I switched from a short reply to your post, and went off on a tangent prompted by thoughts that the 13/07/2020 Announcement flooded into my mind. What I wrote is essentially a self-indulgence that took all day to write. I am not going to redact the resultant material to a short HC post – its too much effort.
Some in the things I wrote below are are erroneous, and I may change them on reflection. Others are peculiar to my disposition (appetite for risk, level of anxiety, imagination, credulity, stoicism, etc) so they may suit me, but not others. I have not dwelt on what FY2021 might deliver, because CCP is likely to issue a guidance, and save us the bother. However, to to toss in a round number, I would moot an NPAT of $100m for FY2021, which we can debate later – see Postscript.
1. Enron probably Impaired too little
I have formed the opinion that relative to CCP, Enron Capital is a poorly operated company (at least in recent years), and it is massively more leveraged, and hence riskier, than CCP is. I do not want to dwell on a company in which I hold no shares, so I'll write no more here.
2. Running-off the Loan Book
Running-off the loan book is conceptually similar to running down PDL values by purchasing fewer new PDLs, and CCP has a history of having done that. The Loan Business was, I understand, created to allow CCP to hold back from buying PDLs when a cashed-up PNC was buying aggressively some years ago, and others were doing the same in the USA. The Loan Book is an alternative target to which CCP can deploy funds. The irregular PDLs-versus-Loans balancing mechanism can swing in any direction at different times, and for months to come, investing in PDLs is likely to more than counterbalance a run-down of the Loan Book. CCP would want to keep its Loan Business, so it will probably retain the Loan Book at a viable level.
Running off the loan book actually improves both short-term NPAT and cash flow. Less new debt means less generous up-front provisioning. The ATO ignores bad debt provisioning as an expense – it accepts only actual debt write-offs. In the longer term, Loan Book run-off affects cash flow, but PDL acquisitions and PDL collections counterbalance that.
3PDL Impairment, Agreed Repayment Plans, and Tax
3.1 PDL Impairment
I mentioned in my post 44829751 that, “Management could seize the opportunity to make FY20 a really bad year, and blame it on Covid-19. CCP likes to preserve its image as an honest company, so rather than exaggerating, management may simply reflect what they think is apt, which may be on the pessimistic side.” The first clause of the second sentence reflects that, at the time, I did not factor in the burst of Australasian PDL acquisitions that happened a few months prior to Covid-19 becoming an issue that retarded conversion of fresh PDLs to agreed repayment plans. The ability to buy Australasian PDLs improved in part because CLH and PNC were, for the want of funds, less active, and CCP acquired Bay Corp.
A generous effective amortisation:collections ratio has no impact in the early life of a PDL. I used the adjective “effective”, because the current accounting model has done away with PDL amortisation as a mechanism to adjust PDL asset value. The current model uses the so-called Fair Value (FV) approach. CCP has a mechanistic way of establishing FV, and because 80% of its collections spring from agreed repayment plans (ARPs), hitting a targeted ARP value per PDL is a significant FV factor. Consequently, if the sign-up to ARPs is retarded relative to what was expected, FV must drop (credit asset), and the contra debit entry reduces income (debit a revaluation account). Late sign-ups would mitigate that effect in FY2021.
3.2 Conversion to Agreed Repayment Plans and FY2020 Tax
The Announcement stated, “The reduced ability to agree new repayment plans means that recently purchased assets comprise the bulk of the impairment and collection shortfall.” However, bear in mind that for tax reasons, there is no inducement for CCP to use hindsight to reduce the impairments it decided to apply in FY2020. Consequently, the words in the Announcement, “More recently, an increased willingness to make one-off repayments has brought PDL collections for May and June back to pre-COVID levels.” will neither be reflected in the FY2020 statutory nor taxation accounts, but claw-back would be good for FY2021, which is what both Enron capital in the USA, and Intrum in Europe reported in respect to their 1 Jan– 31 Mar Q1 reports.
An NPAT of $77m would have implied paying ($77m/.7)*.3 = $33m tax on a before-tax profit of $110m. If CCP had decided on an impairment of say $20m, which it did not, tax on $90m would have been $27m. If profit before tax is actually going to be $10m, then tax will be $3m. I am not fixated on fine-tuning the arithmetic, but suffice to say that not going soft on the original impairment decisions improves cash flow for FY2021 by circa $24m.
3.3 Share Valuation and Impairment
For share valuation purposes, investors must consider the facts, not the statutory accounts that we expect to see. Impairments in circumstances like this may be what I call time-shifting. Taking up expenses, or revenue, in one accounting period, or not taking them up, may simply shift statutory profit from one time span to another, either backward or forward, depending on Management's agenda. If management wants to create the image that the firm did well for period X, it will tend not to impair assets in that period. If management are not obsessed with window dressing period X, and wants to delay paying tax, then it would impair as much as is acceptable as a taxable deduction in period X. As an aside, when CLH and PNC were the darlings of the day, I tried to warn investors in those stocks to look to the agendas of the respective CEO's, and the low effective PDL amortisation.
4. Loan Book Provisioning for Doubtful Debts
Provisioning the Loan Book is a different to both PDL and debtor impairments, because the tax treatment is different. One can only reduce tax by actually increasing the expense via write-off to bad debts (impairment). CCP will have some debtor impairment for FY2020, but because CCP over provisions up-front, I would not expect it to be significant. The increased provisioning mentioned in the Announcement of 13/07/2020 relates to the Management's perception as at 30 June 2020, but the words, “More recently, an increased willingness to make one-off repayments has brought PDL collections for May and June back to pre-COVID levels and, with the exception of auto and SME pilots, has restored loan book arrears.” relates to FY2021.
I restate, for share valuation purposes, consider facts, not the expected FY2020 statutory accounts.
