Q2 2020 Encore Capital Group Inc Earnings Call

San Diego Aug 6, 2020 (Thomson StreetEvents) — Edited Transcript of Encore Capital Group Inc earnings conference call or presentation Wednesday, August 5, 2020 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ashish Masih

Encore Capital Group, Inc. – President, CEO & Director

* Bruce Thomas

Encore Capital Group, Inc. – VP of IR

* Craig Anthony Buick

Encore Capital Group, Inc. – CEO & Director of Cabot Credit Management Group

* Jonathan C. Clark

Encore Capital Group, Inc. – Executive VP, CFO & Treasurer

* Ryan B. Bell

Encore Capital Group, Inc. – President of Midland Credit Management

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Conference Call Participants

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* David Michael Scharf

JMP Securities LLC, Research Division – MD and Equity Research Analyst

* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division – Analyst

* Michael John Grondahl

Northland Capital Markets, Research Division – Senior Research Analyst & Head of Equity Research

* Robert James Dodd

Raymond James & Associates, Inc., Research Division – Research Analyst

* Robert Paul Napoli

William Blair & Company L.L.C., Research Division – Partner and Co-Group Head of Financial Services & Technology

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen, and welcome to the Encore Capital Group’s Q2 2020 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host, Mr. Bruce Thomas, VP of Investor Relations. Please go ahead.

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Bruce Thomas, Encore Capital Group, Inc. – VP of IR [2]

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Thank you, operator. Good afternoon, and welcome to Encore Capital Group’s Second Quarter 2020 Earnings Call. Joining me on the call today are Ashish Masih, our President and Chief Executive Officer; Jonathan Clark, Executive Vice President and Chief Financial Officer; Ryan Bell, President of Midland Credit Management; and Craig Buick, CEO of Cabot Credit Management. Ashish and Jon will make prepared remarks today, and then we’ll be happy to take your questions.

Unless otherwise noted, comparisons made on this conference call will be between the second quarter of 2020 and the second quarter of 2019. The in addition, today’s discussion will include forward-looking statements subject to risks and uncertainties. Actual results could differ materially from these forward-looking statements. Please refer to our SEC filings for a detailed discussion of potential risks and uncertainties.

During this call, we will use rounding and abbreviations for the sake of brevity. We will also be discussing non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures are included in our earnings presentation, which was filed on Form 8-K earlier today.

As a reminder, this conference call will also be made available for replay on the Investors section of our website where we will also post our prepared remarks following the conclusion of this call.

With that, let me turn the call over to Ashish Masih, our President and Chief Executive Officer.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [3]

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Thanks, Bruce, and good afternoon, everyone. Thank you for joining our earnings call. As the COVID-19 pandemic remains front and center in some countries and begins to resolve itself in others, we hope that all of you listening to this call and your families are safe, healthy and finding ways to regain increasing levels of normalcy.

I’m grateful that the steps we have taken as a company, which have placed the health and well-being of our people as our most important priority, have also allowed us to perform at or above the high level of productivity we exhibited before the pandemic. I’m proud of the Encore employees around the globe who have grown closer as a unified team in 2020 even while being physically more distant from each other.

In these challenging times in which financial hardship has become more prevalent, we are reminded that for years, Encore has been helping people recover from financial difficulty and regain their personal economic freedom. It remains at the core of what we do.

Despite the hardships caused by COVID-19, consumers are demonstrating resiliency through their efforts to resolve their debts. As a result, collections in our call center and digital channel have not seen — have not been as negatively impacted by the coronavirus as we had originally modeled when we revised the collections forecast during the early stages of the pandemic a quarter ago. In fact, inbound call volume has been quite strong, particularly for MCM. As a result of investing in our people and in technology over the past several years, we were well prepared for high levels of call volume as well as higher demand from consumers who prefer to reach us through our digital platform. In addition, our team has done an outstanding job in adapting our collections operations to the varying conditions caused by COVID-19.

While we outperformed our Q2 expected collections curves, we also reduced expenses. In addition to our continued focus on expense management, during the quarter, we had lower legal channel expenses as we significantly reduced our efforts to collect through the legal channel in many jurisdictions. I’ll talk more about the legal channel in a few moments.

We delivered strong results for the second quarter of 2020. Global collections were $508 million and came in better than expected for both MCM and Cabot. Record global revenues of $426 million were up 23% compared to the second quarter a year ago. Our ERC of $8.4 billion was up 13% compared to Q2 last year. As a result of stronger-than-expected collections and reduced expenses in our legal channel, we delivered record quarterly GAAP net income of $130 million or $4.13 per share. This result was more than 2.5x as large as our previous record earnings in any quarter. We also established a new record in Q2 for non-GAAP adjusted income of $137 million or $4.34 per share.

