Encore Capital Group Inc Q1 FY2024 Earnings Call

Good day, folks, and thank you for standing by. Welcome to the Encore Capital Group's First Quarter 2024 Earnings Conference Call. Please be advised that today's conference call is being recorded. I would now like to hand the conference over to your first speaker today, Bruce Thomas, VP of Industrial Relations. Bruce, please go ahead.

Thank you, operator. Good afternoon, and welcome to Encore Capital Group's First Quarter 2024 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 2024 and the first quarter of 2023. In addition, today's discussion will include forward-looking statements that are based on current expectations and assumptions and are subject to risks and uncertainties. Actual results could differ materially from our expectations. Please refer to our SEC filings for a detailed discussion of potential risks and uncertainties. We undertake no obligation to update any forward-looking statement. 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 Investor Presentation, which is available on the Investors section of our website. As a reminder, following the conclusion of this call, a replay of this conference call, along with our prepared remarks, will also be made available on the Investors section of our website. 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. I'll begin today's call with key highlights from the first quarter. Encore's solid first quarter performance was driven by strong portfolio purchasing in the U.S. and double-digit collections growth on a global basis. Continued growth in U.S. portfolio supply, driven by both credit card lending growth and a charge-off rate at a 10-year high, has led to very attractive pricing and returns. As a result, we continue to allocate the vast majority of our capital to the U.S. market, deploying a record $237 million in the U.S. in the first quarter. In Europe, the portfolio purchasing market remains very competitive. Although we continue to see some examples of improved pricing, we believe European portfolio pricing still does not consistently reflect the higher cost of capital caused by higher interest rates. As a result, we continue to be very selective, which has led to reduced Cabot portfolio purchases. Overall, our performance in the first quarter was well aligned with expectations as portfolio purchasing, collections, and cash generation are all off to a strong start in 2024. I believe it's helpful to remind investors of the critical role we play in the consumer credit ecosystem by assisting in the resolution of unpaid debts. These unpaid debts are an expected and necessary outcome of the lending business model. Although the levels may vary depending on the stage of the macroeconomic cycle, regardless of where we are in the macroeconomic cycle, our mission is to create pathways to economic freedom for the consumers we serve by helping them resolve their past due debts. We achieve this 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 maintaining an efficient cost structure as well as ensuring the highest level of compliance and consumer focus. We achieved these objectives through our three-pillar strategy. This strategy enables us to deliver strong financial performance while positioning us well to capitalize on portfolio purchasing opportunities. We believe this is instrumental for 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. U.S. revolving credit has been steadily rising since early 2021. Each month for the last two years, the U.S. Federal Reserve has reported a new record level of outstandings. At the same time, since bottoming out in late 2021, the credit card charge-off rate in the U.S. has also been steadily rising and is now at a 10-year high. Similarly, U.S. consumer credit card delinquencies, a leading indicator of future charge-offs, also continue to rise, with both lending and the charge-off rate growing simultaneously. Purchasing conditions in the U.S. market remain highly favorable, with continued strong growth in U.S. market supply and attractive pricing. The most recent delinquency data supports our expectation that 2024 will be another year of record portfolio sales by U.S. banks and credit card issuers. With this environment in the U.S. as a backdrop, Q1 was another strong quarter of portfolio purchasing for our MCM business. We deployed a record $237 million in the U.S. at strong returns, the result of our disciplined purchasing approach amid an attractive pricing environment. MCM collections in the first quarter were $369 million, up 12% compared to the first quarter of 2023. In addition, throughout the quarter, consumer payment behavior remained stable. After expanding MCM's internal collections capacity last year through the addition of approximately 500 account managers, we believe we are appropriately staffed to accommodate our higher recent purchase volumes. We expect the benefits from expanding our operations headcount will increase over time as these newer account managers gain experience and drive increased efficiencies and scale in our MCM collections operation. In contrast to the U.S., supply in the U.K. has been growing much more slowly. Credit card outstandings are still not yet back to pre-pandemic levels as banks in the U.K., unlike those in the U.S., have not meaningfully increased lending since the pandemic. In addition, U.K. charge-offs remain at low levels. Cabot's collections in Q1 were $141 million, up 6% compared to the first quarter a year ago. Given the current state of the U.K. economy, we believe ongoing weakness in consumer confidence is marginally impacting one-time settlements while existing payment plan performance remains stable. We continue to be selective with Cabot's portfolio purchases, which were $59 million in the first quarter. We have maintained a purchasing discipline in the face of portfolio pricing in Europe that we believe still does not yet consistently reflect higher funding costs. We expect to continue to deploy at current low levels until the returns in Cabot's markets become more attractive. We are currently choosing to allocate significantly more capital to the U.S. market, which has higher returns consistent with our well-established strategic focus. We also continue to prudently manage the Cabot cost structure given the reduced level of portfolio purchases in recent quarters. I would now like to highlight Encore's first quarter performance in terms of several key metrics, starting with portfolio purchasing. Encore's global portfolio purchases increased 7% in Q1 to $296 million with record U.S. deployments in our largest business, MCM. This increased portfolio purchasing will help drive Encore's collections growth over the next few years. The fact that 80% of our global deployment in the first quarter was in the U.S. is a reminder of the flexibility that our global funding structure provides to us. This structure enables us to allocate capital toward our highest return opportunities. As market supply remains elevated in the U.S. and the pricing environment remains attractive, MCM's ERC, as well as our global total ERC, continues to grow. The significant amount of ERC we are adding reflects the efficiency of our global capital deployment and is reflected in a higher purchase price multiple. This current highly favorable purchasing environment in the U.S. is allowing MCM to purchase portfolios at strong returns, which adds future cash flows and profitability to the business. Global collections in the first quarter were $511 million and were up 10% compared to Q1 a year ago. The past several quarters of higher portfolio purchases, particularly in the U.S., has led to meaningful growth in collections. I'd now like to hand the call over to Jon for a more detailed look at our financial results.