5. Dividend, Cash Flow and Leverage
With cash now in the kitty (in reality, little debt leverage, or its corollary, swags of funding headroom), and a diminished tax obligation to be paid in FY2021 in respect of FY2020, CCP should be able to pay a dividend in FY2021. CCP may suspend, or reduce, the dividend in H1, and by the time H2 draws to an end, Management would have a good feel for how things are panning out, and pay whatever dividend is apt.
On cash and headroom, it is advisable not to think in boxes, like either “cash”, or “other assets”. Assets have a continuous liquidity spectrum, and the Loan Book and PDLs are on the near-cash end of that spectrum. The two loan facilities of the type that CCP has are cash-like, because CCP can use the facilities to buy PDLs, or to fund Unsecured, Consumer Loans. If CCP keeps the debt leverage low, which it does, it can use the facilities for anything, provided leverage remains within the banks' covenants, in the main, agreed leverage ratios (one relative to the Loan Book), and the other relative to the asset value of PDLs). Loosely speaking, they are set at half the balance sheet value of those two assets. Both PDL and Loan Book collections happen continually at about $1m per working day ($200m a year), which is substantially dissimilar to realising the cash value of farmland, conveyor belts and intangible assets like in-house software and goodwill.
Compared to similar companies world-wide, CCP is modestly leveraged,, and I am sure the banks would alter the covenants if CCP wanted more leeway. This modest leverage is a significant factor when valuing CCP's share value. CCP is a Tier-1 debtor that borrows from Tier-1 banks at low interest, and with a great deal of flexibility. Even after its near-death experience in 2008 or 2009, CCP had no problem laying its cards on the table, and securing bank the support of its banker(s).
CCP has a predilection for paying a steady dividend, so if it has cash that it cannot deploy at its targeted rate of return, and the business is doing quite nicely, Management may pay a slightly higher dividend if it has the cash, and other things are running to plan. Beyond FY2021, things should normalise.
6.Discussion with large US Client and smaller ANZ Client
Warning I moved this Section 6 to the end because it is waffly. It includes experiences of my long professional history in contract negotiations, rather than dwelling on CCPs Announcement, but I'll not redact what I wrote.
6.1 Business-as-usual Contretemps
The Announcement stated, “The Company expects to take up a provision of $11 million for the uneconomic component of commitments not yet re-priced.” That problem is just a business-as-usual contretemps in my book. $11m provision is not good, but neither is it a disaster. Whether that provision transpires to be a real cost of that magnitude is another matter, but for now expect that it would be. When those forward-flow commitments have run their course, CCP could charge the two clients a bit more by lifting its target rate of return for them, and if they lose one or more of these clients as a result of that, too bad. CCP can find new clients to replace them, which should be easy to do in the USA where CCP is a small player.
It is not going to be easy for banks to find PDL buyers as cashed up as CCP is. Except for CCP, virtually the entire sector both in Australia and the USA has had negative litigation experiences with regulators, and bad media publicity. CCP should wear the mispricing cost of what it cannot resolve with those two parties, and then cease to do future business with them. The clever-clever PDL suppliers can hog the time and funding resources of CCP's competitors.
6.2 Negotiation and Compromise
In situations like this, human nature makes it difficult for some parties to do a U-turn, but a quasi-victory may suffice to resolve the loss-of-face issue. For instance, an agreement on a pricing formula may require a longer forward flow term, or taking up some lower quality PDLs than CCP has offered to acquire, but which CCP is prepared to accept as a trade off. The price differential that CCP pays for the Tier 2 PDLs may in effect mean it costs CCP near-nothing to make that compromise, especially if training new staff can be effected by using cheaper PDLs. On the last point, when CCP formed its Manila collections centre, it used the cheaper staff there to collect on lower quality PDLs from utilities, while the better trained and more expensive Australian team collected on better quality bank PDLs).
6.3 Accept manageable adverse outcomes graciously
I have been in many contentious contract negotiating situations for my clients where price was an issue, and usually negotiated a fair outcome. Only thrice have I personally taken small set-backs on the chin, because the amount was not worth a squabble. The first was a trivial amount, $500 ($2000 rather than $2,500), but after that I did over $50K of attractive and pleasant business with that client – over a hundred times the value of what I had graciously foregone. In the second situation, I lost $1,000 ($5,000 screwed down to $4,000), and I ended up doing $1m+ worth of consultancy over about fifteen years in a huge organisation to which the “screwer” had moved. In the third situation, I lost $1,500 (reduced $3,000 by half), and I never sought work there again.
6.4 Inserting a Contract Clause to Handle Covid-like Surprises
A mutatis mutandi (changing with change) provision can usually be easily inserted in contracts when changed circumstances are not in mind, but difficult to insert when the unexpected has occurred. An example would be a price that included Government imposts that should flex as the imposts flex. I have effortlessly slipped many of this style of provision into contracts that I have been asked to proof read in my career, and the slip-ins elicited no reaction, because the focus of attention was elsewhere. I used to call these slip-ins, precisely because the stratagem was not to draw attention to them, and increase the risk of having to negotiate.
Postscript
Let's use $80m as an NPAT baseline (I used $77m in subsection 3.2 earlier, simply because divided by .7 it gave a round number). That NPAT would have occurred normally for FY2020, but for impairments and provisions. With the extra $150m in cash, let's say that contributes 10%, or $15m. Reading in between the lines of the 13/072020 Announcement, CCP will claw back some of the impairment (maybe quite a lot), so add another $5m, and there is the $100m. If the $15m is too high, then the $5m is probably too low, and anyhow, this just a starting number. Remember, there is going to be extra circa $24 cash for part of the year because the normal tax payment is going to be reduced.
(20min delay)