Collection House Group (ASX: CLH) vs Credit Corp (ASX: CCP)

Added Collection House Group (ASX: CLH) and Credit Corp (ASX: CCP) to watchlist

Have you ever faced a moment of “damned if I do and damned if I don’t” with respects to equities investing?  I am currently in such a conundrum on whether to take a plunge into the debt collection business.  The major listed players in Australia are Credit Corp (ASX: CCP), Collection House Group (ASX: CLH) and Pioneer Credit Limited (ASX: PNC).  In a general sense, debt collection is a straightforward business — these companies purchase delinquent receivables from various clients e.g. banks, utilities companies etc and aim to collect more from these receivables than what they purchase for.  These receivables, or otherwise known as purchased debt ledgers (PDLs), are generally purchased for 5 to 20 cents on the dollar although in current times, it is closer to the top range due to pricing pressure.  Because of its business model, certain debt collectors like CCP are able to produce impressive financial ratios such as ROE and profit margin in excess of 20% for FY16.  All these factors has unsurprisingly piqued my interest in this sector.

However, it is the same business model which is a source of indecisiveness for me.  In its purest form, debt collection companies are essentially an outsourcing avenue for  companies.  Companies which has uncollectible debts may ‘outsource’ the collection of these debts for a fee.  In the case of a company selling receivables 20 cents on the dollar, the fee is essentially 80 cents of every dollar.  When debt collectors contacts customers of these PDLs, they give the general impression of acting on behalf of the ‘outsourcers’.  Depending on how the debt collectors act, there may be reputations risk for these companies e.g. a threatening and pushy debt collector may harm the reputation of the company that sold the PDLs.  Consequently, some companies have taken their debt collection in-house.  If enough companies do that, it may result in a structural change in the industry where there are not enough PDLs to go around and remaining PDLs are bid to an uneconomical price.

More importantly, I see some potential issues in revenue recognition of the debt collectors.  Accounting standards dictate that revenue should be recognised on an accrual basis instead of a cash basis.  Therefore, revenue derived from PDL for these companies are calculated based on an effective interest rate (EIR) and does not actually reflect the actual amount that is collected from the PDLs.  EIR is an interest rate derived from the purchase price of PDLs and the amount that the debt collection company is expected to recover from the PDLs.  This opens up an incentive for management to distort short term earnings by making overly optimistic assumptions and bringing forward earnings and impairing and recognising a loss in the later life of the PDLs.  Additionally, because of the use of EIR for revenue recognition, it is always in these companies interest to purchase as many PDLs as possible with little regards to the cost and the credit risk it poses.

Enough of me rambling and have a look at actual companies.  As the title of this post suggest, the focus is on Collection House Group (ASX: CLH) and Credit Corp (ASX: CCP).  CCP and CLH are the first and second largest (measured by market capitalisation) listed debt collection companies respectively.  CCP and CLH have the same business bar an exception – CCP has an addition (subprime) lending business which should not be confused with payday lending.  The table below shows some financial ratios and statistics for the two companies:

ccp-clh-fundamentals

As it can be seen, CCP deserves a higher valuation due to its better metrics.  Also, CCP is deemed to have a more diverse business with part of its operations in the US and its foray in subprime lending.  However, despite this, I prefer CLH as an investment.  Don’t get me wrong, there is nothing awful wrong for CCP. However, I prefer an underdog, and, in terms of valuation, the bar is set much lower for CLH.  Also, there are positive steps currently undertaken by the new CEO of CLH, Anthony Rivas.  CLH has secured a 5 year collection contract from a major ASX client and Anthony Rivas is looking to boost collection staff productivity from the current $166/hour for FY16 to $195-$205/hour for FY17.

At the Awkward Investor, our portfolio will always be of a concentrated nature.  I see no value in making investments just for the sake of diversification.  We are near full investment and therefore I will be adding both CCP and CLH to my watchlist.

Shriro Holdings Limited (ASX: SHM)

Initiated a position  in Nine Entertainment Holdings (ASX: NEC) with average price of $1.06 AUD

Added to CMC Markets with a current average price of 110.76GBX

Added to Seven West Media (ASX: SWM) with a current average price of $0.8 AUD

Added Shriro Holdings Limited (ASX: SHM) to watchlist

I do not believe that the FTA industry is in a death spiral and have initiated a meaningful position in Nine Entertainment. I came across NEC while researching Seven West Media and was impressed by their shareholder friendliness.  It has recently sold Nine Live which is their events business to a private equity and has greatly reduced their debt from 600M to 200M and recently completed a share-buyback.  If you ever need validation of your investment, look to the major shareholder list.  Allan Gray, a deep value fund, owns 10% of NEC – do I need to say more?  An issue which I cannot get my head around is why NEC is more highly valued than SWM by Mr Market despite SWM being the market leader in FTA?  Some possible reasons that I can think of  are that SWM has higher debt and that Kerry Stokes owns majority of SWM. The latter is important as minority shareholders may be given the shaft depending on what Kerry Stokes does.