Thank you, Ashish. The first quarter was another period of strong purchasing for our U.S. business at attractive returns, while our collections grew in each of our key markets. Collections were in line with expectations for the quarter and we had small adjustments to our ERC, which impacted earnings in a negative way. I'd like to highlight a few items and provide more detail. Q1 collections of $511 million was approximately $1 million above forecast. Small adjustments to our ERC resulted in negative changes in expected future recoveries, totaling $13 million, which reduced Q1 EPS by $0.46. ERC at the end of the quarter was $8.3 billion, up 7% compared to a year ago. Operating expenses remain well controlled and were up only 1% compared to Q1 last year as we begin to realize operating leverage and scale benefits of collections growth in our business, as well as the cost efficiencies that accompany a higher proportion of digital collections. GAAP net income of $23 million and GAAP EPS of $0.95 in the first quarter were up 25% and 27%, respectively, compared to the first quarter of 2023. We believe that our ability to generate significant cash provides us with an important competitive advantage, which is also a key component of our three-pillar strategy. Similar to the dynamic Ashish mentioned earlier, higher portfolio purchases at strong returns over the past several quarters have also led to meaningful growth in cash generation, a trend we expect will continue. Our cash generation in Q1 was up 14% compared to Q1 of 2023. The third pillar of our strategy ensures that the strength of our balance sheet is a constant priority. Our unified global funding structure provides us with financial flexibility, diversified sources of financing, and extended maturities. It also underpins one of the best balance sheets in our industry with comparatively attractive leverage. Importantly, even though we continue to purchase at higher levels, our leverage declined slightly during the quarter given our strong cash generation. As we have discussed, this cash generation is driven by both the increased volume of purchases over the last several quarters and the higher returns associated with those purchases. Our leverage ratio of 2.8x at the end of the first quarter remains within our target range and is down from 2.9x at the end of 2023. With elevated interest rates and evolving conditions in the bond markets, I'd like to emphasize the importance of our global funding structure. We believe our balance sheet provides us very competitive funding costs when compared to our peers. Our funding structure also provides us financial flexibility and diversified funding sources to compete effectively in this growing supply environment. In the first quarter, you may recall that we issued $500 million of 2029 senior secured notes as a first-time issuer in the U.S. This offering expanded our options for future financing, establishing our access to the broad and deep U.S. high yield bond market. While we initially used the proceeds to pay down a revolver, we plan to eventually use the proceeds to redeem our 2026 sterling senior secured notes at par in November 2024. I'd like to provide some additional context for this transaction. It is the case that the coupon associated with the new bond is higher than the sterling bond it will replace. Importantly, we've been building this kind of higher coupon into our bidding strategy since rates started to rise over a year ago. This is precisely why we have been emphasizing that pricing in the U.K. and Europe has not consistently adjusted to the currently higher cost of funding. In the U.S., however, market pricing has indeed adjusted to this higher cost of funding. I would also like to point out that our weighted average cost of debt on a pro forma basis after issuing the bonds and paying down the 2026 sterling notes is slightly below 6.5%. We also estimate this issuance and other recent movements will result in approximately $10 million to $15 million of additional interest expense through the end of 2024. Remember, if the current interest rate environment persists, then just as our cost of debt may increase over time, so will the positive impact of our investments in portfolios with higher returns. With that, I'd like to turn it back over to Ashish.

