Lowell - The Greatest Fool?
All,
Please find our new analysis of Lowell / GFKL here.
It’s not our favourite kind of trade, but there is undeniably an opportunity here. Perhaps we should be putting it on. We’d be relying on the greater fool again - we did so successfully in 2020. Let us know if we are the greatest fools if we don’t do it. Sarria are all about fundamentals, but to be fair, the market not always agrees with that approach. What’s so intriguing is that in the short to medium term we think the downside is benign.
Investment Rationale:
- There is a 25% upside trade here, even if we won't be taking it. Lowell will deleverage on a Cash EBITDA basis. In our world, the metric is entirely worthless, but we have to be realistic about there being a large contingent of worshipers of this measure who will readily refinance this business if it can show them what they want. And it can.
- Our analysis demonstrates how easy it is to raise this figure and how likely it is that Lowell will engage its creditors in refinancing discussions by early 2024, promising 25 points of upside to the fearless who decide to toss fundamentals into the wind.
- Meanwhile, we don't see much downside over the coming months. Perhaps we should think about this again.
- We think Cash EBITDA leverage will drop below 3x by the end of the year and we should have the report of it in April.
The business:
- Lowell is a leading European debt collector focused on purchasing and collecting on non-performing unsecured consumer loans. The company operates primarily in the UK, Germany, and Nordics.
- Lowell has been struggling to be profitable for a long time. The company borrows money to buy debt portfolios and collects on them, but the costs eat up all the profits.
- The reason is the highly competitive environment in which Lowell and its peers have to outbid each other on almost every portfolio. Debt collection - for the most part - just requires a call centre, a handful of conversation maps and access to 100%+ financing at competitive rates. So while there are clear barriers to entry, such as pricing curves, it really only requires outbidding the other players to feed the call centre. Hence the notable absence of sustained profits throughout the sector.
The Fallacy of Cash EBITDA Deleveraging:
- Lowell can artificially boost Cash EBITDA by accelerating collections through portfolio sales and deconsolidated JV transactions. This raises Cash EBITDA, allowing management to claim deleveraging.
- But this is just shuffling paper around faster. It doesn't improve the actual cash flow or profitability of the underlying business which remains weak.
- So the Cash EBITDA leverage improvements are merely a creative accounting illusion not supported by fundamentals.
Underlying Cash Flow:
- To understand Lowell’s underlying business, we have peeled back the last five portfolio sales and M&A transactions. The analysis shows how Lowell's underlying cash flow has been weak despite portfolio shuffling to show improving Cash EBITDA leverage.
- Interest and amortisation (portfolio purchase price) have made up 101% of Cash EBITDA since 2017. So there are no true operating profits and certainly no equity value in the business.
- Free cash flow has been flat as the true replacement rate is in fact far higher than the figure Lowell calculated (verified). So leverage reductions are pure illusion.
Game Theory:
- Lowell needs to refinance. Its RCF needs renewal in 2025 and the bonds come up a year later. To have any chance, the company has to please two sets of investors:
1) Investors who still focus on Cash EBITDA to refinance and disregard the fundamentals.
2) Many existing creditors realise the problems but are too heavily invested to exit easily. So they may roll exposure rather than force a restructuring.
- Until then, documentation allows Lowell to continue layering creditors via more ABS transactions.
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk