Making money from debt

Credit card debt has doubled in the last 10 years. It now stands at $50bn, the equivalent of $3,200 per cardholder. The banks and retailers are the big winners in this debt binge but there's another group of companies also profiting.

This year, debt collection agencies will handle more than $15bn in unpaid debts. As unemployment rises and the mining boom draws to a close, debt collectors are becoming potentially interesting stock picks.

Pioneer Credit (ASX: PNC) listed on the ASX in May, but it has a history going back 26 years. Like Credit Corp (ASX: CCP) and Collection House (ASX: CLH), it purchases portfolios of distressed debt, usually unsecured personal loans and credit card debt, that's six months or more overdue.

The ledgers are often purchased at just 5 cents or 10 cents on the dollar. If an agency recovers, say, 20 cents on the dollar, that's a 100% or more return on the purchase price.

But heavy regulation has made collection a fairly standard process. Scale is what really matters.

Pioneer, the smallest of the three debt collectors, generates about $128,000 per employee. Credit Corp generates $151,000. The difference in loan portfolios is even more extreme – Credit Corp has around five times as many staff as Pioneer yet manages a portfolio nearly 10 times larger.

That delivers another advantage. To price a portfolio appropriately, debt collectors rely on data analytics to predict debtor characteristics and behaviours. The software involved is a fixed cost, so a little more of each additional successful collection flows to the bottom line.

Credit Corp has an analytical edge, which is why it was interesting to see its portfolio buying fall 32% in the six months to 30 June, whilst profitability and collections actually increased slightly.

On the other hand, Collection House and Pioneer increased their portfolio purchasing during the period. This will help boost revenue growth in the short term, but returns on invested capital are likely to fall.

Largely as a result of purchasing discipline, Credit Corp achieves an underlying operating profit margin of 36%, compared to 26% for Collection House and just 18% for Pioneer. And while Credit Corp may only account for some 15% of industry revenue, it takes more than 40% of industry profits.

As the Australian economy slows and the mining boom draws to a close, bad debt will increase but in recent years the debt collectors have been dealing with low growth.

Pioneer still focuses solely on purchasing debt portfolios and has been shouldering the higher purchase prices by accepting lower margins.

Collection House and Credit Corp have branched out into additional services, acting on behalf of loan originators or utilities to collect outstanding debt for a fee but without taking on the capital risk associated with purchasing a ledger outright.

Credit Corp has moved even further afield, competing with Cash Converters (ASX: CCV) by offering small short-term loans to those with poor credit ratings.

Another way to boost returns – as well as risk – is to use corporate debt to purchase ledgers. Collection House has taken this approach and increased its borrowings 11% to $100m in 2014. This may boost earnings growth in the short term but it makes the stock far more risky.

Pioneer has sensibly opted for almost no net debt at the corporate level but its small size – a market cap of just $80m – is a serious hurdle.

Credit Corp may have gone through a near death experience during the last financial crisis but has learned from its mistakes. Net debt crept up to $36m in 2014, but mainly on account of the lending business, which shows promise. With operating earnings some 34 times interest expense, it's unlikely to cause any issues.

A clean balance sheet and conservative management means Credit Corp is now much better positioned to take advantage of the next crisis. And armed with economies of scale, higher profit margins and an analytical advantage, we expect the company to continue to take a disproportionate share of industry profits in the meantime.

On a forward price-earnings ratio of 12 and dividend yield of 4.3%, Credit Corp offers better value than the other collectors. It's not quite cheap enough yet but it is one to watch, especially if the local economy starts to dive.

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Disclosure: The author does not own shares in any of the stocks mentioned.