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 in the midst of the highly anticipated growth in U.S. market supply. 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. I'd now like to describe how we are differentiated from others in our industry, especially during a time when a number of our competitors are dealing with their own challenges. First, we are the largest player in the attractive U.S. debt purchasing market. Second, we believe our ability to collect on the portfolios we buy and our corresponding purchase price multiples lead to collecting more over a vintage's lifetime, which in turn generates more cash, more earnings, and ultimately higher returns. Third, our well-diversified global balance sheet allows us to allocate capital to opportunities with the highest returns. This flexibility is vital, as demonstrated by our allocation of the vast majority of our capital to our MCM business in the U.S. in order to maximize overall returns. Our balance sheet also provides us the flexibility to fund our business in a myriad of ways. This provides a significant advantage in times when traditional markets become less certain and more expensive. And finally, our $8-plus billion of ERC represents our enormous capacity to generate cash. In closing, I'd like to quickly summarize our first quarter performance. Portfolio supply in the U.S. market, where we are currently focusing our capital continues to grow to record levels. Against this favorable backdrop, we deployed a record $237 million in the U.S. in Q1 at strong returns. In the U.K. and Europe, we are maintaining our discipline, being very selective in our purchases, and constraining our capital deployment until returns become more attractive. Our overall performance in Q1 was well aligned with expectations and 2024 is off to a strong start. Driven by a strong first quarter performance and the disciplined execution of our strategy, we remain on track to deliver on our 2024 guidance provided in February. This guidance called for portfolio purchasing this year to exceed our 2023 total and for our collections to grow approximately 8% to over $2 billion. Now, we'd be happy to answer any questions that you may have. Operator, please open up the lines for questions.

Our first question comes from John Rowan of Janney Montgomery Scott.

John?

Hey, John, we can't hear you.

Sorry, my phone was on mute. Can you hear me now?

Yes.

Okay. So, I guess, Jon, just to unpack kind of the commentary around interest expense, you said 6.5% is kind of the current weighted average cost. You said $10 million to $15 million of additional interest expense by the end of the year, if I wrote that down correctly. I guess, I'm just trying to understand, is that a run rate per quarter? Or maybe if you could just give us what the weighted average cost of your interest will be once you do refinance those notes in November?

No, that's a good question. To clarify, the 6.5% refers to the assumption that we refinance the bonds. It doesn't mean we are paying down the bonds. This represents the entire process; it's not just about raising money and paying down a revolver. We're using the capacity from the revolver to pay down the sterling bonds, which is what the 6.5% reflects.

Okay. How much would that increase your cost of funds in general? Maybe around $10 million to $15 million? Is that just for the fourth quarter? I'm just trying to clarify the guidance.

Yes, $10 million to $15 million is for the balance of the year.