We continue to consistently generate significant cash as we collect on the portfolios we own. And as we continue to purchase portfolios at more attractive multiples, we enhance our ability to generate even higher levels of cash. In fact, in the second quarter, we again set a new record for adjusted EBITDA, including collections applied to principal, which is the industry benchmark for cash generation. I would like to remind you that this metric is largely insulated from the implications of any accounting changes. Cash is cash. Even after subtracting cash taxes, cash interest and CapEx, it is clear that we are generating a substantial amount of cash.

Turning now to our business in the U.S. Our MCM team delivered very strong results by leveraging a combination of social distancing and working from home as we continue to adapt quickly to changing work environments. I’m pleased that MCM has remained fully operational throughout this period. MCM collections in Q2 were a record $386 million, up 16% compared to the second quarter of last year, and exceeded our Q2 expected collection curves by 29%.

Our improved collections performance over the past several quarters, including in Q2, have been driven by several key factors. First, over the last few years, we have been laying the groundwork to direct a larger proportion of our collections toward the call center and digital channel. Second, within that channel, we continue to see a steady expansion in the number of consumers who connect with us through digital means. Third, we are seeing better productivity from our account managers due to investments in training, process improvements and technology. And finally, our consumer outreach strategy over the last few years continues to increase the proportion of inbound calls to outbound calls. As you would expect, the higher proportion of inbound calls improves the rate at which we convert our consumers into payers.

We expect the combination of these factors will allow us to meaningfully scale our collections capacity when we need to while only modestly increasing our account manager headcount. The resulting operating leverage is one of the reasons we are particularly excited about the prospects for increased supply in the future.

MCM deployments totaled $125 million at an attractive purchase price multiple of 2.5x, reflecting our differentiated collections performance and slight improvements in market pricing. As a result of the COVID impact, we reduced our planned expenses related to MCM’s legal collections by approximately $27 million in Q2. This action reduced our overall operating expenses and helped reduce MCM’s cost to collect to 32% in the quarter.

Looking forward, court costs and other expenses related to legal collections cannot be reasonably spent in such a way that we quickly catch up and spend the $27 million that we did not spend in Q2. Instead, we expect legal collection expenses to return to a more normal level in Q3 and then for increases to be layered in gradually over the next year or more as activity levels in the courts return to normal.

We succeeded in again reducing our cost to collect compared to a year ago period. Even if we had incurred all the originally planned expenses related to legal collections in Q2, MCM’s cost to collect would have improved compared to the year ago quarter. This is a strong reflection of our continued focus on expense management and operating efficiency. Finally, MCM’s collections trend in Q2 has continued into July.

Turning to Cabot. In the U.K. and in Continental Europe, the COVID-19 pandemic has had a varying amount of impact from country to country. Cabot has adapted quickly to these varying conditions and is fully operational in each market. Cabot’s collections in the second quarter was 17% higher than our Q2 expected collection curves. As the quarter progressed, we saw continued improvement in each of Cabot’s markets. In the U.K., we continue to see no material change in payment plan breakage rates. Cabot’s focused on cost management through these challenging times has enabled continued strong profitability.

The purchasing environment in the U.K. remains subdued for the time being, and we expect this lower level of supply to persist throughout most of 2020. However, we do anticipate an increase in purchasing opportunities at attractive returns in 2021 and beyond as charge-offs are expected to rise meaningfully. Finally, similar to what we are seeing at MCM, our collections trend at Cabot in Q2 has continued into July.

I’d now like to hand the call over to Jon for a more detailed look at our second quarter financial results.

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Jonathan C. Clark, Encore Capital Group, Inc. – Executive VP, CFO & Treasurer [4]

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Thank you, Ashish. As a reminder, we will sometimes refer to our U.S. business by its brand name, Midland Credit Management, or more simply MCM. We may also refer to our European business as Cabot.

Global deployments totaled $148 million in the second quarter compared to $243 million in the second quarter of 2019. MCM deployed a total of $125 million in the U.S. during Q2, down from $180 million in the same period a year ago. European deployments totaled $23 million during the second quarter compared to $57 million in the same quarter a year ago. European deployments decreased in Q2 primarily due to a limited supply of portfolios coming to market as a result of the COVID pandemic.

Global collections were $508 million in the second quarter, down 1% compared to the same quarter a year ago, a period in which Baycorp, a business we sold in August 2019, generated $11 million of collections. In constant currency and after adjusting for the sale of Baycorp, global collections were 2% higher this year than in Q2 of 2019.

MCM collections grew 16% in Q2 to a record $386 million. Within that total, MCM’s call center and digital collections grew 35% compared to Q2 of last year. Cabot collections from our debt purchasing business in Europe in the second quarter were $116 million, down 24% in constant currency.

Global revenues in the second quarter were up 23% to a record $426 million compared to $347 million in Q2 a year ago. In the U.S., revenues were $287 million in the second quarter. In Europe, Q2 revenues were $135 million. Significantly higher-than-expected collections drove an incremental $66 million of revenue in the second quarter. This is reflected in our income statement under changes in expected current and future recoveries.

