and Craig Buick, CEO of Cabot Credit Management. Ashish and Jon will make prepared remarks today and then we will be happy to take your questions. Unless otherwise noted, comparisons made on this conference call will be between the second quarter of 2022 and the second quarter of 2021. In addition, 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 Ashish Masih, our President and Chief Executive Officer.

Thanks, Bruce, and good afternoon, everyone. Thank you for joining us. Encore delivered another quarter of strong operating performance in Q2. To better understand our results, let's begin with some important highlights. Our financial results in the second quarter were again impacted by better-than-expected collections within our MCM business in the U.S. This performance led to an increase in future period collection expectations and resulted in higher revenues in Q2; similar to the first quarter of this year but on a much smaller scale. On a global basis, our portfolio purchases were $173 million, up 21% compared to the second quarter last year. We continue to purchase at attractive returns relative to our competitors. Looking forward, banks are reporting that their lending continues to grow and delinquencies are rising. In the past, lending growth and rising delinquency levels have been strong leading indicators of increased portfolio supply for our industry. Finally, consistent with our capital allocation priorities, and as we continue to deliver strong returns and solid cash flows, we repurchased $25 million of Encore shares in the second quarter. As context, I believe it's helpful to understand the critical role we play in the consumer credit ecosystem by assisting in the resolution of unpaid debts, which are an expected outcome of the lending business model. Our mission is to help consumers resolve their debts so they can regain the freedom to focus on what is important to them. And we do that by engaging consumers in honest, empathetic, and respectful conversations. We look to purchase portfolios of nonperforming loans at attractive returns while minimizing funding costs. For each portfolio that we own, we strive to exceed our collection expectations while both maintaining an efficient cost structure as well as ensuring the highest level of compliance and consumer focus. We achieve these objectives through our three pillar strategy. This strategy enables us to consistently deliver outstanding financial performance, positions us well to capitalize on future opportunities, and we believe is instrumental in building long-term shareholder value. The first pillar of our strategy, market focus, concentrates our efforts on the markets where we can achieve the highest risk-adjusted returns. As the pandemic emerged in 2020, changes in consumer behavior and government support of the economy led to lower credit card balances and below-average charge-offs, which in turn has resulted in lower portfolio sales by banks. However, since early 2021, outstandings have been rising as banks are now reporting growth in lending. In fact, revolving credit in the U.S. has now surpassed pre-pandemic levels, while credit card balances continue to recover in the U.K. We believe that continued lending growth will translate into more charge-offs and lead to higher levels of portfolio sales by banks in due course. This also means that more consumers will be looking to resolve their debts in order to regain their economic freedom, and our team stands ready to support them. Turning now to our largest and most valuable market in the U.S. MCM collections in the second quarter were $355 million, down 19% compared to Q2 last year. This decline was primarily due to normalizing consumer behavior and lower portfolio purchasing in recent quarters. With regard to our back book which contains all of the portfolios we purchased before this year, our collection operation continues to outperform expectations. This sustained over-performance at MCM led us to again raise future collection expectations, similar to the first quarter of this year but on a much smaller scale. In Q2, this resulted in $60 million of additional estimated remaining collections or ERC. MCM portfolio purchases in the second quarter were $116 million, an increase of 30% when compared to $90 million in the same quarter last year, and were the result of increased supply in the U.S. market. We also believe that somewhat higher pricing we had seen recently in the U.S. has plateaued. MCM's purchase price multiples continue to reflect a competitive advantage. Turning to our business in Europe. In the second quarter, Cabot collections were $142 million, down 16% compared to Q2 of last year, primarily due to the impact of foreign currency exchange and lower portfolio purchasing in recent quarters. In constant currency, Cabot collections were $158 million, representing a decline of only 6% compared to Q2 of last year. Cabot portfolio purchases in the second quarter were $57 million, compared to $53 million in Q2 of last year. Market supply has been inconsistent and portfolio purchasing remains highly competitive. In keeping with our strategy, we've maintained discipline in buying portfolios. The second pillar of our strategy focuses on enhancing our competitive advantages. A competitive platform enables us to generate significant cash flow. Although our cash generation has been impacted by lower portfolio purchasing in recent quarters as well as the normalization of consumer behavior. Nonetheless, we expect this trend to begin to reverse after we resume purchasing higher volumes of portfolios that are more in line with pre-pandemic levels. Our competitive advantages also allow us to deliver differentiated returns. In addition to cash generation, another important measure of our business is the return on invested capital, which considers both the performance of our collections operation as well as our ability to price risk appropriately when investing our capital. Accordingly, one of our fundamental financial priorities is that our underlying business delivers strong long-term returns. Our ROIC performance continues to be favorably impacted by the revenue effect of our recent increases in ERC, reflecting higher returns on those portfolios for which we raised our collections expectations. The third pillar of our strategy makes the strength of our balance sheet a constant priority. A strong operating performance and focused capital deployment over many consecutive quarters have driven higher levels of cash flow and contributed to a lower level of debt, which in turn have reduced our leverage significantly over time. At the end of the second quarter, our leverage ratio was 2.0 times compared to 1.9 times a year ago, and remains near the lowest in the industry. We remain well positioned with sufficient liquidity and capacity to fund the opportunities that lie ahead. I'd now like to hand over the call to Jon for a more detailed look at our financial results.

