Encore’s purchase of a majority stake in Baycorp

Introduction

On 28 September 2015, US debt collector Encore Capital Group (NASDAQ: ECPG) announced that it had acquired a 50.25% stake in New Zealand based debt collection company Baycorp from ASX listed investment company Oceania Capital Limited (ASX: OCP) and superannuation fund SAS Trustee Corporation/Capital (SAS). After the transaction Baycorp remains a private company.

When the transaction was announced Kenneth A. Vecchione, Encore’s President and Chief Executive Officer, said "Our vision is that Baycorp will be the number one or two player in Australia ....”.

This statement, combined with Encore’s international expertise in debt collection, operational reputation and financial muscle seems to have been a catalyst for some of CCP’s shareholders to sell. CCP fell 19% between 28 September and 2 October. Was this transaction the reason for CCP’s tumble, and if it was do CCP shareholders rally have something to fear from a beefed-up, Encore-backed Baycorp?

The following discussion sets out the bones of the Encore-Baycorp transaction, assesses Baycorp’s current financial and competitive position, summarises some of Encore’s key features and gives an opinion as to whether Baycorp can really ‘beef-up’ and become a serious challenge to CCP.

Encore-Baycorp Transaction Details

Prior to the transaction OCP held a 52.76% stake in Baycorp and SAS a 47.24% stake. OCP sold 27.9% for $A18.3m (Source: OCP ASX announcement) and SAS sold 22.35%. Post transaction OCP hold a 24.9% stake and SAS 24.9% stake.

Given the price OCP received from Encore, I infer that SAS sold their stake for approx $A14.5m. Encore’s total compensation was approx $A33m. The transaction therefore valued Baycorp at $65.5m.

Baycorp’s Revenue, EBIT, Profits, Interest, Borrowings and Tax

In 2014 Baycorp made a loss of around $11.4m, after taking and impairment charge of $10m. The company was clearly struggling in 2014. Things improved in 2015.

The OCP 2015 Accounts show that in 2015 Baycorp had revenues of $63m, of which only $39m was from PDL collections. The remainder of Baycorp’s revenue ($24m) came from ‘contingency, legal and other’ fees. Baycorp declared EBIT of $6.3m in 2015. Unfortunately, the OCP accounts do no clearly state what Baycorp’s profit after tax was. It is however possible to infer that this was between $1.9m and $2.3m. My working assumption for this discussion is that Baycorp made a profit of $2m in 2015.

Observation: The amount paid by Encore values the Baycorp at 33 times 2015 profit. This figure suggests that Encore is hoping that going forward Baycorp’s future profits and revenues will be substantially higher.

We can use the EBIT of $6.3m and profit of $2m (gap = $4.3m) to guesstimate Baycorp’s interest, and tax figures. I estimate that Baycorp’s 2015 interest expense was about $3.2m and their tax expense was about $1.1m.

We can now use the interest expense estimate to get a rough estimate of Baycorp’s underlying borrowings. Assuming Baycorp was borrowing at 8% then we get a calculated value of $40m. If they are paying 4% on their loans then borrowings will have been closer to $80m. Note that even the lower end of this estimated range is a significant figure. If this inference is correct, these liabilities will likely crimp Baycorp’s ability to grow aggressively by taking on additional debt.

Credit Corp Comparison
In 2015 CCP’s PDL revenues were $152m, 4x greater than Baycorp’s.
In 2015 CCP’s profit after tax was $38.4m, 19x greater than Baycorp’s.
In 2015 CCP declared dividends on 44 cents/share, Baycorp did not declare a dividend.
At 30 June 2015 CCP had borrowings of $64.8m, about the same as Baycorp. CCP’s debt equity ratio is a modest 36%.
In 2015 CCP had interest expense of $1.3m, one third of the amount (I infer) Baycorp expensed.
CCP is currently trading at a 2015 earnings PE of 11. The price Encore paid is equivalent to Baycorp having a PE of 33.

