Encore Capital Group Inc Q1 FY2023 Earnings Call

Thank you, operator. Good afternoon and welcome to Encore Capital Group's first quarter 2023 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; and Ryan Bell, President of Midland Credit Management. Ashish and Jon will make prepared remarks today, and then we will be happy to take your questions. Unless otherwise noted, comparisons on this conference call will be made between the first quarter of 2023 and the first quarter of 2022. In addition, today’s discussion will include forward-looking statements subject to risks and uncertainties. Actual future 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 performance in the first quarter reflected normalized consumer behavior in each of our key markets. As such, collections have returned to pre-pandemic levels for our MCM business in the U.S. and have stabilized for our Cabot business in Europe. At the same time, as anticipated, portfolio supply growth in the U.S. is accelerating with lending and charge-off rates steadily growing. Consequently, MCM portfolio purchases in the U.S. in the first quarter were a record $213 million, more than twice the amount we purchased in Q1 a year ago. Due to increases in our collections from purchasing portfolios that provide attractive returns over the past few quarters, especially in the U.S., we are now seeing a turning point in our cash generation, which grew sequentially in the first quarter. This is a trend we expect to continue. Earnings comparisons to the year-ago quarter are challenging due to the significant impact of collections overperformance, and ERC forecast increases in the U.S. in the first quarter of 2022. As a result of the disciplined execution of our strategy, Encore is well-positioned with the operational capacity and balance sheet to capitalize on the growing portfolio purchasing opportunities in the market. We also remain as committed as ever to both the critical role we play in the consumer credit ecosystem, as well as the support we provide to consumers to regain their financial freedom, especially in this rising charge-off rate environment. I believe it's helpful to reiterate 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 create pathways to economic freedom for the consumers we serve by helping them resolve their past due debts. We do that by engaging consumers in honest, empathetic, and respectful conversations. Our business is to purchase portfolios of non-performing 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. The strategy enables us to consistently deliver outstanding financial performance and positions us well to capitalize on future opportunities. We believe this 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. Let's now take a look at our two largest markets, beginning with the U.S. Changes to consumer behavior during the pandemic led to unusually low credit card balances and below-average charge-offs, which in turn resulted in a reduced level of portfolio sales by banks. However, since early 2021, outstandings have been rising, and revolving credit in the U.S. surpassed pre-pandemic levels in early 2022. Each month thereafter, the U.S. Federal Reserve has reported a new record level of outstandings. Additionally, banks continue to report growth in lending in the first quarter financial results. In addition to the upward trend in credit card outstandings, credit card delinquency rates in the U.S. have continued to rise in recent quarters. This sustained increase in delinquency rates is now leading to higher charge-offs and an increased supply of portfolios for debt buyers such as Encore. With lending by U.S. banks continuing to set new records with each passing month and charge-off rates steadily rising, we are seeing increases in volumes from our existing forward flow agreements, as well as significant additional volume being brought to market by banks and issuers. It's clear that we have continued to transition into the portion of the consumer credit cycle in the U.S. in which portfolio purchasing becomes increasingly favorable in terms of both market supply and returns. MCM portfolio purchasing in Q1 of $213 million was more than twice the purchasing total for the same period last year and represents a record level of capital deployment for our U.S. business. As market supply remains elevated in the U.S., we expect MCM's portfolio purchases in Q2 2023 to be at a similar level to our Q1 total. In addition, the purchasing pipeline for the remainder of 2023 remains robust with expected improvement in both volumes and returns. MCM collections in Q1 were $329 million, which was in line with pre-pandemic collection levels, indicating that consumer behavior has largely normalized compared to a year ago. As market supply growth accelerates in the U.S., MCM is focused on expanding collections capacity. Turning to our business in Europe, Cabot's collections were $133 million in Q1, a decline of 10% as reported due to the impact of foreign currency and lower portfolio purchases. In constant currency, Cabot's collections declined only 2% and remained broadly in line with our expectations. The largest outlier on a competitive basis was in Spain, where collections were somewhat impacted by strikes in the Spanish court system. Overall, we are still not seeing any changes in consumer behavior due to macroeconomic headwinds. Cabot portfolio purchases in Q1 were $63 million. Importantly, we do not yet see the impact of higher funding costs from higher interest rates reflected in market portfolio pricing. As a result, we have remained disciplined in our approach to portfolio purchasing. As we have said in the past, ultimately, pricing will need to align with higher funding costs before we allocate additional capital toward growing deployments in Europe. As outlined in our 2022 results, we reduced our headcount