Thank you, Ashish. When comparing the second quarter of this year to the second quarter a year ago, keep in mind that the elevated level of collections in Q2 of 2021 was extraordinary and resulted in part from the U.S. consumer behavior that has largely normalized since the beginning of 2022. The combination of collections over-performance in the second quarter and higher collections expectations for the future increased our revenue and contributed to increases in earnings and returns in the quarter. In accounting for the additional ERC mentioned earlier, the corresponding changes and expected future recoveries contributed $15 million at the revenue line in the second quarter and added $0.43 of GAAP EPS in Q2. Collections were $498 million in Q2, down 19% compared to the extraordinary collections in the second quarter of last year but were higher than we expected. The decline on a comparative basis was driven primarily by lower portfolio purchasing in recent quarters and normalizing consumer behavior. For portfolios owned at the end of 2021, Encore's global collections performance through the second quarter was 107% of our portfolio ERC forecast for the period as of December 31st, 2021. For MCM and for Cabot, collections through Q2, by the same measure, were 116% and 91%, respectively. With regard to collections in Europe, the weakening of the pound in relation to the U.S. dollar has created a separation between reported and constant currency results. In this case, Cabot's collections performance through Q2 on a constant currency basis was 96% of our ERC forecast, with the underperformance largely the result of weakness in Spain. Collections in the U.K. through the second quarter of 2022 on a constant currency basis were generally in line with expectations. Revenues in Q2 were $357 million, down 17% compared to the second quarter a year ago. Our global funding structure provides many benefits to Encore, including financial flexibility, diversity of capital sources, lower funding costs, and extended maturities. At the end of the second quarter, available capacity under our global RCF was $576 million, and we concluded the quarter with $135 million of non-client cash in the balance sheet, which is sufficient liquidity and capacity to fund the opportunities that lie ahead. We believe our strong balance sheet provides us very competitive funding costs relative to our peer group. Nonetheless, the cost of capital is increasing for all players in the industry due to the current rising interest rate environment, which should have a moderating effect on portfolio pricing. With that, I'd like to turn it back over to Ashish.

The second quarter for Encore was another period of strong operational performance. Though comparisons to Q2 last year are difficult, as it was Encore's biggest collections quarter ever. But a lot has changed over the last 12 months. The consumer behavior that in part drove record collections in the U.S. last year has largely returned to normal. It is important to note that this same consumer behavior also contributed to meaningfully reducing charge-offs and portfolio supply during the same time period. However, we are continuing to see the credit normalization that we have discussed in the previous quarters. As a result, we have started to see an increase in portfolio supply in the U.S., although the supply in Europe remains inconsistent. This, of course, means more consumers will need our support, and we are ready to help them resolve their debts and restore their financial health, consistent with our mission and the critical role we play in the consumer credit ecosystem. As we look ahead, we anticipate a few key factors will unfold during the upcoming portion of the cycle. On the one hand, we expect pressure on our earnings for the next few quarters, after two years of lower purchasing, coupled with the normalization of consumer behavior. On the other hand, we expect to deploy increasing amounts of capital to purchase portfolios, particularly in the U.S., in line with the supply increase being driven by the same normalization of consumer behavior. I really like the position we are in as we believe that players such as Encore, who are experienced operators and have strong balance sheets, liquidity, and access to capital, are best positioned to benefit from the portion of the cycle we are now entering. Now we'd be happy to answer any questions that you may have. Operator, please open up the lines for questions.