Any astute readers of my website would notice a religious pattern to my stock selection — the preference for beaten down stocks with low P/E ratio and sound business fundamentals.  Therefore, one should not be surprised that my analysis today is on Shriro Holdings Limited (ASX: SHM).

SHM is a distributor of kitchen appliances and certain consumer products.  The Kitchen Appliances division include company-owned brands (e.g. Omega) and third party brands (Blanco).  Ditto for the Consumer Products division, with company-owned brands such as Everdue and third party brands such as Casio.  SHM executed an IPO in 2015 at $1 AUD and is currently at $1.17 AUD.  Its trailing P/E ratio is an undemanding 8.5X and it distributed a full franked dividend of 6 cents for FY15.  These statistics would be enough to whet any value investor’s appetite and it has rightly done so for me.  However, I will further detail below on why I am reluctant to pull the trigger as yet.

screenshot-at-jan-19-18-54-35
SHM’s share price (Courtesy of Google Finance)

Right, let’s get the pros out of the way.  Low P/E ratio, high divided yield and manageable debt (i.e. 9M on 120M of market capitalisation).  The business is easy to understand and its performance is partly tied to the construction of new houses which is currently booming in the two biggest cities in Australia i.e. Sydney and Melbourne.  SHM has a policy of paying 60%-70% of NPAT as dividend and management has guided that NPAT for FY16 would be modestly higher than FY15 of $12.4M AUD. SHM has also embarked on new products such as a BBQ range with celebrity chef Heston Blumenthal and the Neil Perry Kitchen.

Now to the fun stuff.  The general consensus for SHM’s low P/E ratio is that it’s fortunes are too intricately tied to the housing market.  Putting it another way, the housing market is a double-edged sword for SHM.  On one hand, the boom in Australia’s new built houses has greatly boosted its bottomline but a low P/E is justified for SHM because the perception of  a housing bubble in Australia.  I am not going into the futile debate of whether  Australia is in a housing bubble right now because I believe the debate will never have a conclusion.  Only time and the benefit of hindsight will tell if we are in a housing bubble now.

However, my concern is not so much with SHM’s exposure to the new home starts.  According to the annual report for FY15, out of EBITDA of 22M, the Kitchen Appliances division only contributes 6M of it.  What concerns me is the remaining 17M of EBITDA which relates to the Consumer Products division.  One of the mainstays of this division is Casio which is a third party brand.  SHM has no formal agreement with Casio which means that Casio can terminate this relationship as it sees fit. Management does not provide how much revenue is attributed to Casio but judging from Casio prominence in the prospectus and FY15 annual report, I am willing to bet that it is significant.  If the relationship with Casio is terminated, potentially a large portion of 17M could be wiped out.

Also, the FY16 interim results reveal that revenue from the Kitchen Appliances division dropped 13.7% YoY as a result of loss of sales channel for Blanco appliances.  Specifically, Harvey Norman retail and The Good Guys has stopped carrying Blanco products. Management has indicated that the shortfall will be caught up in the second half of FY16 once a new sales channel is found.  On face value, this sounds like non-issue but let’s do a little of ‘inverted thinking’.  If Blanco is profitable for Harvey Norman Retail and The Good Guys, would they stop carrying the Blanco appliances range?  One can only conclude that Blanco is underperforming for Harvey Norman and The Good Guys. Blanco is the default kitchen appliance e.g. oven for many of the new built houses and anyone that has recently built or purchased a new house could attest to their undesirable quality.  Management has provided updates that Bunnings will now carry the Blanco kitchen appliances range.  However, I am not hopeful that they will be able to claw back lost sales in the H1 of FY16.

In addition to that, buried deep in Section 9.4 of SHM’s IPO prospectus is the onerous nature of the contract with Blanco.  This includes a clause which allows Blanco to terminate with a 12 months notice whereas the notice period for Shriro is 5 years.  Also, under the distribution contract, Shiro must not sell or promote any similar products in competition with licensed products manufactured by Blanco.  Does this seem fair to anyone?  This essentially means that SHM would have to distribute Blanco products no matter what happens.

Maybe some readers may judge me to be too paranoid in listing the above concerns.  However, I believe that the hallmark of being a value investor is the protection of capital.  It is not the fear of missing out on potential profits that should drive a value investor but the fear of losing money.  Having said that, I am not writing off SHM as an investment. It will be in my watchlist until the contract situation has been resolved or the share price has come down to a point where there is immense value.  One can only hope….