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Published 13 October 2011 05:04, Updated 20 October 2011 05:21
It is worrisome when investors wallop a small-cap market leader. It can signal deeper industry problems if the smart money sells, and cast doubts on competitors. A 38 per cent fall in Credit Corp Group shares since April raised concerns about the credit receivables industry, but it may be a buying opportunity in Credit Corp and its nearest listed rival, Collection House.
Small financiers in this industry buy distressed debt from banks, utilities or other companies at a fraction of its price, and try to recover a portion of amounts owed for unpaid credit card, phone, utility or other bills. It can be a terrific business when companies buy debt at, say, 15¢ in the dollar, and recover twice that or more over several years.
The global financial crisis had a big effect. Tighter lending standards and sharply higher household savings should mean less distressed debt in coming years, assuming unemployment does not jump. Greater competition to buy such debt, especially for debt less overdue, could lift prices paid. Offsetting those headwinds is potential higher debt recovery rates as more bills are repaid.
A simpler explanation for Credit Corp’s fall is that its shares ran too far, too fast. They almost doubled in 2010 thanks to the company’s stellar earnings performance. Investors Mutual and Fisher Funds Management sold some Credit Corp shares this year. Less liquid small-cap stocks can be whacked when fund managers take some profits and invest elsewhere. It is hard to see what has fundamentally changed in Credit Corp to warrant such a large price fall.
Credit Corp’s rivals clearly like the industry’s prospects. Thorn Group paid $32.5 million for National Credit Management, a smaller player, in March. Collection House had its banking credit facilities extended from $85 million to $100 million, and announced it would buy another $60 million to $70 million in debt in 2011-12, to drive revenue and earnings growth. This is an aggressive move from a company that has had its share of detractors in the past.
Collection House is easy to overlook. A $70 million valuation makes it too small for most sharebrokers to research, or for conservative portfolio investors. Even by micro-cap standards, Collection House has an average share register, with no small-cap fund owning more than 5 per cent. Poor acquisitions in the past decade gave Collection House a single-digit return on equity in four of the past six reporting periods. The 10-year average annual shareholder return is minus 11.6 per cent.
Collection House’s 79 per cent net gearing ratio and 3.6 times interest cover are other turn-offs for those who avoid highly geared small-caps, even though it is in the business of borrowing money to buy debt, and in some ways is more defensive than many realise, given reasonably visible and recurring earnings from debt recovered through payment plans.
Collection House looked tired and in need of board renewal a few years ago. Chief operating officer Matthew Thomas became chief executive in June 2010 and two directors joined the board. There is now a sense that Collection House has more momentum and a clearer strategy than in a long time. The last full-year profit result ticked the right boxes and the next game-changer could come at the company’s annual general meeting this month when the board reports strategic initiatives.
Collection House announced in February that a board subcommittee would consider succession and sharemarket communication, produce a segmental review and focus on capital optimisation. Watch the latter.
Collection House could improve its capital structure and share register with an equity capital raising that attracts small-cap fund managers.
The board could also better position Collection House as a growth stock. I can’t see the point in a micro-cap yielding 8.6 per cent fully franked when there are many growth opportunities.
It might be appropriate to reduce the dividend payout ratio (about 60 per cent) to retain more earnings and buy more debt.
Collection House’s purchased debt ledger portfolio stands at $1.32 billion, of which $220 million is collected through repayment arrangements, where consumers agree to pay back debt through structured programs.
Collection House expects to recover $175 million from its repayment arrangement book over four years, or about $120 million in today’s dollars.
The repayment arrangement debt ledger is growing by about 20 per cent a year as Collection House tracks down more consumers with unpaid bills and works with them to settle their account over several years or sooner.
Earnings upside is tempered by weak trading conditions in Collection House’s New Zealand business, partly because of the Christchurch earthquake, and a tough outlook for debt collections where it receives a success fee (almost a quarter of its revenue).
Another threat is fewer organisations outsourcing debt collection. Collection House announced in June is would offer credit consulting and training to companies that collect their own debts.
Collection House shares have fallen from a 52-week high of 83¢ in July to 72¢, amid the sharemarket rout. This compares with book value per share of 98¢ in June 2011.
Collection House shares should trade at a discount to their net asset backing, given purchased debt is a less certain asset. The question is whether such a big gap is warranted, and if a trailing price-earnings (P/E) multiple of 7 times is a touch low, given Collection House’s recent performance and prospects.
More will be known when the company gives its first earnings guidance at the October AGM. For a small-cap to give guidance in this market says something in itself.