As Ashish mentioned earlier, when we revised our collections forecast at the end of Q1, we overestimated the near-term negative impact of the COVID pandemic on our collections. Since that time, our team has done an outstanding job in adapting our operations to the varying conditions caused by COVID and the attempts to contain it. Having said that, we believe the majority of our overperformance in Q2 reflected a pull-forward of future collections, the very same collections that we pushed out in our Q1 revision.

From my perspective, which I shared last quarter, I suspect that each of the companies in our industry will continue to make curve adjustments as the COVID pandemic evolves, and I believe that all these charges will be self-correcting over the next few quarters. For Encore in Q2, we have essentially pulled forward about half of the delays to our collections forecast that we made in Q1. As I also said last quarter, as we progress over time from projections to actuals, the true economic impact of the pandemic will be generally consistent across firms within each asset class and region.

Our global ERC total was $8.4 billion at the end of June, up $949 million when compared to the end of Q2 last year. In constant currency terms, global ERC was up 14% compared to Q2 a year ago.

In the second quarter, we reported GAAP earnings of $4.13 per share compared to $1.17 per share in Q2 of last year. After making noncash and nonoperating adjustments and accounting for the tax effects of these adjustments, our non-GAAP economic EPS was a record $4.34 per share in the second quarter. This compares to $1.28 per share of economic EPS in Q2 of last year.

By strengthening our balance sheet over the past 2-plus years, we have put ourselves in the strongest liquidity position in the company’s history. During this time, we have reduced our debt-to-equity ratio from 5.9x to 3.2x. We have also reduced our ratio of net debt to adjusted EBITDA, including collections applied to principal, a measure common in our industry. Over the last 2 years, we have reduced this ratio from 3.2x to 2.4x, resulting in a level that is among the lowest in our peer group.

Encore’s delevering has been driven by strong operating performance and focused capital deployment, which have driven higher levels of efficiency and cash flow. Available capacity under our combined revolving credit facilities was $618 million at the end of the second quarter, and we concluded Q2 with $273 million of nonclient cash on the balance sheet, which together comprise the highest level of liquidity on record for Encore at that time. This allowed us to comfortably pay off the $89 million of convertible notes that matured on July 1 and still maintain healthy liquidity after that payment.

The retirement of this issue reduced the size of our convertible debt complex by 13%. If you follow us closely, you will recall that we are in the midst of a concerted effort to reduce the proportion of convertible debt in our capital stack. Also in July, we amended and extended our revolving credit and term loan facilities in the U.S., increasing commitments by $268 million and extending the maturity of the vast majority of commitments to July 2023, further improving our liquidity.

With that, I’d like to turn it back over to Ashish.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [5]

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Thank you, Jon. We believe our 3 strategic priorities are instrumental in building shareholder value. As a result of our continued emphasis on these priorities, we remain well positioned for the unprecedented environment caused by the COVID-19 pandemic.

Our focus on the U.S. and U.K. markets has allowed us to concentrate our efforts on our highest risk-adjusted returns. In the U.S., our returns continue to rise and particularly, after hearing second quarter updates from the banks, we believe a significant increase in charge-offs is inevitable. In the U.K., we are expecting a meaningful increase in supply for both our purchasing and servicing businesses when delinquencies rise. Also, we closed the sale of our Brazilian portfolios in April, allowing us to further concentrate our efforts on our more valuable markets.

Innovation and investments in technology, such as digital collections and speech analytics, have enhanced our competitive advantages in our core markets and have also enabled us to keep our people safe while we quickly adapted to the varying operating conditions resulting from the pandemic. We believe these competitive advantages lead to better underwriting and improved liquidation capability, which ultimately are reflected in differentiated purchase price multiples and higher returns.

Our heightened focus on strengthening our balance sheet over the past 2-plus years has positioned us well for this period of uncertainty. In addition, our liquidity puts us in a strong position to capture the substantial purchasing opportunity, which we believe is sure to follow.

In summary, Q2 was an exceptional quarter for Encore in which we delivered record revenues, profits and cash generation. Over the past several years, we have made investments in our training, compliance and technology, which have enabled us to safely remain fully operational in each of our markets.

Looking ahead, our strong balance sheet and liquidity have positioned us well to capture upcoming opportunities in our core markets: the U.S. and the U.K. These markets are poised for what we believe will be a substantial increase in charged-off receivables coming to market in 2021 and beyond.

In closing, our earnings year-to-date are a strong indicator of our continued earnings growth trajectory. I believe this trajectory demonstrates the progress we have made in building shareholder value. We are delivering superior returns and generating significant cash and are well positioned to capture the growing and increasingly attractive future opportunities.