Your first question comes from Mark Hughes of Truist Company. You may go ahead.

Yes thank you. Good afternoon.

Hello Mark.

Ashish, you mentioned pressure on earnings the next couple of quarters. Any desire to throw a few adjectives to that, what do you think and what should we think when we think about pressure on earnings year over year, sequentially?

Thank you for the questions, Mark. As we've mentioned before, we do not provide quarterly guidance because our focus is on the long term. To recap, we expect our earnings to face pressure over the next few quarters, while our deployments are likely to increase. Let me explain further. During the pandemic years of 2020 and 2021, consumers accumulated excess savings and significantly paid down their card balances and debts. This led to two main effects. First, this behavior, especially in the U.S., drove our strong collections and earnings. Second, the same behavior resulted in lower charge-offs, which caused our purchasing levels to be much lower than historical norms for a prolonged period of two years. However, as we reach the middle of 2022, we see consumer behavior returning to normal. Banks are referring to this as credit normalization on their earnings calls, and this will affect both our collections and portfolio purchasing in different ways compared to the previous two years. While consumer payment behavior is normalizing for collections, we are also seeing an increase in delinquencies and charge-offs, though there are significant improvements in portfolio supply, particularly in the U.S., and our purchasing is growing as well. In summary, it may take a few quarters for these trends to fully reflect in our collections and earnings. I want to emphasize that given our operational strengths, solid balance sheet, and increasing supply, we are in a strong position today.

Jonathan, if we maybe just think about that, if we take this quarter's $2.29, and I think you mentioned the $0.43 benefit from the change in expected recoveries, if we just back that out, is that kind of a run rate starting point and then we apply other factors to that? Does that make any sense?

Yes, we included that information so that everyone could see the quarter's impact. How you interpret that going forward is really up to you. We want to avoid giving any kind of guidance, even tentative, so we prefer to take a long-term approach. I believe it’s reasonable for you to exclude that number, but I will let you decide.

Very good. And then the collections multiple for the new portfolios that you acquired in the second quarter, I don't know if the Q is out yet, but what number will we see in terms of multiple? And I think you presented year-to-date, but can you share those numbers?

Yes, the Q is out, Mark, and what you will see is 2.2. That's for year-to-date purchasing for MCM. For Cabot, you will see 2.1.

Okay. Very good. And then, Jonathan, the tax rate in the quarter, high 20s, that's a good number going forward?

I think, as we've said in the past, Mark, I think I'll still peg us at mid-to-low 20s for the year.

Okay. And then just one more for me. The share buybacks, how much capacity do you have or availability on the authorization? And then what should we think about pace? Is this a good pace, the $25 million?

So, as we have said before, Mark, the authorization was $300 million by our Board. And at the end of Q2, $128 million is remaining. Any repurchases are subject to it's a multiyear plan. As we've said, timing and purchase sizes are subject to strong balance sheet, liquidity, as well as continuation of strong financial performance, but $128 million remains in our $300 million authorization.

Thank you very much.

You’re welcome. Thanks Mark.

Your next question is from the line of Mike Grondahl from Northland Capital Markets. Your line is open.

Hey guys, thanks. Ashish, could you provide a bit more detail? You mentioned that there’s more supply in the U.S. Can you help us understand that better? Is it that more banks are involved, or are you bidding on a larger volume of paper? I’d like to clarify that.

Yes, Mike, that's a great question. So in U.S., as I've said before, all the banks used to sell before the pandemic, continued to sell, and they're still selling. And what we are starting to see is, for example, in some cases, you can observe pretty clearly in terms of forward flow agreements kind of how the volumes are trending. And if we look back over the last several months, that trend is clearly upward in a very steady way from those contracts. And in general, we observe, and we are reading the same earnings reports for all the banks and the banks are reporting increased lending, and the charge-off rate is ticking up slowly. So the combination is what drives the dollar volume of charge-offs. And lending is back above pre-pandemic level. So the combination is showing pretty steady and meaningful increases in charge-off supply and sales by the banks in the U.S.