But if you're doing that in November, then that's only for November and December, right?

No, this is assuming everything happens in November and assuming it all plays out as we just talked about. From a modeling perspective, we can assume $10 million to $15 million between now and the end of the year.

Okay, so that would be in addition to the kind of the 1Q run rate of $50 million, $56 million?

That would be in addition to the $235 million that we gave as guidance, soft guidance kind of prior, right? We told people what we thought would be a quarter ago.

Okay, so $235 million plus $10 million to $15 million would get you to like $245 million to $250 million for the year of interest expense?

Correct.

Can you remind us what the $2.7 million of other income was?

In other income, we typically see derivative impacts and interest income. We do have some funds around the world that earn interest, even though that's not our standard approach. This interest income, when comparing the three months ending March 31, 2024, to the end of the previous year, reflects an increase in both interest income and gains from derivatives.

Okay. And then just one last question from me. You mentioned a $13 million decrease in forecasts, but also $1 million in cash over collections. Can you clarify if there has been a quarter where you've experienced over-collections alongside reduced forecast revisions? I'm trying to understand if we're nearing a point where you're finished revising forecasts downward. It seems contradictory to reduce forecasts when you're over-collecting. I understand one is longer-term than the other, but I'm looking to grasp any connection, if there is one, between these two aspects.

Yes, that's a great question, and I'll keep it brief because we can dive deep quickly. They are separate issues. One involves current cash impact, while the other relates to changing expectations. However, as you pointed out, they are also connected. For instance, you might see significant over-collection in the current period, but then have a negative revision to your forecast, which indicates that you viewed the over-collection as a pull forward rather than an improvement in your projections. They are interconnected, and it's important to consider the many variables at play. Not all portfolios are experiencing the same trends in how we collect or what our expectations are, and this is simply the summary of how things have come together. Does that make sense?

Yes. Okay. The pull forward makes sense. I appreciate it.

Our next question comes from Mark Hughes of Truist Securities.

Jonathan, I'm going to ask that same question. You provided guidance of $235 million, with an additional $10 million to $15 million. If this transaction is happening in November, will there be any additional interest expense leading up to that?

Remember, Mark, it's short term. What we're doing is we're paying down a revolver at x rate and have created new funding at y rate, so there's that delta as well, right?

And when does that transaction take place? If you could...

Well, no, the first step....

If you look at the $10 million to $15 million. Yes.

I'm talking about the first step, which has already occurred. We have the U.S. dollar bond and we are paying down the revolver, but the revolver has a lower interest rate than the bond. So, if you're looking for where the incremental impact comes from, that's it. Does that make sense?

Right. It does. That would be spread out evenly between now and the year-end.

Now until November, correct?

Okay. And then there's a more substantial impact post November.

No, there's a negative carry due to the transaction we completed, and we are in the process of unwinding that. Our revolver will increase, and our older, lower-cost bond, specifically the sterling bond, will be eliminated. So I wouldn't worry too much about it. There are some factors to consider, but the main part of the transaction will occur in November.

Thank you for that. Did you mention the collections multiple on the 2024 paper during the call? I assume it's in the queue. I haven't had a chance to look at it. How does that multiple compare to 2023, perhaps for the U.S. or the U.K.?

We did not provide that multiple, but it's 2.4. This is Ashish, Mark, so it's 2.4 for us in 2024. And yes, so overall, just to step back, supply is still very strong, pricing remains very favorable, the way it's been recently. So we continue to feel very good about how pricing is going and how multiples are going. Just remember, the multiple is one element of a return, the shape of the curve cost to collects at times. We have portfolios we buy that are lower multiple and much lower cost to collect. So that mix effect also plays out on a quarter-to-quarter basis, just to keep that in mind. But overall, the supply and return picture looks very similar and very favorable and we booked a very good multiple for U.S. this quarter.

Expenses were very favorable this quarter. The efficiency ratio is 54%, if I'm looking at it correctly.

52%. 52%, I believe.

52% on a trailing 12-month basis.

Yes. But please go ahead, I'll then answer your question, Mark.

