Ceasing coverage on Credit Corp

After seven years of profit growth, Credit Corp has once again delivered a good result (see Table 1), with all segments of its business growing.

The company's Purchased Debt Ledger (PDL) division continued to perform well, with segment NPAT rising 11%, from $19.8 million to $22m. 

Profits from its consumer lending division also rose, albeit from a low base, more than doubling to $3.2m.

Rounding out Credit Corp's business, its US division inched closer to profitability, with breakeven now expected in the second half of 2017. With regulations in the US increasingly focused on compliance and the reputation of debt collectors – a strength of Credit Corp's – it is well placed to grow its US business. 

Debt-funded growth

Speaking of growth, from 2012 to December 31, 2016, purchased debt ledgers (PDLs) on Credit Corp's balance sheet rose 144%, from $129m to $315m, while receivables in its lending business rose from zero to $126m. All in all, total assets more than tripled.  

With only a minor increase in shares over this period, the company has funded this growth using retained earnings and, in particular, debt. From a modest net cash position in 2012, net debt has ballooned to $201m, rising a cool $61m in the last six months alone and a staggering $142m over the last 18 months.

While still nowhere near the 200%-plus achieved pre-GFC, Credit Corp's net debt to equity ratio is now approaching 9%. After a record first half of PDL purchasing, Credit Corp's ratio of borrowings to the carrying value of PDL and consumer loan receivables has shot up to 46% from 29% a year earlier. 

This is clearly concerning management, as it has noted that the purchase of PDLs will moderate in the second half of 2017, helping return the company to positive cash flow and thereby reduce this ratio to around 41% by the end of the financial year. We would, though, like to see this ratio much lower.

Key Points

• Profit growth continues

• But debt rising quickly

• PDL purchases to moderate

Mismatch 

While Credit Corp's assets – its PDLs and loans – pay fixed rates of interest, its debt is floating rate and unhedged. This isn't a problem when the company's debt load is reasonable and interest rates are falling – as they have in recent years – but when the opposite occurs, this could cause problems. 

So with both its net debt position and interest rates rising, it's no surprise that management has decided to ease off purchasing PDLs and use the resulting increased operating cash flow to reduce debt. 

Unfortunately, while cash flow will increase, the company needs to keep investing in PDLs or loans to grow its earnings. With debt already near its maximum, either the company needs to raise equity – which will in any case dilute earnings – or growth will moderate while it pays down debt. 

At this stage, the debt appears manageable but with earnings growth likely to slow and perhaps decline, we think Credit Corp is now fairly valued on a forward PER of 15.  

Ceasing coverage

The risk for Credit Corp is that conditions deteriorate considerably and the company's collections come in much less than anticipated, putting additional pressure on its balance sheet. On the flipside though, a worsening of conditions may provide an opportunity for Credit Corp to buy PDL's on the cheap, assuming of course it survives to that point. 

As we noted when we first upgraded Credit Corp (see Credit Corp hits income sweet spot, March 2016 [Buy – $9.81], "too much debt combined with underperforming PDLs can cause existential problems." The sudden increase in debt makes us nervous, particularly given the mismatch and rising interest rates noted above.

We prefer not to wait to see when and if PDLs start underperforming. This could occur if interest rates continue to rise and slow wages growth crimps its customers' disposable incomes and hence ability to repay Credit Corp. 

In any case, since we first upgraded the company to Buy, the stock has returned 76% (not including dividends). This is a satisfactory return in little under a year. 

Unfortunately, trying to pick the top for any stock is a mug's game, and even harder for cyclicals like Credit Corp. For all we know Credit Corp's share price could keep rising from here. 

However, with benign economic conditions assisting its collections, a full valuation, increasingly nervous debt levels and the risks inherent in its international expansion, we think it's time to take our profits and move on to better ideas. We're downgrading to SELL and CEASING COVERAGE.