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:
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.