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Catch the Knife Again: PRAA Analysis

February 16, 2009 – Comments (1) | RELATED TICKERS: PRAA , AACC

It's been 15 months since I last posted an in-depth look at Portfolio Recovery Associates, which is a firm that recently met its earnings numbers. This meeting of expectations might as well have been a beat, as it squeezed some of those shorts out this past week. The last time that I looked at this stock, it was at a 40 handle, and I said that I thought it could run to the mid 40's, and over the year following topped out at 50, about a 25% return. This is not bad considering that the overall market had declined 20%; actually it was great. I sold around 44, and took some profits personally, never re-entering. However, a year after my post, the stock was down 20%, related to the S&P, which was down 40%. Not bad at all. It is since then that problems have arose, as they both sit at about a 45% decline yoy.

For such a small company, PRAA is rather well known in the CAPS community. As a refresher for anyone who doesn't know,according to a MF article “Portfolio Recovery (PRA) buys defaulted consumer debt (mainly charged-off credit card accounts) for pennies on the (face value) dollar, and then collects 2.5 to 3.0 times its initial purchase price over the next seven years.” In addition, as an update since the last time that I wrote, they discontinued their outsourcing operations which collected debt on behalf of other firms in order to use the people to collect their own debt. This is a good move in my opinion because it has higher margins, and there is plenty of debt that needs to be collected. On the other hand, I suspect that the credit card firms will need these services in the future, so it's an interesting move. PRAA has also made some small movements into their tax services with some small acquisitions.

 To get a view into the world of Portfolio Recovery, I took a look at their recent transcripts, courtesy of Seekingalpha.com. I got some very useful information out of it, but, basically, when looking at the future of PRAA, it comes down to two things: volume of collections and margins.

On the most basic level, fee based revenue was up 79% yoy, which is an excellent sign considering that they also dissolved the fee based collection services. So really, the gain was the addition of Muni services + Broussard – Fee Collection Services. While they didn't provide exact organic growth numbers, they said that in the case of both Muni and Broussard they were up substantially. This is excellent news because it provides some diversification and elimination of risk to net income during troubling economic times. In addition this money can be rolled into more debt purchasing, which allows them to take on more debt while maintaining a constant debt-equity ratio, which was evident in their business practices this past year.

As for attempting to outline the future of costs, and collections for PRAA, to be honest, in the current economy, combined with the ramp up efforts and questions of scalability for PRAA, I feel like I'm taking a ball, kicking it in 20 ways and attempting to guess where it's going to land. The first issue I see that has presented itself is that PRAA is facing diseconomies of scale. Due to the fact that they now have more equity and more credit, the amount of debt purchased has increased. I'm a little fearful that this could lead to less average yield on a given portfolio, as the ability to collect a certain debt may decrease when you are taking on more and more debts. Furthermore, due to ramp up efforts, you will see more inexperienced workers at certain call centers; these workers are going to naturally get fewer yields than someone who has been collecting for a few years. That is why the collection per man hour was down. It's reasonable to assume that each of these workers has a learning curve that could increase their productivity.

One executive for PRAA addressed the issue of the gap in productivity between the best and laggard call centers; management attributed $28 Million of lost revenues due to the gap and said they are working on improving the collection methods at these call centers. PRAA faces a learning curve especially when dealing with a ramp-up effort and, thus, by the time they can really begin collect, I suspect they will be much better at collecting than they are right now. For that reason, I will be closely monitoring the productivity numbers reported by PRAA throughout the next year. I love the fact that PRAA management never seems to be satisfied with performance. Complacency is a quick way to death in my opinion and, personally, seeing ROE down only 1.7% in the past year would make me ecstatic, but management is insistent that better numbers can be achieved which is great news.

With a full-scale ramp up effort underway for PRAA, when the economy begins to improve the scalability of the company will be the only question mark. As an analyst from Shaker Investments pointed out in the conference call, PRAA experienced significant growth after the last recession during which they had purchased a lot of debt. PRAA has been doing the same thing adding, $280 Million in portfolio acquisitions this past year and should benefit from lower interest rates currently. It's no secret that PRAA has been ramping up to explode; the question is when.

From 2003-2007, PRAA experienced a 300% increase in stock price; now they are a much larger company than they were then, which will limit the amount they can grow. They are extremely well positioned and, with a strong conservative management base, should capitalize beginning in the second half of 2009 or early 2010. Furthermore, they wrote down $9 million in allowances, the highest the number has ever been significantly. On the positive side, this could indicate that the worse has already come. By meeting EPS numbers this past week for the first time since I've been following them, PRAA seems to be getting ready to roll.

 On a technical basis, the stock is coming off its lower Bollinger Band, and some shorts got squeezed out on Friday's 10% increase in stock price. Well, the short ratio was at 27.5, thus the lingering effects of the good earnings numbers and margins should cause more upwards price drift. In addition, the MACD shows an upwards cross, hopefully marking the end of this brutal downward trend. Overall, by using a variety of technical oscillators, which is the extent of my chartist abilities, the indication of PRAA is that it will begin to trend upward.

 In comparison to everyone else in the financial sector, PRAA flat growth rates look extremely good. The public company with the closest business plan Asset Acceptance Corp, faced a steep drop across the board. In which leaves me to believe PRAA is by far a best of breed.

Lastly, the fundamentals of PRAA are just screaming “cheap” right now. The shorts have wrongfully pushed this one down, from priced for perfection to priced to fail. P/E is at the lowest levels ever, and having Peg at .85 is just the beginning. PRAA sports a price to book ratio of 1.18, and for a company which will face extreme boom during the next businesses cycle peak, it is being priced like a consumer staple instead of the heavy growth opportunity it has which has PRAA very attractively priced. I'm going to place a very lofty price target of 45 on PRAA; this would give it a P/E of 15 and with the growth potential, I feel over the course of the year, as we get closer to the boom, Mr. Market will push this one upwards. In five years, I see no reason why PRAA couldn't be topped out at around 80 plus. While this is titled catch the knife after the gap up on Friday, the knife may have already hit the floor. Regardless if this trends down to 20, in the short term or worse, long-term PRAA is a steal at these prices