The worst is yet to come for debt-laden, cash-strapped and increasingly jobless U.S. consumers.
At least that is the view of major debt collectors -- many of which are holding off on acquiring much in the way of troubled consumer debt from banks and other institutions, betting that it will get cheaper as the economy languishes.
With unemployment and defaults on the rise, companies like Portfolio Recovery Associates Inc (PRAA.O), Asset Acceptance Capital Corp (AACC.O) and Encore Capital Group Inc (ECPG.O) hope to be able to grab bad debt portfolios at fire-sale prices later this year.
Once they acquire debt portfolios such firms aggressively pursue at least partial repayment from troubled borrowers, badgering them via phone calls, text messages and emails.
Once they decide to buy the portfolios and get a sizable amount, the portfolios could be lucrative for the companies over a number of years, Sameer Gokhale, an analyst at Keefe, Bruyette & Woods said.
These companies could be setting themselves up for big future profit gains should debt prices fall as they would stand greater chances of getting better returns once the economy firms up.
Our strategy has been to reduce purchasing ... We are waiting for those advantageous prices, said Rion Needs, chief executive of Asset Acceptance Capital, in a recent interview.
The CEO expects consumer debt prices to bottom out in the second half of the year and said the company will ramp up the purchase of debt portfolios in the third and fourth quarters.
The struggling consumer and resulting increases in defaults and writedowns are not the only reasons why purchase prices are expected to take a beating.
Debt portfolio prices are also likely to fall because of a lack of financing for Asset Acceptance and its rivals, which is depressing deal activity in the sector, analysts say.
Debt collectors depend on banks to fund their purchases. With credit markets still tight, they are finding it more difficult to borrow on reasonable terms.
But having raised billions of dollars as a result of the government's stress tests, banks are now more willing to sell their portfolios at lower prices and take hits to their balance sheets, analysts said.
Collectors' caution about acquiring bad debt could also stem from past experiences. Not long ago, they paid heavy prices for some debt portfolios and had to record impairment charges against their results as collection became difficult and fell short of their estimates.
Asset Acceptance's year-ago second-quarter earnings were way below analysts' estimates, as the company recorded an impairment charge of 10 cents a share. Portfolio Recovery had to take a similar charge in its last reported quarter.
Under accounting rules, debt buyers have to take impairment charges when their collections fall short of expectations or slip below their purchase prices.
WHAT THAT MEANS
While their near-term outlook remains modest, as the companies are still recovering debt bought several years ago -- Portfolio Recovery is still collecting on debts it bought in 1996 -- a long-term benefit from purchasing debt at very low prices cannot be ruled out.
There is potential that the debt collection companies may be more profitable going forward because the cheap prices will boost incremental margins on whatever they are able to recover, said analyst Larry Berlin of First Analysis Securities Corp.
Purchasing portfolios at very low prices -- pennies on the dollar -- these companies will limit their chances of having to book any losses on them. On the contrary, they could see their profits skyrocket even if they can collect only a small part of the purchased portfolios.
Encore stock has gained 72 percent since January, while Portfolio and Asset Acceptance have seen their shares rise 21 and 61 percent respectively. And several analysts say they may have a lot further to go.
Portfolio Recovery is currently trading at about 14 times its 2009 estimated earnings and lags the sector multiple of 16. Encore and Asset Acceptance trade at 11 times and 16 times their estimated 2009 earnings.
While many Wall Street analysts believe debt collectors are becoming a better investment story, they do not expect near-term earnings to reflect that improvement due to impairment charges.
It will be unusual to see an acceleration in performance (near term) because the consumer is still so strapped, Mark Hughes of SunTrust