*The full write up ended up as 77 pages so this is my abridged final checklist instead…
About
Collection House (CLH) capitalises on distressed consumer debt either directly through the purchase of debt ledger's or contingent revenues via outsourced receivables management commissions. In addition to this, they also provide a range of services in relation to Legal, Financial Education, refinance brokerage and Financial Hardship.
Business Sustainability
The business can find opportunities throughout the cycle and is 'a-cyclical' in that sense, providing investors with consistent returns throughout the cycle. In expansion, CLH gains consistent collections revenue as consumer sentiment improves and willingness to pay. In contractionary environments, Distressed debt is flooded with more opportunities to capitalise on due to an out-stretched credit uptake.
Mega trends include a downtrend in the utilisation of credit card's. The inverse to this is the uptrend of Buy-now-pay-later merchant options such as Afterpay etc. These debt's are not interest bearing and the fees are paid for by retailer in the form of Merchant costs. Furthermore, Household debt has experienced an uptrend, possibly further explaining a decline in discretionary debt. Personal debt only makes up 3% of the average Australian's Liabilities.
Competitors
Credit Corp. Group has advantages in the form of collections diversification overseas and lending operations in Australia. Furthermore, a premium on equity allows credit corp. to finance from their shareholders to improve liquidity, as they have done recently. Collection House has alternative funding from the Portfolio enhancement program.
Pioneer Credit lack's many of the positives of both Credit Corp. and Collection House. Firstly, Pioneer Credit is mainly tied to Financial services related debt such as credit cards etc. A downtrend in the usage of credit cards due to the increasing popularity of BNPL debt funded by merchant fees has occured. Furthermore, Pioneer Credit is having significant difficulty in relation to adopting AASB9 Financial Instruments. This difficulty has resulted in a swathe of issues, involving financiers looking to withdraw their funding, forcing PNC to re-finance somehow, and a pause in trading due to a delay in their 2019 report.
Management Integrity
I am impressed by their recent additions to the non-executive board of directors, their is a wealth of experience their in regards to independence. Notably, Sandra Birkensleigh is on the RBA Audit Committee and Leigh Berkley (Chairman) has had several large scale positions throughout Europe in regards to industry bodies.
As for the Executive Board, their priorities have been swayed towards that of profit and have left that at the expense of their corporate culture. Employees consistently talk about how demanding their roles are and the lack of care management carries in regards to fostering healthy employment relationships.
Management Incentives
Director ownership leaves much to be desired for shareholders. Executive management owns less than 1% of the Shares outstanding, with 4 out the 5 having no vested interest in the company at all. Doug McAlpine can be excused as he was only appointed in late June, however Anand (CDA), Jonathan (CLO) and Denica (COO) have all been in their roles for a number of years. The lack of incentive here is concerning from an interest alignment viewpoint. Interestingly enough, Non-executives are the ones buying shares, with Leigh Berkley and Micheal Knox both buying stock in recent months. What does this mean, do the executives know something they do not?
Remuneration is heavily skewed towards the financial outcome of the business. With the one metric being 'Earnings Per share'. This accounts for 80% of the Performance rights scheme. Other non-financial factors include a measly 5% to corporate culture (This would explain their toxic work environment), 10% to compliance and 5% to implementation of new software.
Capital Allocation
Given the low Director ownership in the stock, CLH is not afraid to fund using equity as it does not impact them. They have chosen to do this by persuading shareholders to reinvest their dividends with a 5% discount attached. In defence of this treatment, CLH has enough dividends for $1.86 per share of fully franked dividends, meaning that a gross yield with a discount attached is extremely attractive for shareholders.
Contrast to this, it seems a no-brainer that CLH won't be buying back stock anytime soon. The only reason one could make the case that they needed to meet their EPS performance incentive. Putting cash into the register could give that metric a boost.
Capital expenditure has been interesting with a recent investment in Volt Bank stated to have potential to bring in $3m of profits in FY20 (35% ROI). This seems optimistic yet still is reassuring for shareholders. Furthermore, expenditure on technology and a new Chief Data analyst on board could lead to efficiency gains in collections, which would line up with their improved collections guidance.
Risks
Risk of Inaccuracy of pricing models causing impairment of assets, failure to retain/acquire new agency clients, availability of funding to support operations, information system security, maintaining liquidity requirements for debt covenants.
The big risk on shareholders minds is Lez Mizokovsky. I have analysed his claims and much of his allegations are false or opportunistic with ulterior motive. For example, he states that the PEP program is "Very, Very expensive debt", however learning how it works one would find that it isn't debt at all. Rather it was a sale of a portion of the CLH Arrangement book for consideration up front. To add to this, CLH is servicing it and receiving commissions for doing so. They have a call option in place to ensure that they can buy it back IF THEY WANT TO at the end of the 5 year contract period.
Changes to compliance regulations are incentivised to manage with a 10% weighting in the executive incentive program.
Competitors are active and demanding in the industry, posing significant threat in the sustainable value creation over time.
CLH does have relatively large amount of gearing, interest rate changes can affect profit, however as outlined in their sensitivity analysis a 0.25% basis point change from 1.5% at time of report would only change profit +- $369,000.
Fundamentals
Earnings per share, Free cash flow per share and returns on equity have all trended upwards over the present bull market. This has been the function of growing affordability of borrowings allowing them to reinvest cheap capital at a consistent 10% ROIC. In the most recent report, this has been increased to a 47% gearing ratio, presumably this will result in stronger profits in FY2020. This is a smart use of capital in the short to medium term. The risk lies in the fact that liquidity concerns need to be addressed.
The partnership with PEP is a very smart method to offload debt ledgers to increase liquidity in the short term. While this consideration has been used to reinvest rather than pay down debt, if it calls for it, CLH can use this facility to deleverage.
Collection House has a fair balance sheet and intriguing cash flow and liquidity management. The portfolio enhancement program offers substantial liquidity availability while also doubling as additional cash flow. Concerns raised by Lez Mizokovsky were addressed above and additional accounting concerns are thoroughly addressed by KPMG in the Key audit matters of the audit report.
Gearing levels are higher than compared across the industry, however with additional funding available through Balbec this risk can be managed.
A low portion of current debt ledgers in comparison to CCP represents a lower portion of face value in the arrangement book. Having debt in arrangement will speak for the majority of cash flows.
Valuation
On an adjusted EV/EBITDA basis (Amortisation of PDL's included) CLH is cheaper than it's peers at 3.91x (CCP = 5.9x, PNC = 5x)
On a historical EV/EBITDA Basis CLH is below it's all time average of 4.5x at 3.1x EV/EBITDA (Non-adjusted)
Gordon Growth Model Results using a 10% discount rate and Earnings Growth inputs from the remuneration STI plan.
0% Growth = $0.98 per share
5% Growth = $1.69 per share
7.5% Growth = $2.62 per share
10% Growth = $5.90 per share
Potential Catalyst in Lez Mizokovsky shareholder activism relief.