Yes. Yes. So on a trailing basis, it was 52% and this quarter was stronger than that. Is this quarter a better guide for go forward? I know there's some seasonality to collections and expenses, but...

Excuse me, just dealing with a lingering cough. That's a great question, Mark. Regarding the efficiency ratio and general costs, as you noticed, my collections increased while expenses remained nearly flat, just rising by 1%. There is some seasonality in the first quarter, with collections typically increasing more during this time. We have also been making significant purchases over the past two years. With the rise in collections, we anticipate a few outcomes. As John mentioned, natural efficiencies and economies of scale will contribute positively. Therefore, we expect the efficiency ratio to improve as a result, leading to operational leverage. Specifically for MCM, we have been increasing the use of call center and digital collections, focusing on resolving consumer accounts earlier through these channels instead of legal means. This quarter, the legal share for MCM is at 35%, marking a record low in many years. A number of factors are contributing to this situation, and we expect to continue seeing operational leverage as we grow our collections. We have also fully staffed our MCM operation. Last year, we hired 500 account managers and believe we have sufficient capacity to support our increased purchasing activities.

Yes. So nothing per se unusual in this quarter. No timing shifts or anything like that. A good result because you get, what, 10% growth on collections, 1% growth on expenses is quite strong. And so thinking on a go forward basis...

Nothing unusual. I mean, from a comparison to a year ago basis, we had some one-time charges in Cabot for restructuring a year ago, but those are still small, I mean the big trend, as you correctly noticed. Collections grew 10%, expenses only 1%. As a result, cash generation was up meaningfully about 14%. If you compare Q-over-Q. So I'll just be seeing what we have been anticipating as to 2024 to be the turning point. And Q1 is proving to be exactly that. We've been purchasing well, and we expect to grow collections through the year and we continue to expect to purchase well. And all of that effect will show in collections and cash generation.

Our next question comes from Mike Grondahl of Northland Securities.

I did get on a little late. Did you say anything about Q2 purchases so far or kind of the pipeline or backlog?

Mike, this is Ashish. We did not provide that information. We shared our expectations last quarter to help illustrate how the year was beginning. However, we are maintaining our guidance for the year. For the full year, we anticipate our purchasing in 2024 to be greater than our purchasing in 2023.

Got it. And I guess you guys use the term soft guidance a couple of times on this call. Could you just maybe remind us just so I make sure I'm hearing all of it, like what is or what was the soft guidance for 2024? And then is this interest expense situation the only change to it?

So, yes, let me take a stab at it, Mike, and then I'll let Jon chime in as well. So I would call it very not soft, real guidance is what we provided last quarter in February on purchasing and collections. On purchasing, we said it will be higher than 2023 level. And in Q1, we're off to a good start. We are up 7%. Collections, we said we expect to grow year-over-year collections 8%. And we are off to a good start in Q1 with 10% growth. So those are the two key guidance elements that we provided. In addition, we provided some helpful what John have alluded to as soft guidance, including on tax rates and interest expense. And interest expense is the only one we kind of provided some revised estimate of $10 million to $15 million higher expenses compared to the $235 million number we gave back in February because of the bond refinancing.

Got it. Got it. And then the $13 million negative collection, kind of the change in expectations, was that related to some of the recent books? I know you've talked about some post-COVID '21, '22 books where maybe initial payments were a bit smaller or was it related to older books? Could you just, I mean, talk a little bit about what made up the $13 million? What, years, maybe?

Yes. So a couple of things. First, $13 million is quite small, we would consider it minor in relation to our overall expected recoveries of $8 billion. This amount is a result of analyzing all quarterly vintages and their performance. You mentioned the recent vintages of MCM or U.S. vintages. In Q4 of last year, we had been underperforming the 2021 and 2022 vintages in the U.S. because we had projected them based on peak pandemic collections. We adjusted those forecasts back in Q4, and their performance is now satisfactory. The 2021 vintage actually exceeded expectations by a few hundred thousand, while the 2022 vintage fell short, possibly explaining the $2.7 million change. The remaining amount comes from other vintages in the U.S. and Europe. To summarize, if you look at our quarter, the $13 million adjusts our expected recoveries of $12 million, with about $4.5 million coming from the U.S. and roughly $8 million from Europe. Overall, it stems from various sources, but nothing significant. The 2021 and 2022 vintages are performing well, and it's just a minor fluctuation considering the overall size of those vintages.