Now we’d be happy to answer any questions that you may have. Operator, please open up the lines for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We have your first question from Eric Hagen from KBW.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division – Analyst [2]

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Congrats on a really solid quarter. You noted that you pulled forward about half the collections you pushed out in the first quarter. What’s the outlook for collecting the remaining half? In other words, how did the collection curves near — over the near term get adjusted? And are you building in any consumer stimulus into your collection curves? Or could another round of stimulus there help support maybe another quarter of outperformance relative to what you estimated?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [3]

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Eric, there’s quite a few things you put in there. So as we said, we — the changes we made in our collections curves back a quarter ago were predominantly delays in collections, not a loss in collection. I would say 90% was delays, and we pulled forward about half of that. We are confident in how collections are growing in all our markets. As we said, July is — it looked exactly or very similar to Q2 trend. So we are confident in how things are going, and it will take a while for this to play out in terms of which quarter exactly things overperform and get pulled forward. Some of those are legal collections that take quite a while to come back, but they are not lost. They just will take a longer time to come back into our operations.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division – Analyst [4]

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All right. That’s helpful. Can you address the consumer stimulus element of my question, just are you building in any stimulus into your collection curves now? And could another round there potentially help support an outperformance relative to what you’ve estimated?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [5]

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Yes. So that’s a good question. So stimulus, we do not target stimulus payments, first of all. We have not targeted stimulus checks. Now the hardships that we see consumers — we are used to dealing with consumers in a hardship situation for years and adapting to what their situation is. Whether they get some funds or they don’t, they make holistic decisions about their financials. So these hardships are no different, and we are dealing with those. And what we did find is, Eric, to your point, the consumers were demonstrating quite a bit of resiliency through these times in efforts to — and were resolving their debts quite a bit. So a bunch of factors could be in there: consumers are spending less money, a bunch of other things may be happening in their families and personal finances. So we do not target stimulus checks, and we don’t bake in any of that explicitly in any of our expectations.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division – Analyst [6]

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Okay. Great. And then I think you noted in the prepared remarks that supply was slowing down incrementally recently due to COVID. Can you just give a little bit more color there? Any specific color on supply trends in both of your markets, that would be helpful, just to hear how banks are responding to the crisis.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [7]

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So let me go one market at a time. In the U.S., banks in Q2 continued to sell as they were doing before. We did see a slight improvement in pricing. And what we are hearing from our bank partners for rest of the year is the supply should be flat, maybe a tad down. But that’s, again, predictions because of the way the delinquencies are working through due to forbearance programs. But we are also hearing banks are expecting a very significant increase in charge-offs in 2021 in the U.S. And that’s very evident from all the allowances that have built up. If you go look at the major issuers, the allowances have increased to 2.5x, 3x, in some cases. In the U.K., the supply, the sales did slow down in Q2. And we are hearing that banks will continue to be a bit cautious and slow in bringing supply back. Again, forbearance programs there also in play, a little bit more actually in U.K. So that supply is coming in delinquency forms in our servicing business, and we’re having very good conversations in supporting our bank partners. But the charge-offs will be in 2021 and beyond, not in this year. So we expect supply in portfolios brought to sale to be quite muted for rest of the year in the U.K.

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Operator [8]

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(Operator Instructions) We have your next question from David Scharf from JMP Securities.

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David Michael Scharf, JMP Securities LLC, Research Division – MD and Equity Research Analyst [9]

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First off, Ashish, wondering if you can expand a little on the legal collection outlook. And not surprisingly, it sounds like in the early stages of the pandemic, you kind of deliberately pulled back on filings and pursuing more cases. But as we think about ultimately sort of forecasting those expenses, is this strictly a response to COVID and we should ultimately expect the mix that traditionally comes from legal to get back to more normalized levels? Or do you feel that over the next 24 to 36 months, this ongoing shift to kind of purchasing more fresh and more call center collections is going to continue?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [10]

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Yes, David, a couple of things there, and then I’ll let Ryan chime in after that. So there’s 2 separate things. One is our — if you look at our long-term trend in the U.S. business, the shift away from legal towards call center and digital has been very steady over the last few years. Every quarter, the mix has been shifting and as part of our strategy. So that’s continuing. Now clearly, we saw in Q2 an unusual kind of disruption to that mix shift and legal slowing down tremendously. We also did really well in call center and digital. We do expect to recover, as we said, 90% of our legal collections over time. And that’s going to take a while, a year, more actually, in many cases, and depends on how courts will open up and how everything comes back online. So I expect that to happen over time, but I would still expect our steady change towards more call center will continue. In terms of expenses, we also don’t expect the $27 million I mentioned that they’ll go back to being spent in Q3, Q4 or anytime soon. Q3 onwards, we expect more normal legal expenses. And then after that, there might be layering in of some of these backlog of expenses over time as we ramp up legal again, depending on how the environment opens up.

Ryan, do you have anything to add to that?