Got it. And then how are you thinking about overall operating expenses today and the next few quarters? Are you at a level you want to be with operating expenses? Do you wish they were a little lower and tighter? How are you just thinking about that overall?

So the operating expenses, they have a fixed component relative and then the variable component, as you know. Overall, we think of operating expenses as part of our overall strategy to maximize returns on our portfolios. So, of course, we are looking to decrease and control our fixed expenses and minimize collections expenses for each of the channels, for example. And as we migrate accounts to lower-cost channels, that should improve. But it also depends on the portfolio mix of purchasing, the average balance, whether it's secured versus unsecured, whether it's paying versus non-paying as often happens in the U.K., for example. So that will drive the expense levels. In terms of any inflation impacts, we've been able to mitigate that by productivity improvements and automation and so forth. In terms of the cash efficiency margin, that's a metric we have now been using. I would expect that to be somewhat under pressure as well. As I mentioned earlier, the collections will be under pressure given the lower volume of purchasing that we've had for quite a while, but we're now starting to increase that.

Got it. Lastly, you mentioned that the impact of inflation on consumers was somewhat muted or offset. What more can you share about that to help us understand how it might be affecting the results?

Yes, that's a great question. Inflation is a significant concern for us. There are two main impacts to consider. Firstly, regarding our business, we have not experienced any negative effects on collections or consumer behavior due to inflation so far. Consumer behavior has normalized from the high payment rates we observed in the U.S. a year ago. We have not seen any impact on collections. As for cost and wage inflation, like many others, we have managed to absorb these increases within our expense structure. While we haven't noticed any impact on collections, we are prepared to assist our consumers, as many are beginning to feel the effects of rising expenses. Our business is devoted to supporting consumers in financial distress for various reasons, with inflation being just one of them. We offer multiple options for payment flexibility, such as skipping a payment, adjusting payment amounts, extending payment plans, and utilizing our hardship policies. We have an array of tools to assist consumers who may be struggling with the impact of inflation on their household finances.

Got it. Okay, thank you.

And your next question is from Robert Dodd from Raymond James. Your line is open.

Hi everyone. In the past, periods of economic stress for consumers have often affected collections before any supply issues arise, leading to timing mismatches. Although inflation hasn't had an impact so far, do you anticipate that the current pressures on Walmart's earnings will influence collection levels ahead of an increase in defaults? Or do you believe it won't unfold that way in this cycle?

Robert, this cycle feels different. In the past during the Great Recession, we experienced some pressure on U.S. collections, around 5% to 6%, but we recovered quickly over time. This time, the economy seems unique. Typically, during a recession, the unemployment rate is higher, but now it's quite low, allowing people to secure new jobs even if they encounter financial difficulties. It's difficult to predict the outcome. What we do know is that normalization is underway, which is unlike previous times. The pandemic led to excess savings, and people's payment behavior has returned to normal. This shift is affecting banks and credit card issuers, resulting in rising delinquencies and charge-offs. We're observing a steady increase in supply from last year. While it's not yet back to pre-pandemic levels, it is climbing steadily and significantly. I can't precisely determine how a recession, if it occurs, might negatively impact collections in conjunction with increased supply. However, given our current position in the cycle, I feel very positive. Over the last couple of years, we've strengthened our balance sheet and improved our operations, putting us in a favorable position as we prepare for continued growth in supply.

I understand, and I appreciate that insight. Regarding cost efficiency, legal expenses have understandably decreased due to lower supply. They often increase ahead of collections during ramp-ups, but relying on legal actions isn't the ideal way to engage with consumers. If supply continues to grow, when do you think you would start considering more investments in the legal channel?

