The Reserve Bank chart below on household debt should be stuck on every policymaker’s desk. The data shows extraordinary growth in debt relative to income over three decades.
As other countries had a plateauing of debt after the 2008-09 GFC, ours raced higher because of rising house prices and the need to borrow more to buy a property.
Australian households are now among the world’s most indebted relative to income – and among the most vulnerable to house-price falls and rising interest rates.
Chart 1: Household debt
The RBA debt chart, of course, shows only half the equation. The other side, asset values, has risen, thanks to rising property and share values this decade. Australia ranked first in global median household wealth in the latest Credit Suisse Research Institute 2018 Global Wealth Report.
Chart 2: Household wealth
In that context, household debt is not the “time bomb” that some commentary suggests. But it is a significant threat, particularly if the decline in national property prices quickens, interest rates rise in 2019 and as billions of dollars of interest-only loans revert to principal and interest loans because of tighter bank lending standards in the next three years.
Higher debt relative to equity, higher interest-servicing costs, sluggish wages growth and rising living costs are a toxic combination. More than a million Australian households are in mortgage stress (where net income does not cover ongoing costs), according to latest data from independent researcher Digital Finance Analytics.
If this trend persists, more Australians, sadly, will experience financial distress in the next two years. Some will be forced to sell their home at a loss and others will skip debt repayments, such as on credit cards and phone bills, to make ends meet. A rise in debt delinquencies is likely.
That’s a tailwind for listed debt collectors such as Credit Corp Group (CCP), Collection House (CLH) and Pioneer Credit (PNC). And also for debt consolidator and lender, FSA Group (FSA). Listed pawnbroker and provider of small cash-advance loans, Cash Converters International (CCV), is another “hardship stock” that can benefit from this trend.
The debt collectors buy portfolios of distressed debt, usually unsecured loans, credit cards and unpaid bills, from utilities and banks. They might buy a debt ledger for, say, 10 cents in the dollar and look to recover 20 cents of each dollar of unpaid bills.
It’s good business when it works. A telephone company, for example, that sells a portfolio of distressed debt gets something back for its unpaid bills. And the debt collector that purchases the debt can achieve a good return on its investment if its recovery rates are reasonable.
However, it’s simplistic to assume a rise in financial distress will boost all debt collectors. For a start, householders with higher income and who own a home, tend to have most of the debt and better capacity to service it.
As Digital Finance Analytics notes, the US experience shows households that get into financial difficulty tend to make up a minority of all households, but stay in distress for longer.
As important is demand for distressed debt, or what debt collectors pay for it. Competition in debt collection is rising as some foreign players enter the Australian market. As listed and unlisted debt collectors pay more for distressed debt ledgers, profit margins contract.
Recovery rate is another critical lever. Higher unemployment negates the benefits of a greater supply of distressed debt because it is harder to recover. People stop paying their bills because of a sudden job loss and cannot repay them if they remain unemployed. That’s bad news for debt collectors that take the risk of buying and recovering distressed debt.
Taken together, I expect a steady increase in the supply of distressed debt, greater competition to buy it and improving recovery rates. The economy, for now, is in good shape, unemployment is low and debt collectors are utilising technology to assess and recover debt.
This is an interesting point in the cycle for debt collectors: the potential for greater supply of distressed debt as mortgage stress rises, and still low unemployment.
Although commentators focus on overall debt, which is influenced by property demand, it may be younger consumers and renters who drive the increase in financial distress.
Outstanding credit-card balances, a key source of financial distress, total around $45 billion, ASIC data shows, and one in six consumers is struggling to repay the debt. Almost a million Australians have persistent credit-card debt and just over half a million are in arrears.
Rising electricity and gas bills are another source of financial distress, as is the propensity of younger consumers to buy iPhones and other gadgets on credit. I hope I’m wrong, but the odds favour an increase in debt in arrears, which is later sold to debt collectors.
Stocks to watch
Credit Corp Group, the largest of the listed debt collectors, has been a good stock for a long time and is among the higher-quality small-caps on ASX. Credit Corp’s five-year annualised total return (including dividends) is 21% over five years and almost 50% over 10.
The stock is down from a 52-week high of $23.99 to $18.95 this year, amid general market weakness.
I like Credit Corp’s growth potential in the US, where it is experiencing strong growth in the supply of purchased debt ledgers. The stock looks moderately undervalued at the current price, but there is not a sufficient margin of safety to buy, for now.
Still, Credit Corp is one to watch and recent news that it intends to buy more distressed debt in FY19 than previously announced is positive.
Pioneer Credit, a May 2014 Initial Public Offering, is well rated among small-cap equity fund managers. The Perth company specialises in acquiring and servicing unsecured retail-debt portfolios. It buys debt that is more than 180 days overdue and seeks to recoup part of it.
Pioneer’s $1.60 issued shares raced to a 52-week high of $3.78, before easing to $2.90. Earnings growth is strong and there is a lot to like about its strategy and execution. Like Credit Corp, Pioneer looks undervalued, but not by enough to buy just yet.
Brisbane-based debt collector, Collection House, has a mixed record and has underperformed the market, amid management and board uncertainty, and an activist campaign by a substantial shareholder to spill the board. An annualised three-year total return of minus 9% reinforces the company’s tough patch.
Collection House has invested in technology as part of its transformation to become a financial-technology (fintech) company that can achieve a higher valuation. After-tax net profit rose 50% to $26.1 million for FY18 and its purchased debt ledger grew 39% over the year.
Collection House says the outlook for FY19 is positive. The insightful share-valuation service, Skaffold, values Collection Group at $1.93 in 2019, $1.82 in 2020 and $2.25 a year later. That suggests the stock is undervalued at the current $1.22.
An average share-price target of $1.71, based on the consensus of six broking firms that cover Collection House, also suggests it is undervalued at the current price.
At the current price, Collection House is trading on a forecast Price Earnings (PE) multiple of about 8 times and expected to yield 6.6 per cent, fully franked. The PE is undemanding.
Collection House has had its ups and downs and is not in the same league as its larger rival, Credit Corp. Collection House’s Return on Equity of 11% compares to 24% for Credit Corp.
But every stock has its price and at $1.22 the market is underestimating Collection House’s turnaround prospects and tailwinds in its sector.
Chart 5: Collection House
Debt consolidator FSA Group is another company leveraged to growth in financial distress. FSA, best known for its Fox Symes Debt Solutions division, is Australia’s largest provider of consumer-debt solutions. It also provides non-conforming home and personal loans.
FSA’s market share of debt agreements in Australia is 39 per cent. The business has about 22,000 clients with debt agreements worth $398 million.
In consumer lending, FSA’s loan pool was $360 million in FY18, up 18 per cent on the previous year.
FSA’s net profit rose 7% to $16.1 million in FY18. The shares fells because profit growth slowed and FSA’s market share in debt arrangements eased.
The reaction looked overdone and the market may be underestimating the potential of FSA’s lending business. The company wants to grow its loan book from $360 million to about $500 million by 2020. As banks tighten lending criteria, FSA could see greater demand for its services.
Skaffold values FSA at $1.31 a share in 2019, rising to $1.52 in 2020 and $1.71 a year later. If Skaffold is correct, the current price ($1.06) offers a sufficient safety margin.
Like Collection House, FSA is a thinly traded micro-cap that suits experienced investors who understand the risks and opportunities of investing in this part of the market.
Chart 6: FSA Group
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 21 November 2018.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.