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Published 21 February 2013 00:16, Updated 21 February 2013 08:14
Credit receivables stocks Credit Corp Group and Collection House show it pays to look beyond market noise and focus on value. Both have soared this year and further medium-term gains look possible, especially for Collection House, which is still playing catch-up.
The debt collectors could have been overlooked. The supply of distressed debt was expected to fall as consumers borrowed less after the global financial crisis or paid down existing debt faster. More competition to buy that debt would lift its price and dampen the profitability of listed debt collectors.
If that were true, somebody forgot to tell the market. Credit Corp Group, a star small-cap stock, has raced from a 52-week low of $5.45 to $8.93. Collection House has rocketed from $1 to $1.60 this year after impressing with a solid first-half result and lifting its earning guidance.
Improving recovery rates on distressed debt are a tailwind for credit receivables stocks and a reason they can go higher this year or next. Better consumer confidence will encourage people to repay overdue debts and the financially sound eventually will be inclined to borrow again. The industry may be in a sweet spot.
Business forecaster IBISWorld thinks so. It forecasts Australia’s debt-collection industry will grow at 6.5 per cent a year between 2013 and 2018, after yearly growth of 3.4 per cent between 2008-2013.
IBISWorld says reduced consumer reliance on credit and fewer bankruptcies in coming years will lower the volume and value of distressed debt for credit receivables companies to buy. “Although there hasn’t been a large increase in the overall supply of distressed debt recently, companies are seeing better recovery rates of debt as more risk-averse consumers are paying down debt rather than incurring new debt and less lending to fringe customers is positive news for the industry.”
Debt collection is complex. The industry has two main business models: one is contingent collections, where credit receivables companies work on behalf of the original creditor and receive a fee or a commission on debts recovered.
Under the other main business model, the debt collector buys distressed debt ledgers and keeps funds recovered.
For example, it might buy distressed debt at 10¢-15¢ in the dollar and aim to recover twice that amount.
Recovering a higher amount, especially from debt more than two years old, can boost earnings. It also means the credit receivers are milking more from existing debt portfolios, rather than having to buy as much new distressed debt.
This trend was evident in Collection House’s interim result. Collections on its purchased debt ledger in the first half of 2012-13 improved 11 per cent on the same time a year ago. Remarkably, more than 36 per cent of debt recoveries came from accounts bought in 2009-10 or earlier. Better customer analytics software and debt-recovery procedures are helping Collection House recover unpaid debt from older accounts that previously it would have written off earlier.
I last wrote about Collection House in October 2011, when it was trading at 70¢. My interest was the potential for new management to turn around a tired-looking company with (ironically) too much debt, a sub-optimal capital structure and an inappropriate dividend policy for a small-cap growth stock. I wrote: “There is now a sense that Collection House has more momentum and a clearer strategy than in a long time.”
Chief executive Matthew Thomas is making Collection House’s earnings more sustainable and reducing the potential for bad surprises. He could take advantage of the higher share price, raise equity capital and buy a slab of new debt to speed growth. Instead, the company is making its debt ledger work harder and is investing slightly less in new debt in the second half. That’s a good sign.
It’s also ticking other boxes: the return on equity (ROE) rose from 10.5 per cent in the first half of 2010-11, to 12.6 per cent in first-half 2012-13. That must improve further but rising ROE signals sustained profitability and is the best indication of improving company performance. Board renewal, led by last year’s appointment of David Liddy, the former chief executive of Bank of Queensland, as chairman is another plus.
Collection House’s drawn debt ($95 million) peaked in the first half and should reduce in the second. The dividend payout ratio has been lowered to reinvest more earnings. Although it annoys some investors, small-cap growth companies with rising ROE should reinvest more earnings to compound their returns, not pay high dividends.
At $1.61, Collection House looks fully valued in the short term. A price-earnings multiple of 13 times, although below the market average of 15 times, is a touch high. RBS Morgans’ valuation is $1.48 a share; InvestorFirst Securities’ is $1.30; Patersons has a $1.53 target.
Even so, Collection House has much medium-term growth in it. Efficiency improvements, better debt recovery rates and small acquisitions should assist the next re-rating. Collection House suits experienced investors comfortable with higher risk.