within Cabot during Q1 primarily in our support functions to manage our cost base. These reductions resulted in a $6 million pre-tax charge in the quarter. We believe that our ability to generate significant cash provides us an important competitive advantage, which is a key component of the second pillar of our strategy. Now that many of the impacts of the pandemic are behind us, it's instructive to look back and offer some perspective on the cause and effect relationships that affected our business performance. For example, in the U.S., the same atypical consumer behavior that drove reduced market supply in our industry, namely lower credit card balances and charge-off rates, also led to higher collections for our business. When incremental cash generation from these higher collections began to subside, our cash generation came under pressure as the prolonged period of lower portfolio purchases, in turn, led to reduced overall collections. However, as expected, higher portfolio purchases at attractive returns in recent quarters have now reversed this trend, and our cash generation in Q1 has begun to grow. We expect this trend to continue. Executing on our three-pillar strategy ensures that the strength of our balance sheet is a constant priority. Over the past several years, our strong operating performance and focus on capital deployment drove higher levels of cash generation and contributed to a lower level of debt, which reduced our leverage significantly over time. More recently, our leverage has risen, driven by both lower collections and increased portfolio purchasing over the last few quarters. When compared to the pre-pandemic years, Encore has become a much stronger company with lower leverage. We now have a unified global funding structure that provides us with financial flexibility, diversified sources of financing, and extended maturities. Through our strong balance sheet, we remain well-positioned to fund the portfolio purchasing 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 Q1 results to those from a year ago, keep in mind that the elevated level of collections last year was atypical and resulted in part from U.S. consumer behavior that has since normalized. In addition, in the first quarter of last year, our revenues and earnings benefited from $167 million of changes in recoveries. I'd also like to highlight a few other items that I believe are noteworthy. As we mentioned during our last earnings call, we reduced Cabot's headcount during Q1 principally in support functions to manage our cost base. These reductions resulted in a $6 million pre-tax charge, which reduced Q1 2023 EPS by $0.19. Elsewhere, we continue to effectively manage our cost base as operating expenses remain well-controlled despite inflationary pressures. Collections in Q1 were approximately 3% lower than expected and resulted in $15 million of recoveries below forecast thus reducing Q1 EPS by $0.46. Changes in expected future recoveries totaling $6 million was a result of a very small increase in our existing global ERC, less than 1%, which increased Q1 EPS by $0.18. I'd like to emphasize that CECL accounting can cause significant fluctuations in quarterly reported results, but they do converge with cash results over the long term. This is yet another reason that we believe it's important to take the long view of our financial metrics. This is consistent with the way we run the business and make decisions employing a long-term perspective to building shareholder value. Portfolio purchasing in Q1 more than doubled in the U.S. compared to the first quarter last year as we have transitioned to a new phase of the credit cycle with increased purchasing. This growth in purchasing is also reflected in our estimated remaining collections or ERC, which was flat compared to a year ago on a reported basis at $7.8 billion. However, ERC actually grew 2% in constant currency and is expected to grow from here. Collections were $462 million in Q1, down 11% compared to the atypically high collections level in the first quarter a year ago. Breaking that result down to two major businesses, MCM's collections in the U.S. declined 11% compared to Q1 last year, primarily due to lower portfolio purchasing in recent years and the normalization of consumer behavior. Cabot's collections in the first quarter declined 10% as reported primarily due to the foreign currency effect of the weakening of the British Pound and Euro compared to a year ago. In constant currency, Cabot's Q1 collections were down only 2%. For portfolios owned at the end of 2022, Encore's global collections performance through the first quarter was 96% of our year-end portfolio ERC. For MCM and for Cabot collections through Q1 by the same measure were 95% and 98% respectively. For MCM, the collection shortfall in Q1 appears to be mainly a timing issue for recently acquired vintages as we transition back to more normalized collection patterns. For Cabot, collections were generally in line with expectations, though collections in Spain were somewhat impacted by strikes in the court system. With rising interest rates and challenging conditions in the bond market, we cannot overstate the importance of our global funding structure. It provides us the financial horsepower, financial flexibility, and diversified funding sources to approach the growing supply environment from a position of strength. We believe our balance sheet also provides us very competitive funding costs when compared to our peers and competitors. In this environment, we believe higher financing costs are beginning to have a moderating effect on portfolio pricing in the U.S. as debt buyers adapt their bidding behaviors to their higher cost of capital. Having said that, we believe current pricing in Europe does not yet reflect this moderating effect, but we expect it will over time.

