Why Is Share Price Tanking?, page-292

I started this post by commenting on Encore Capital's Jan-Mar 2020 quarter report at https://encorecapital.gcs-web.com/static-files/fff86e29-e989-495f-9155-8be3cf811e9d. By the time I had written the stuff below, I decided to go no further than Point 12, because that sufficed to cover Covid-19 issues in regard to supply of PDLs, and PDL asset impairment, my main interests.

1. PDL Acquisition

On future acquisition of PDLs, Encore reported, “However, over the medium-term, we anticipate that increased volumes of portfolios with strong returns will come to market as charge-offs are expected to rise meaningfully as a result of the COVID-19 pandemic.” I would expect this is the same for CCP, hence the decision to raise capital to seize the day.

2. PDL Impairment

Encore's report states, “Importantly, these forecast changes are very much driven by anticipated delays in collections and not by an expectation of permanently reduced collections.” In gist, Intrum AB, Sweden, stated similar sentiment to the effect that collections are expected to be delayed, and clawed back later. It boils down to the CECL-style accounting model used, and I suspect CCP will be less affected, because of its conservative implementation of that accounting model. CECL (explained later) treats PDLs like bonds, which I think is inappropriate for the debt-buying sector.

2.1 Negative Side

Encore's non-cash charge [impairment] of $US109m reduced its earnings by $US87m after tax, or $US2.77 per share. It is not easy to prorate what happened to Encore to CCP – Encore's North American business has a greater percentage of up-front collections relative to agreed repayment plans, and it has relatively fewer shares to collections than CCP has. Encore buys about $US900m PDLs a year, and CCP about $225m. Encore collects about $US2,100m a year, and CCP about $A400m, so in crude terms CCP is a fourth or fifth the size of Encore, so $A20m impact on NPAT could be a starting stab in the dark for CCP, or at 67.3m shares, about 30c a share, and that can be increased by some multiple to be conservative. However, first understand the CECL accounting issues before you apply any sky-is-falling factors.

2.1 Mitigating CCP-related Factors

There is an argument to suggest that CCP's impairments may be relatively modest. This is because the effective interest rate Encore has used to value its PDLs is high, and its collection time is short, so if it collects the money over a longer term, it must meaningfully downward adjust the asset value. Encore has many more up-front debt settlements than CCP does. This is what Encore states:

“Under CECL, the discount rate is the effective interest rate - or EIR - based on the purchase prices of the various portfolio contained within a pool group and the expected future cash flows at the time of purchase. And for Encore, we’ve been booking portfolios at strong returns for some time. As a result, even a modest delay in collections for a large pool group with a high EIR, causes a meaningful non-cash charge.”

CECL is a credit-loss accounting standard model. CCP pretends that it adheres to such a model, but it is an apparent adherence, because in effect CCP sticks to the CCP amortisation model of yesteryear. That is, CCP substantially recognises profit when the cash is actually collected, rather than via uplifting its asset value earlier on the basis of what it expects to collect. PNC got itself into strife by aggressively following the CECL model. For folk not familiar with accounting, if one buys a PDL for $10,000, values it at $12,000 via a NPV calculation based on bullish collection expectations, then double-entry accounting (debit asset, credit revenue) creates a profit of $2,000 before the money is collected. If collections are delayed, the asset value must be impaired, and significantly impaired if a short collection time was expected and a high effective rate of interest that flowed from bullish collections expectations apply.

What I think CCP does is bias its valuation model towards collecting slower than history suggests, and thus it derives a conservative effective interest rate, and thus a conservative PDL asset value is derived. Towards the end of a PDL's 6-year collections-time window, collections are substantially fully “amortised”, so those tail-end collections drop straight into interest revenue. This is why when CCP collects more on old PDLs than fresh ones, the PDL “amortisation” that CCP reports as a non-standard metric, tends to be a little lower than the typical circa 47% that CCP has reported for years. As the concept of amortisation does not exist in the CECL model, the profit recognition mentioned above is effected via the contrivance of up-valuing the asset first (debit PDL asset, credit revenue), then the money collected reduces the asset (debit cash, credit PDL asset). The auditors can then declare that the accounts adhere to the applicable standard.

In summary, CCP has tended to over provision its lending business, and vigorously reject many loan applications, plus CCP in effect only books revenue and profit on collection, not via asset appreciation pursuant to the inappropriate CECL model. Consequently, CCP should not suffer much Covid-19 balance sheet damage, IMO. Let us see what happens.

I am not an accountant, so take my views on accounting with a pinch of salt. All I wanted to convey is what happens at CCP, not exactly how it is effected in the rubbery world of accounting.