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Ryan B. Bell, Encore Capital Group, Inc. – President of Midland Credit Management [11]

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No, I think you covered it well, Ashish. I just will highlight, I think the 2 key points is that we have seen a shift away from legal to call center over time, and we continue that shift to continue to play out over time as we see more and more of our collections come from the call center. And then on the depression of legal expenses in Q2, that was an event-driven decrease in expenses. We do expect expenses in the legal collection to get back to normal — somewhat normal in Q3, but we won’t claw back all those expenses in the next few quarters. It will take time to claw back the depressed expenses we saw in Q2 in our legal channel.

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David Michael Scharf, JMP Securities LLC, Research Division – MD and Equity Research Analyst [12]

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Got it. Just to clarify, because I thought those last 2 comments were somewhat contradictory. In Q3, you expected to get back to more normalized legal expenses, meaning sort of the kind of $50 million per quarter range based on the volume of court filings. But I was trying to contrast that with this comment of not being able to claw back certain other things, maybe you can just clarify.

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Ryan B. Bell, Encore Capital Group, Inc. – President of Midland Credit Management [13]

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Sure. So yes, back to the normal, I guess, the clawback is the expenses we didn’t spend in Q2. We don’t get all those back and more in the next quarter, so you won’t see a large increase in expense in Q3.

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David Michael Scharf, JMP Securities LLC, Research Division – MD and Equity Research Analyst [14]

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There won’t be a [shift] is what you’re saying.

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Ryan B. Bell, Encore Capital Group, Inc. – President of Midland Credit Management [15]

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You got it.

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David Michael Scharf, JMP Securities LLC, Research Division – MD and Equity Research Analyst [16]

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It will just be more in that $50 million range. Okay. Got it. Okay. Other question I was going to ask, and I think you addressed it on the last one, about kind of the European debt sale environment. But I just wanted to confirm because I was specifically going to ask whether in the U.K. in particular, you’re seeing forbearance programs and any kind of federal support kind of delaying the inevitable role of delinquencies into losses that we’re seeing here. Did I hear you say, Ashish, that it may actually be even greater levels of forbearance and other sources of liquidity? I’m just wondering, should the eventual surge in charge-off volume coming to market over in the U.K. lag the U.S., do you think?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [17]

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Possibly a bit because I think forbearance is a bit more prescriptive based on FCA’s guidance. I’m going to let Craig chime in. He’s on the phone as well from U.K.

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Craig Anthony Buick, Encore Capital Group, Inc. – CEO & Director of Cabot Credit Management Group [18]

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Yes. David, I think what we’re seeing in the U.K., you’re right, there’s quite a significant level of government support at the moment for the consumers in the U.K. in terms of both the forbearance measures that the banks are then granting to some of their customers, combined with then some of the government support schemes in relation to furlough. If I think about what that means, what we’re seeing in the banks right now, the level of delinquencies right now actually remains down at relatively low levels compared to the past. But when you look at those banks’ results, you will see that they are booking up quite significant provisions right now because they are expecting many of those customers to roll in the future when those forbearance measures and employment support measures are unwound.

What we’re seeing in our business right now, the level of forbearance that we have been providing to our consumers hasn’t really changed over the last quarter or 2 compared to the normal levels that we see. As Ashish mentioned earlier, what we do is provide forbearance to our customers. That’s at the heart and soul of what we do on a daily basis. What we have seen through the crisis, through the depths of it, the lengths of those forbearance holds have increased slightly. But what we’ve seen in the last couple of months, the actual duration of those holds are coming back. What we expect to see and what the banks are talking about is later in the year, when those measures are released, we expect the bank defaults to start to rise and those accounts to start to roll and particularly when unemployment rises.

Now it’s interesting to note, when unemployment rises, one of the things we saw in Cabot in particular, in the U.K. through the financial crisis, even when unemployment rose, the strength of our back-book collections remain very robust through that particular period. And today, given where we stand compared to where we were back in the crisis, our focus on affordability and understanding customer situations, we believe the back book will again perform in a very robust manner. And we look at the front-book opportunities in terms of what’s happening at the banks and look forward to that.

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David Michael Scharf, JMP Securities LLC, Research Division – MD and Equity Research Analyst [19]

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Got it. Got it. That’s very helpful. If I can sneak in just one last quick question. Obviously, in the last 4, 6 weeks, the rise in COVID cases in India has been tremendous. And I know you have, I think, 3 separate buildings, but they’re all located in one city, Ashish, as far as collectors. Any kind of an update on the call center operations over there?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [20]

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Yes, David. So we do have a substantial presence in India in one city, Gurgaon, outside Delhi, which has a lot of high-tech and BPO kind of companies located. So it has very good infrastructure there. But overall, we’ve been fully operational and full capacity using work from home and, as necessary, of essential teams in the office combination across all our countries. And within MCMs, all operations in Costa Rica, U.S. and India, we’ve been fully operational. So we’ve not seen any impact from some of the recent rise. Actually, the rise is not recent in India, it’s been more steady over time. It hasn’t really flattened yet. So — but our operations are fully functional there. And across MCM, given that’s a focus of your question, very productive as well as you can see from the results.