Before I close, I'd like to remind everyone of our commitment to a consistent set of financial priorities that we established long ago. The importance of a strong, diversified balance sheet in our industry cannot be overstated, especially as highly anticipated growth in market supply has arrived in the U.S. We will continue to be good stewards of your capital by always taking the long view and prioritizing portfolio purchases at attractive returns in order to build long-term shareholder value. In the U.S., now that consumer behavior has normalized and portfolio supply growth is accelerating, it's clear that we have transitioned to the next phase of the consumer credit cycle. As a result, more consumers than ever will need support, and we are ready to help them resolve their debts and restore their financial health, consistent with our mission and the essential role we play in the consumer credit ecosystem. A few quarters ago, we spoke about facing pressures on collections, revenues, and earnings due to lower purchasing in recent years and the normalization of consumer behavior. Our recent results have reflected these expected pressures. Now that our portfolio purchasing in the U.S. has turned the corner, and returns are improving, we have begun to see these pressures subside on cash generation. The recovery of our U.S. market is evolving as we expect it, and we remain confident in our view of the business and are well-positioned to capitalize on this opportunity. Although the recovery of our business in the UK and Europe is unfolding more slowly, we remain confident that we are taking the right actions to best position our business for the opportunities that will come when the market becomes more constructive. 2023 has started off as a strong year for portfolio purchasing, driven by growth in the U.S. As we look ahead, we expect MCM portfolio purchases in Q2 will be similar to our Q1 total, which was a quarterly record for our U.S. business. We also see a robust pipeline for MCM in the second half of the year in both volumes and returns. And as I mentioned earlier, quarterly cash generation has grown sequentially in the first quarter, a trend we expect to continue. Now we would be happy to answer any questions that you may have. Operator, please open up the lines for questions.

Hey guys. I guess the first question is for Ashish. Ashish, back in August, you kind of said collections were normalizing, and purchases are starting to ramp up. But that's going to take a little bit of time. And you said there'd be a couple of weak quarters. You've had three weak quarters so far. Where are you kind of sitting today? Do you see another weak quarter too, or I don't know. How are you handicapping it today?

Mike, thanks for your question. You're absolutely right. We started talking about this collections pressure back in August last year where we said compared to the pandemic years, our collections and revenues and earnings will be under pressure now, just to recap, that was from two reasons. One was due to lower purchasing for a long period of time as well as unusually high collections in the U.S. during that same pandemic period. Recent quarters have indeed reflected these pressures. But as I said in our remarks, a portfolio supply in the U.S. has turned the corner and returns are improving. We set a quarterly record for our purchases, and we expect Q2 to be at a similar level. I do expect these pressures to start subsiding, having begun to subside in some ways. For example, we highlighted a key metric, a turning point—a key metric of cash generation that grew sequentially, and we expect it to continue. So over time, as purchasing continues at a higher level and at good returns, these pressures will continue to subside, and I'm very confident and like the position where we stand today looking ahead.