It is challenging to predict. You are correct that as supply continues to grow, some expenses are incurred upfront. However, we are seeing improved collections from non-legal channels like digital and call centers. This could lead to an increase in expenses, though the timing is uncertain. Additionally, our legal expenses this quarter were affected by foreign exchange issues related to European operations, which impacts all our expenses. We are using legal services less frequently, even though they remain a part of our collections strategy. The decision to increase legal investments will depend on the types of portfolios we acquire, but it’s difficult to determine when that might occur.

I appreciate that. Thank you.

Your next question is from the line of Spencer James from William Blair & Company. Your line is open.

This is Spencer James on for Bob Napoli at William Blair. I was wondering if you could expand on the softness you called out in Spain. And then maybe could you also provide an update on why loan growth has continued to be slower to return in Europe versus the U.S.

So I'm going to let Craig Buick who's on the line from London to respond on the Spain but also touch on the supply increase being slower in Europe. And I can then add to it as appropriate. Craig?

Yes. Thanks Ashish. Hi, Spencer, can you hear me okay? Perfect. And thanks for the question. In terms of the Iberian piece, I think couple of pieces to call out, as Jonathan mentioned in his prepared remarks. One is just bear in mind the impact of the foreign exchange movements. The appreciation of the U.S. dollar has led to a widening in the reported percentages. The underlying percentage across Europe is more like 96. And as Jonathan mentioned, in our U.K. business, collections are performing broadly in line with those expectations. In the Spanish business, what we see there is a number of our portfolios comprise what we'd call small and medium sized enterprises or SME accounts. And the very nature of these accounts means the average ticket is a little bigger, and you inherently have more volatility in those portfolios. And that's what we've seen in the first half of this year. So I call that the natural volatility implicit in the portfolio there. If I think about the European loan growth, I guess my views on that one is, if you look at most of the historic cycles, you'll see that European financial services sector tends to probably recover slower than the U.S. sector. I think there are some structural differences around the capital levels, etcetera, and the efficiencies there that tend to drive a slower recovery. You still see the same directional trends taking place. It just takes a little longer for those to move. But I'll pass it back to Ashish for any further thoughts on that one.

No, I think you've covered it, Craig. Spencer, if you have any follow-up on that, happy to address.

Could you maybe just comment on the disconnect between the normalization of credit quality in Europe, is that lagging behind the normalization in the U.S.? Or is there bit of a disconnect between the credit quality and the supply of paper in Europe? Is there anything distinct to call out there between the two markets?

Yes, I agree with what Craig mentioned. There are distinctions between the European and U.S. markets. It's not strictly a matter of credit quality, but rather consumer behavior. While most people were affected similarly by staying home and saving money, U.S. government support for consumers was somewhat different. This may have led to U.S. consumers accumulating debt at higher rates than in other countries, resulting in a quicker decline in charge-offs and delinquencies and stronger collections for us. Conversely, in the U.K., government programs focused more on job and salary support instead of direct financial assistance, which could contribute to some inherent structural differences. U.S. consumers have definitely shown different behaviors and are spending more actively now. Consequently, we are witnessing a faster rise in lending in the U.S. compared to the U.K.

Thank you so much guys. Appreciate it.

Your next question comes from the line of Mark Hughes from Truist Company. Your line is open.

Yes. I don't know if this was in the presentation. I didn't see it. The cash efficiency margin this quarter versus the year ago quarter, what were those numbers?

Yes. I don't know if it's in the presentation, it's in the Q. So 57%, it's a trailing 12-month number, 57% for this quarter, and last year it was 57.8%, so very close.

It's also on Page 29 in the slides, Mark.

Okay. Yes, very good. Thank you.

No further questions at this time. I would now like to turn the conference back to Mr. Ashish Masih for closing remarks.

Thank you. As we close the call today, I'd like to reiterate a couple of key points. Our strategy of focusing on the right markets, executing effectively to deliver strong returns on our portfolios, and maintaining a strong balance sheet are key drivers of our best-in-class performance. Looking ahead, as credit continues to normalize, leading to higher portfolio supply; we expect to continue increasing our portfolio purchasing. We're also as committed as ever to the critical role we play in the credit ecosystem and to help consumers regain the financial freedom. It's what we do best. Thanks for taking the time to join us, and we look forward to providing our third quarter results in November.

This concludes today's conference call. Thank you all for participating. You may now disconnect.