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Operator [21]

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(Operator Instructions) We have your next question from Mike Grondahl from Northland Securities.

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Michael John Grondahl, Northland Capital Markets, Research Division – Senior Research Analyst & Head of Equity Research [22]

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Congratulations on a very strong quarter. Two questions. One, digital collections, you’ve been doing that well for a long time, but can you kind of talk about — it seems like it’s accelerating, just sort of what’s driving that at Encore? And then secondly, could you help us think about your expense levels outside of legal collections, how you’re kind of managing the rest of the business on the expense side? Because clearly, revenues were up a lot and expenses were down a lot, so a pretty good trend there, and if you could help us understand that going forward.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [23]

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Yes. Thanks for the compliments, Mike. So the first question on digital, it’s been an investment we’ve been making in all our businesses, particularly U.S. and U.K. over the years. And the teams have been sharing capabilities and learning from each other as certain things in Europe are — technology is more advanced, regulatory regime is different. So we’re learning from them as well with many other things. U.S. team has done really well. So overall, you’re absolutely right, we’ve been investing a lot on this and actually getting very strong results. And for MCM where you can see much more of a homogenous business, you can see the call center digital share steadily rising. So that’s for sure. And a lot of capability deployments we have done, both online, kind of on web and apps and so forth.

What we did see this time around in Q2, consumers engaging even more so digitally with us. And that also included calling in. So perhaps consumers had more time, they demonstrated resilience in their financials and wanted to take care of their debts. But we found digital grew quite a bit through this time. And we expect that will continue, although it could go up and down based on kind of what may be happening in the macroeconomic picture. But clearly, our capabilities that we’re deploying are working. Consumers are engaging. Consumers are setting up plans, making payments and certain elements completely online, right? So that’s been a very positive trend, and we are very proud of what we’re doing. And I think it will continue growing. And consumers are becoming more digitally savvy as well, and they expect to engage in that manner because that’s what they did with the bank and the credit card before the charge-offs.

On the expense side, if you look at our Q, pretty much every category, our expense line number is below last year’s number. So you can expect some benefits from the COVID impact whether it’s travel, G&A and a bunch of things. We have been just — as the pandemic started in March, we had even a sharper focus on expenses to make sure we are managing that very carefully. And I would expect some of that will persist for a while. I don’t exactly know which ones may go back up because they are more normalized trends. But in general, we are managing expenses really well, and some of this will eventually persist as well. And again, as we get more collections through digital and call center channel, which are lower cost than others, our cost-to-collect trend will also keep improving, assuming we keep buying this similar mix of portfolios over time.

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Operator [24]

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We have your next question from Bob Napoli from William Blair.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division – Partner and Co-Group Head of Financial Services & Technology [25]

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Nice job. The first half earnings, $414 million, I think — I mean, obviously, second quarter and the first quarter, some of the accruals and pullbacks. I think are you suggesting — did you suggest that that, that is representative of the first half of the year of the ongoing earnings power in 2020? Is that how you’re viewing the first half?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [26]

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Yes, it’s a great question, Bob. So what we are saying is — I think you caught it correctly. Given the accounting kind of variances and noise, if you add up Q1 and Q2, that reflects kind of our strong continued earnings growth trajectory. As we continue to perform really well in our operations, we’re buying portfolios at good multiples, I’m very confident in our ability to continue to deliver strong results. We’re not giving guidance. It would not be prudent to do so. We don’t normally do that except in rare cases. So we’re not giving guidance, but we are saying Q1 and Q2 combined, because of the accounting noise, is a good reflection of our performance and trajectory. I would also note July collections demonstrated a similar trend that we saw in Q2, at least a month into Q3. So I hope that’s helpful.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division – Partner and Co-Group Head of Financial Services & Technology [27]

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Yes. And then just a follow-up on the legal question. Legal costs are — will go back to “normal levels”. Was that, $50 million or $60 million in the third quarter? I mean that’s — obviously, the other side of that is that we should expect cash collections from legal to accelerate in the third, fourth quarters and going forward as well. I mean you wouldn’t have the expenses unless you’re going to have the collections, I would guess.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [28]

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That is correct. We’re very thoughtful in how we spend the money. So at times, legal is a bit more front-loaded in terms of expense versus collection curve. So that might get delayed a bit. And again, $27 million was the reduction in expense in MCM. The analogous number for Cabot is $6 million, which we didn’t talk about in the prepared remarks, but it’s similar. And again, Cabot will also see slowly rising expense levels to normal levels, not catch up. But we do expect the legal expenses to start getting more normalized, not added on from the backlog, just more normalized. And it will take a while for them to kind of flow through and collections to also come through. If there’s something that changes that we are seeing we should not spend the money, then we won’t, that’s what we did in Q2, for example.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division – Partner and Co-Group Head of Financial Services & Technology [29]