Okay, well, I'll give you some clarity on the number, then I'll turn it over to Ashish to talk about our go-forward at MCM. But the number I just want to ground you in what the number is comparing, which is something we do during the course of the year. We compare to our ERC as of year-end, and that's a good solid metric to go back and revisit every quarter. The first quarter, it was 96 on a combined basis, 95 for MCM, and Cabot was higher, at 98, I think. I just wanted to make sure we grounded you on what that metric is, and then we come back and revisit it every quarter.

So if I could add to that. Thanks, Jon. That was, as Jon mentioned, some level of timing in the recent vintages; the 2021 and 2022 vintages are the ones that faced the most negative performance that we saw. In terms of timing, the point there is we are seeing a bit of lower cash from consumers in terms of the initial payment or the down payment, and actually, we're seeing even better-than-expected payment plans set up. We expect to get that cash over time, perhaps even more, but for sure get that cash over time. It's just lower initial cash on some of those recent vintages, and you can see those in our K and Q filing as well on the '21 and '22 vintages.

Thanks. Good afternoon.

Hello, Mark.

Jonathan, I thought I heard the first time around MCM was 98, and Cabot was 95.

No, no. You wrote down wrong, I think. The combined was 96. MCM was 95, and Cabot was 98.

Okay. All right. Very good. The availability under your credit facility, what is that total at quarter-end?

$388 million. And we also have $100 million. I'm sorry, we have $140 million in cash as well.

Yes. That'd be my question.

I anticipated that question.

How did you find tax season? I think I saw the tax receipts or refunds were down maybe 10% or something like that in the first quarter. What was your experience?

Yes. In the U.S., we're not seeing any different behavior regarding taxes from consumers. We do track refund rates very, very closely in our operations. But we're not seeing any kind of impact that we can attribute to taxes. Now overall, consumer behavior, as I just mentioned, is seeing a bit less cash upfront and more willingness to set up payment plans, which tend to hold pretty well over time. So that's what we're seeing currently on the tax front and U.S. consumer front.

Okay, and then do you have the collections multiples? I didn't say that the Q was out for us—have paper than Cabot that 2023 paper?

Yes. So for 2023 U.S. multiple is 2.2, and Cabot's multiple is 1.7.

Okay. And then Jonathan, interest expense, I think maybe about a quarter of your debt is floating with the Feds up to these days. What do you think it looks like in Q2?

Yes, I think as I would stick by our mid-40s indicator we gave last quarter. I think there's probably a reasonably good number as you know, Mark, and in an environment like that I guess I'm supposed to say subject to, subject to, subject to, but if everything was at a constant rate, that would be a reasonable assumption.

Yes, Ashish, you mentioned additional volume from banks and issuers in addition to higher order flow activity. I guess one idea is the pressure on banks might lead them to sell paper a little more quickly in order to raise capital. Is that? Does that jive with your experience? Are you hearing anything like that?

Mark, no, we're not hearing any talk around that being a driver. What we are clearly seeing for several months now is just a couple of drivers. Lending has grown a lot; these banks and credit card issuers have lent a lot. As those vintages season, delinquencies, and charge-off rates are rising. Combined, we are seeing both flows being at higher levels than before and more due coming to market from the same issuers, and actually, some new issuers—consumer lenders, FinTech-type players. That's what we are seeing. We have not heard any reason around the recent banking situation driving them to sell more. At least from the credit card players that we deal with, we have not felt any of that. Perhaps that becomes a driver in the future for some, but nothing so far. It's just happening in due course of the consumer credit cycle that we're seeing, which is accelerating in some ways, the supply increase for our industry.

Yes. And one more, if I might, you're still well within your leverage target, but it's been moving up a bit here. If things continue to move in the right direction in terms of supply, is there a thought to maybe tempering your appetite here in the near term and perhaps being a little more measured— not that you're not being measured, but maybe thinking about delaying some purchases until later?