Our next question comes from Mark Hughes of Truist Securities.

Yes. Thank you. Jonathan, did you give the performance relative to expectations for the MCM and the U.K. or Cabot? I think, in times past, you've given us the kind of percentage numbers. Last quarter, it was kind of high-90s.

Yes. I'll jump in, Mark. So we did write it in the slide presentation. We didn't talk about it. So overall, it's 99%, 100% for MCM and 96% for Cabot. And on a constant currency basis, that 96% is actually 98% for Cabot.

And with the constant currency, the total would it be 100% perhaps, or 99%, still 99%?

Still rounds to 99%.

And our next question comes from Robert Dodd of Raymond James.

On the legal front, as you mentioned, the legal collections were quite low because our focus has been on call centers and digital methods, which are less expensive to collect. However, legal expenses during this quarter were higher than we have seen in several years. Are you increasing the legal investment now to improve that mix? Is the $35 million where you want it to be, or is it slightly lower because you may have desired more legal engagement in the future? Any insights on that? Given that you are fully staffed in call centers, that expense line seems well managed. But what about the legal expenses? Should we expect some increase there to enhance that channel?

So, Robert, we are working to reduce our use of legal by resolving consumer issues through our call center and digital channels. What is happening is we have been buying more accounts, and there is a delay in selecting those accounts after the initial outreach. This gives time for consumers who may be able to pay but are reluctant to engage. As a result, the volume of legal placements will increase over time due to our higher purchasing levels. Remember that legal expenses come from two sources: court costs, which depend on volume, and legal fees paid to collection law firms, with about two-thirds of the expenses being external and one-third internal. This dynamic also contributes to the situation. However, we are not trying to use legal more than necessary or than we have in the past. Additionally, currency effects have impacted Cabot's legal expenses, making them appear higher. There are various factors at play, but as we noted in our Q, the increase is primarily related to volume, which is expected to continue as we maintain higher buying levels.

And then just on the U.S. volume, I mean, obviously there can be lags, etc., but to the point in the slides in the presentation, I mean, there has been tremendous growth. And you did hit a really high number in the U.S. Your guidance for growth overall, I mean, is there anything you can tell us about where you expect the U.S. to be this year? I mean, do you think you can break $1 billion? Or any color on how much of that growth or how much of the overall growth is going to come from growth in the U.S. given the returns are better right now?

I assume you are referring to purchasing. We are allocating the majority of our capital—specifically about 80%—to the U.S. at this time. This allocation is unlikely to change unless there is a sudden shift in market dynamics in Europe. Our purchasing in the U.S. and U.K. is largely flow-based, whereas Europe has less flow orientation. We have a clear view of how these flows are progressing. While these flows may vary, we expect the U.S. to remain the primary location for our capital deployment. As for our guidance, I still stand by what we mentioned in February, which is that we anticipate surpassing the 2023 figure of just over $1 billion in deployment, around $1.74 billion. So, we will predominantly focus on the U.S.

Thank you. At this time, I'm showing no further questions. I would now like to turn the call back over to Mr. Masih for closing remarks.

As we close the call, I'd like to reiterate a few important points. We believe Encore is truly differentiated in our sector with a solid track record of operating results and superior capabilities. As the consumer credit cycle continues to turn, the U.S. market is seeing the world's strongest supply growth. With 2024 off to a strong start, we continue to apply a disciplined portfolio purchasing approach by allocating record amounts of capital to the U.S. market which has the highest returns. When combined with our effective collection operation, we believe this approach will enable 2024 to be a turning point in our operational and financial results. Thanks for taking the time to join us and we look forward to providing our second quarter results in August.

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