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Okay. And then we are in a really strange environment, obviously, where unemployment is at really high levels, weekly unemployment claims. You can normally chart unemployment claims and charge-offs directly. But now you have delinquencies at close to low levels. They haven’t gone up much or they’re — in some cases, they’ve gone down because of all the stimulus, obviously. There’s probably going to be more stimulus, either they’re going to come to a deal or our President is going to use executive action to — for unemployment payments and deferrals of being removed from your property. Is it possible — I mean I guess if — and I know the banks have built massive reserves and expect high charge-offs. And I think that’s likely to happen, but it might not. And if it doesn’t, if those charge-offs are covered by the government stimulus payments essentially, I mean how do you view — I mean your balance sheet is in great shape. I mean if you don’t get that great purchasing opportunity you typically would, what are your thoughts on how to manage your capital and to, I mean, I guess, grow earnings or return capital to shareholders? What are your thoughts in the case that you don’t get this spike that seems likely will happen?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [30]

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Yes, Bob. So let me answer. There’s 2 questions in there, and I’ll kind of let Jon chime in for that as well. So first one is I’m not sure if there will be a scenario where charge-offs don’t happen. They might be delayed. So you’re right, maybe stimulus but also consumer behavior, whether they had less expenses or whatever, maybe a driver of lower delinquencies. But the other one is just forbearance programs. So banks in U.K., much more so in U.S. as well, when they give forbearance, you just delay your payments. But at some point, the accounting will catch up. I mean the allowances have grown by 2.5x easily, if not 3x, from just a couple of quarters ago, right? So that set of delinquencies will flow through into charge-offs.

Now it’s possible consumers are able to take care of those charge-offs. Now a portion of those charge-offs, as you know, come to our industry and to Encore. Some may go to agencies or law firms or to banks on operations, which is pretty minimal in a post charge-off world. So if consumers take care of those post charge-off, it’s going to benefit us as well. As we saw, consumers really focus on taking care of their debts, in more numbers than one would have imagined at the beginning of Q2. So I’m pretty sure the charge-offs will happen. The timing may be off here and there. If the forbearance wasn’t there, the delinquencies would have risen right now, and charge-offs would have started later in the year. Now what we’re hearing from the banks, and this is not just us speculating but conversations with banks, they are expecting, in the U.S., charge-offs to rise into 2021 by a very meaningful amount based on what they predict will happen to delinquencies and the flow rates.

Secondly, if things get delayed or don’t, we will make best capital allocation decisions. The first one is foremost, we make investment returns on portfolios based on IRRs, cash IRRs. So that’s a very global set of standards we have in measuring that against and risk-adjust it back and whatnot. So we are making good decisions, and we’ll do that. And depending on which quarter there’s more portfolio and there’s not, and you can see that happened with Cabot in Q2, we deployed less. We maintained our discipline. And also abundance of caution when Q2, the times are a bit uncertain in the early part. On a broader question, that’s always front and center, and we look at that question of returning capital. But it’s not something that I’m prepared to kind of project or discuss at this time. But I’ll let Jon chime in as well.

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Jonathan C. Clark, Encore Capital Group, Inc. – Executive VP, CFO & Treasurer [31]

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Yes. No, I actually don’t have anything to add. You have a future as a CFO. Great.

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Robert Paul Napoli, William Blair & Company L.L.C., Research Division – Partner and Co-Group Head of Financial Services & Technology [32]

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Well done. I guess maybe the last question there. I guess the other side of that, if those charge-offs didn’t pick up, you’d probably do a lot better on cash collections as well but — or if they didn’t pick up anywhere near the expected levels. I think just — I mean so near-term purchases, we would expect to be relatively light in the third quarter, both U.K. and North America, and then probably picking up in the fourth quarter and, certainly, by the first quarter of next year would be the expectation.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [33]

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I would just — a little bit of nuance on this. So for U.S., we would expect continued good purchasing in Q3, Q4, maybe at a little bit less level. Remember, deployment is money going out. It depends on 2 factors: face amounts sold and price. And it can go down based on both or one or the other, right? So that’s an important factor. So U.S., we expect much more purchasing. At least what we are hearing from European banks and U.K. banks is Cabot is probably much more paused and in hiatus in the second half of 2020. But again, that’s as of now. Things could change. But as of now, I would say, U.K. and Europe would be slower. U.S. much — could be much higher levels of purchasing because banks are continuing to sell. There’s been no pausing or change of sales. It’s just the incremental volume of charge-offs hasn’t come through yet. So nobody has paused, and you’re going to buy those portfolios.