Yes. Mark, it's a perfectly valid question. Just to start off, we take our leverage very seriously. As you know, we've told people our target is two to three times. And some of the explanation, I think it's worth saying is give me a little bit of color—the explanation of the growth in leverage, right, because it could be easy to come to a misperception of what's driving it. We haven't been buying much in the way of charge-off receivables until recently. As a result, as you've heard, Ashish said a number of times our collections, and therefore, our adjusted EBITDA have been under pressure, right? Second, our debt naturally does go up when you think about the cycles here; our debt naturally does go up as we're—it’s good news, where we have more to buy, and it happens to be front-end loaded. As the cash flows come from those purchases, and we're buying at very attractive multiples, it works to give you stronger and stronger leverage metrics. I just want to explain a little bit about the dynamics, and I don't want anyone to just extrapolate from the recent trajectory and come to the conclusion that we're just going to soar through our levels, but we will be managing as necessary as best we can to stay within our target range because we take our, as you know, we take our balance sheet and our rating very seriously.

Yes. I know the portfolio is starting to throw off cash pretty quickly, and so they certainly give you the ability to buy paper now and later, but I wanted to get your perspective on that. So thank you. That's good for me.

Good afternoon. Thanks for taking my questions. First one, Ashish. I guess this may be a softball question, but just wanted to make sure, setting aside for the time being accounting or sort of orders of magnitude. In a very high level, is there any new message from you on this call versus the one we were on two months ago?

Yes. I would say it's consistent as we've kind of built up our message. But now, for sure in the U.S., we are seeing an acceleration in supply compared to the last quarter. I mean, we had signaled what we were going to purchase in Q1; we are seeing continued flows, an increase in size, continued use coming to market. Now we see after Q1 results of the banks and insurers with delinquencies and charge-off rates rising, as you've shown in the charts we share today as well. I would say the different messages—the supply increases are accelerating, and it's real. In the last couple of months, I would say we also saw price improvement, or rather price decreases in the U.S. market. Now it's early, and you may not see that reflected in Q1 2023 because those are results of flows signed previously. Over time, as those flows run off, and the new ones take hold, if there's more pricing improvement—which normally should happen when supply rises—you should see better multiples being booked through the year. So that's a new message that's different. We had anticipated it to some extent, but we are seeing it very real in very real situations now to the deals that are coming through.

Got it. That's helpful color. I guess additionally I wanted to just get a better feel for what's going on with the U.S. consumer in the sense that the anecdote you provided about the '21 and '22 vintages being timing-related and specifically maybe lower upfront payments in more payment plans. I'm putting myself in the shoes of a debtor. If I can't make any payments, and somebody offers me a payment plan for a little bit, I mean, I can just see behaviorally, that's not a good reflection of where the U.S. consumer is headed in. Obviously, there have been recession signals going on for months now. Is that usually a leading indicator for you to get a lot more cautious on collection forecasts going forward when there seems to be more headwind on upfront payments and more of a desire to accept extended payment plans? And I guess related to that, does that, will that be reflected in perhaps lower yielding and a little more cautious forecast going forward?

So there are a few things you mentioned there. But you're absolutely right in trying to read the U.S. consumer, David. So what's happening is it's much more normalized. If you go back to pre-pandemic levels, it's much more in line with what we used to see. What we saw for a couple of years during the pandemic when consumers saved money or had support was unusually excess liquidity and high cash payments, right? I mean, the savings rate has shot up. Now savings rates have actually fallen below pre-pandemic levels in some ways. We are seeing much more normal behavior. You're absolutely right; consumers are facing certain pressures. But they're not fully there yet as a recession word, because inflation is there, which is new, while the unemployment rate is at record lows. All of those things combined are leading to much more normal behavior at this time. We will, of course, be watching out for consumer behavior changes and adjusting our operations to make sure we are dealing with consumers and addressing their situations. For example, inflation has tamed down a bit, and gas prices have reduced again, so that's less of a conversation. Consumers are absolutely behaving more normally—kind of usual consumers that we see given the recent charge-off before the pandemic. So it's more normalized, and I would say that whole excess liquidity that consumers had—that is gone and we are back into a normal situation now.