Baycorp’s Current Market Position

Baycorp is the leading debt collection company in New Zealand, but is only the 5^th/6^th largest debt collection company in Australasia. It has offices in Auckland, Parramatta, Perth and Manila. They say they have the largest database of ‘defaulters’ in New Zealand, but it is not clear how significant their Australian ‘defaulters’ database is. In their 28 September press release Encore said that “Baycorp has the largest customer default database in Australasia”. Given that CCP has the dominant market position in Australia, I am not persuaded that Encore’s statement is exactly so.

On 28/29 September Donna Cooper, Baycorp’s general manager said they have around 300,000 active accounts and has just 600 staff. Encore say that Baycorp has $US118 million ($A168m) estimated remaining collections. Interesting term, but I’m not sure exactly what it means.

Credit Corp Equivalents
CCP is the leading debt collection company in Australia/Australasia.
CCP has by all accounts a number of client databases and a reputation for excellent client analytics.
CCP has 700,000 client accounts with a face value of $4.9b.
CCP has 1,200 staff.

In 2015 Baycorp’s per employee income was $105k, while CCP’s was $158k, 50% higher.

Encore Capital Group

Encore Capital group trades on the NASDAQ under the ticker ECPG. On 2 October 2015 the stock hit a new 52 week low of $US35.47. Encore’s SP has lost 20% in the last 12 months and 27% in the last 18 months. Encore has a market cap of $US895.16m. It is currently trading at a PE of approx 9.

As at 30 June 2015 Encore had $US3.1b in long term debt, an increase of $US416m compared to the same figure one year earlier. Their debt to equity ratio is 487%.

In the year to 31December 2014 revenues were $1.072b an increase of 39% over the previous year. Earnings per share increased 30% but at only $100m remain relatively small compared to their revenues and borrowings.

Overall I get the impression that Encore has been aggressively expanding on the back of higher levels of debt, but that strategy is not yet being fully reflected in the bottom line. The Baycorp investment seems to be a small part of the overall expansion strategy. Given that ECPG’s PE is around 9 and falling, the US market seems to be reluctant to whole heartedly embrace their expansion strategy.

On 9 September 2015 the US Consumer Financial Protection Bureau (CFPB) announced that it has taken action against two of the biggest debt buyers in the U.S., Encore Capital Group and Portfolio Recovery Associates (PRA). The Bureau cited both buyers for what it termed illegal debt collection activities, including purchasing debts they should have known were inaccurate and/or not legally enforceable and attempting to collect on that debt through unlawful means. “Encore and Portfolio Recovery Associates threatened and deceived consumers to collect on debts they should have known were inaccurate or had other problems,” said CFPB Director Richard Cordray. “Now, the two biggest debt buyers in the market must refund millions and overhaul their practices. We will continue to take action to protect consumers from illegal and obnoxious debt collection practices.” The Bureau ordered Encore to refund customers up to $42M, to stop efforts to collect on $125M in debts and to pay a $10M penalty. Encore issued a statement vigorously disagreeing with the Bureau’s characterization of its practices but said it agreed to the settlement in order to move forward.

Should CCP’s Shareholders be concerned about Baycorp’s ability to launch a substantial challenge?

The picture I have drawn shows a strong efficient sector leading player – Credit Corp Group, and compares this to a smaller, less productive company – Baycorp.

The vital question now is – can Baycorp grow significantly from where it is today so that it becomes the number 1 or 2 player in Australia?

I think the above discussion answers this question with a resounding no or at least not easily. It appears that for the time being Baycorp will be ‘operational constrained’ by a high level of existing debt (not proven, but probable). Operational improvements are unlikely to generate much free cashflow in the short term. So where can additional financial resources come from to fund the desire expansion? Encore could decide to inject a wad of new equity, but as we have already seen, Encore already has its own pile of debt which it will need to manage. I believe that growth, especially in the form of higher levels of PDL purchases, will not come easily or soon for a new ‘beefed-up’ Baycorp and that CCP shareholders have little to fear.

K