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Operator [34]

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(Operator Instructions) We have your next question from Robert Dodd from Raymond James.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division – Research Analyst [35]

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Congratulations on the quarter, in this environment, very impressive. Just if we go — a question first, I’ve got 2 questions, on kind of the shape of the curve. So obviously, I mean, it got reset, and you now obviously have the info about collections. Trends are continuing that late in July from what you’ve said. So would it be fair to say that the curves at the end of Q2, after being obviously revised, changed shape in the Q1, have been revised again and kind of embed the level of cash collections you’re currently seeing? Or if July trends continue, would that produce another cash over quarter in the third quarter?

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [36]

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Great question, Robert. I’m going to let Jon jump in on this one.

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Jonathan C. Clark, Encore Capital Group, Inc. – Executive VP, CFO & Treasurer [37]

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Yes, the one thing you can’t do if you’re sitting in my seat is to, based on however things look at the moment, move your curves around dramatically, right? We moved our curves once as a result of COVID. I would admit we were too aggressive in terms of our reductions and collections. We overperformed in Q2, and we’ve pulled forward those curves as we discussed, right? But when we pushed them out, we pushed them out into 2021, in the case of MCM in particular. But Cabot was the same, it’s 2021 and beyond, right? And so now, we always try to come up with our best curve. But as it is clear, I’m sure, from your other calls and certainly from this call, the future is still not crystal clear. Sitting here today, we can’t say that what we experienced in Q2 and in July of this quarter is set in stone, that’s going to be the way that every month plays out for the balance of the year. So we really don’t know.

So if we continue on where we are in both for MCM and for Cabot, I expect that we will have some material cash overs once again. And in some cases, in adjusting our curves, I’ll point out that we have already vanquished, if you will, the pull-forward opportunity and are starting to increase those curves. So it’s very, very curve-specific, very, very vintage-specific, but to answer your question, if I were sitting here today, if the world doesn’t change, I would expect that we would have more cash — significant cash overs in next quarter. But sitting here today, I wouldn’t speculate we’d have the same level we have today in Q2.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division – Research Analyst [38]

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Got it. Got it. I really appreciate that color. And then if I can, on the second one, kind of related to leverage and opportunity. Obviously, over the last year, leverage is down. Over the last 2 years, leverage is down to 2.4 on net debt to adjusted EBITDA. Where could we expect that to go in the near term in the sense that if supply really does increase in 2021, which seems to align with your expectations in the banks right now, you would obviously want a material amount of excess capital, so to speak, going into that period. So could we see more deleveraging through the rest of this year? And then how high would you be willing to go in 2021 and your lenders be willing to let you go, so to speak, if that supply jumps come through? And basically, how much buying power does the leverage multiple give you going into 2021?

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Jonathan C. Clark, Encore Capital Group, Inc. – Executive VP, CFO & Treasurer [39]

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Well, if you look at — there’s 2 snapshots for you, right? And one of the — in our prepared remarks, I did mention that we had amended and extended our facility in MCM, right? So if you look at 6/30/20, right, the end of the quarter, Cabot had availability of $262 million, right? I’m converting pounds to dollars to make it easy. In MCM, we had $356 million. So $356 million — and to be clear, in both cases, that’s what we could write a check for, right? That’s not theoretical availability. That’s what I call availability. We can write a check to that. Post amend and extend, I could write a check today for — a few days ago, for roughly $560 million. And I have another $113 million behind that, that if my ERC continues to grow, that’s more availability.

So if you match that with an attractive environment with the same or, hopefully, improving money multiples — they’re very good now. I’d like them to be even better. But you don’t really need much capital as your multiples increase. So I see us having plenty of liquidity, no issues at all with any of our covenants, any of our leverage, obviously. But I wouldn’t make the assumption depending — because you and I haven’t talked about what multiples we might assume, but I wouldn’t make the assumption that we have a significant increase in volume that it’s going to be a dollar-for-dollar, if you will, increase in leverage because it all depends on the money multiple, right, how much cash you throw off.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division – Research Analyst [40]

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Right. To be clear, though, if you wrote that check, you would be comfortable with the pro forma leverage multiple that comes with that.

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Jonathan C. Clark, Encore Capital Group, Inc. – Executive VP, CFO & Treasurer [41]

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Yes. Yes. We have plenty room.

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Operator [42]

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There are no further questions at this time. Mr. Masih, please continue.

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Ashish Masih, Encore Capital Group, Inc. – President, CEO & Director [43]

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Okay. Thank you, operator. I just wanted to clarify our response to one of the questions that was raised earlier on legal expenses. I think there was a mention made of approximately $50 million as being kind of our normal rate for MCM. I would say it’s between $50 million and $60 million. That’s the range for MCM legal expenses kind of when we get to a normal level. So I just wanted to clarify that for the group.

With that, thank you all. This concludes the call for today. Thanks for taking the time to join us, and we look forward to providing our third quarter 2020 results in November.

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Operator [44]

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Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation, and have a wonderful day. You may all disconnect.