Okay, got it. And then just a couple for Jonathan. First, as we think about kind of modeling labor costs, which I imagine are impacted by inflation as well. Salary and benefits are always the biggest line item, obviously, call center employees. It went up 15% sequentially. I don't know if the restructuring, or if some of the headcount reductions in Europe hit that line item. But is there a level we ought to be thinking about quarterly this year? Because there's a pretty big variance between kind of $90 million per quarter in the second half last year and $104-105 million in Q1?

Yes, I'll take that and Jon can chime in. David, you're absolutely right; the $6 million charge did hit the SMB line for sequential impact. Some of those changes are there, and we're continuing to watch them. But that's the biggest one I would say. The inflation is still there, although the effects of that we are managing through in terms of productivity, use of technology, wage increases, and whatnot, as well as some reductions. It was not just reductions. What we didn't talk about this time around is, and we mentioned last time, is we actually closed a number of open positions, equal number of open positions, and we are managing that globally to drive better productivity and performance. We continue to manage through that effect, I think, pretty effectively, and we are doing those changes mostly in support functions, the reduction in Cabot and support functions primarily, to preserve our collections capacity and capability for the volume that will come in and ensure our collections are not impacted.

Got it. That's all I have. Thank you very much.

You're welcome.

Hi, guys. Just going back to that headcount question if I can. I mean, were the support reductions focused in support for any particular geography or product? Or are there any areas that maybe you've talked about the returns in Europe that just don't look like they're going to get more appealing or deteriorate? Is it or was it just kind of the same across the board reduction, but was there any particular area of focus to that charge and nationalization of headcount?

Robert, it was all in Europe, UK, and continental Europe in support functions primarily. It was a very thoughtful exercise that the team went through in terms of which teams have the opportunity, which teams are doing certain functions that are critical. So then also, we’re closing open requisitions or open positions. This exercise was across all countries in Europe and the UK. I wouldn't say it's regarding any particular sub-market there. There's no message that I would want one should imply from that. But it was all in the UK and continental Europe. We continue to manage across other countries, including the U.S. and the headquarters and support functions here as well, in terms of open position management and all that. But the reductions were all in Europe and the UK.

Got it. Thank you. And then about the '21, '22 vintages in the U.S. if I can, I appreciate all the color you've given already. If you would look at what the mix of upfront versus payment plan or down payment so to speak versus payment plan was in, say, 2017-2018 versus where it is now for those '21-'22. Is it comparable to kind of historical norms or were you assuming already considering the normalization? And how should that be modeled into the curve if you can put any well-formed question? But yes, any color there?

Yes. I mean, it's kind of reverting to more normalized behavior. Again, if you try to find slides too much, it kind of mirrors meaning, but it is reverting to more normal behavior that we would see prior to the pandemic. Ryan, any color you would add? Ryan's here as well on that.

It's returning to the usual behavior we observed before the pandemic. In 2017, 2018, and 2019, we experienced a lot of changes in 2020 and 2021, but now it seems to be going back to that normal pattern.

Thank you. At this time, I would like to turn it back to Mr. Masih for any further comments.

Thank you. As we close the call today, I'd like to reiterate a couple of important points. As the consumer credit cycles and our key market each evolve in their own unique ways, we continue our disciplined purchasing approach by allocating capital to a market with the highest returns. When combined with our effective collections operation, this approach has enabled us to begin to grow our cash generation once again. This is the portion of the credit cycle we have been anticipating. We are as committed as ever to the essential role we play in the credit ecosystem and to help consumers regain their financial freedom. Thanks for taking the time to join us, and we look forward to providing second quarter 2023 results in August.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.