Seeking Alpha
Research analyst, oil & gas, tech, mid-cap
Profile| Send Message| ()  

The debt collection business in the U.S. is facing some issues regarding the historically low delinquency rates on credit cards and rigid federal regulations. The delinquency rates have been declining since 2009 and reached to 2.52% in the second quarter of 2013 from 6.58% in the first quarter of 2009. Lower delinquency rates could mean that the banks will have smaller debt portfolios to sell.

Portfolio Recovery Associates (PRAA) is one such debt collector that is feeling the heat but is performing well in comparison to the industry. Recently, it was named one of the Fortune's 100 fastest growing companies. The company showed excellent revenue and EPS growth rate. We believe that investors should expect a 15% upside potential in the stock price as the company is observing increase in its cash collections and various initiatives it is taking to expand in Europe.

(click to enlarge)

Source: Investors Business Daily

Increasing cash collections

Portfolio Recovery observed an impressive growth in the second quarter of 2013, and an increase in cash collections was one of the driving factors. The $296 million cash collection comprised of bankruptcy payments of $125.7 million, $90.2 million in call center collections, and $80.5 million in legal collections from customers. The rise in the number of collectors during the second quarter of 2013, which was 80 more collectors than the first quarter of 2013, supported the company to collect debt more efficiently.

It added these staff members to keep pace with the current and immediate future purchasing activity. Going forward, we expect the company to expand the staff size to collect debt even more efficiently. The growing number of staff and consistency of the monthly payer base enhances productivity since significantly less effort is required to collect those payments. It also favorably impacts future cash collections and indicates the staff's ability to reflect Portfolio Recovery's long-term approach to collect debt.

Moreover, it uses the medium of call and email to contact the customers to obtain payment through its call centers in the U.S. The U.S. call center cash collections were again strong in the second quarter of 2013, up 23% higher compared to the same period in the prior year. The company operators through its five call centers, and around 3,300 employees as of June 30, 2013 across the U.S. that are an integral part of its cash collection system. The call centers contribute more than 30% of the revenue coming from cash collections.

On the other hand, GC Services, a private player in the business and its competitor, has more than 30 call centers all over the U.S. It manages more than 20 million call every month though its 9,000 employees. It can be clearly seen that GC Services is a threat to Portfolio Recovery. We expect that if the company increases the staff in these call centers, then it will observe a much improved debt collection process, as this is a cheaper option. This might appear to be an increase in cost, but it is actually a smart investment. Portfolio Recovery follows a simple approach of 'not to spend a dollar -- or more -- to collect a dollar', which will also guide them to bolster the revenue from call centers.

Source: Investors Business Daily

U.K. market may prove to be profitable

The U.K., being the largest mature debt purchase market in the world after the United States, Portfolio Recovery eyes the U.K. Market for further expansion of its growing business. It continues to buy bankruptcy accounts in the United Kingdom, amounting $4.9 million in the second quarter of 2013. We expect it will continue to ramp up data analytics and operating efficiency, eventually achieving the standards it set in the United States, which will make it a major competitor in the U.K. market. The acquisition of Mackenzie Hall Holdings, a leading UK debt collection and purchase group, in January this year has also strengthened its presence in the U.K. market.

Once the management becomes comfortable with the market, purchases could be more than $4.9 million per quarter in the next two years. The U.K. market, which has a rational regulatory environment, is a good diversification strategy for Portfolio Recovery. It is our belief that the company will replicate the performance it has in the U.S. market.

Allured from the potential in the U.K., its closest competitor Encore Capital (ECPG) is also trying to extend its reach. It is trying to widen its footprints in the U.K. through an acquisition of 50.1% in Janus Holdings, an indirect holding company of U.K. and Ireland-based Cabot Credit Management. Also, Portfolio Recovery will have to face some local players including Wescot, which services more than 5 million account holders each year.

We assume that if the company keeps the pace of its buying strategy, it will strengthen its presence in the U.K. market. The increased buying will toughen its confidence in both the business model and its operating strategies. In our view, Portfolio Recovery should start looking for better resources to acquire profitable accounts and clients. This initiative should ultimately help it drive improved results for both the business and its clients. The company should follow the same long-term approach in the U.K. market as it did in the U.S. by capitalizing on the charge-off and bankruptcy markets. Moreover, in May this year it has taken a step forward to compete in the market by expanding its local call centers in Birmingham, U.K. and plans to add 200 employees. In tandem with the increased buying, the expansion will also benefit by more efficiently debt collection.

Credit facility and senior notes to strengthen financials

During the last month, Portfolio Recovery modified its Credit Agreement, which was announced in December 19, 2012, by increasing its revolving credit by $35.5 million. The company increased its aggregate credit facility from $597.5 million to $633 million. This credit facility significantly increases the borrowing capacity as it had only $214.5 million under its old credit facility as of September 30, 2012. This credit facility will also boost the financial flexibility of the company, thereby allowing it to increase its expenditure on business investments. Moreover, we expect this credit facility will aid the company to reduce its cost of funds since the interest earnings will be more. In addition to the expansion of the credit facility, Portfolio Recovery closed its previously announced offering of $250 million aggregate principal amount of 3% convertible senior notes due in August 2020.

"Our expanded credit facility coupled with our recently completed $287.5 million convertible debt offering puts PRA in a strong position to accomplish its growth objective" said Kevin Stevenson, Executive Vice President, Chief Financial and Administrative Officer, Treasurer and Assistant Secretary, PRA.

We believe that this expansion in the credit facility along with closing of the senior notes will strengthen the financial position of Portfolio Recovery in the market and aid it to grasp any opportunity for growth in the upcoming years.

Caveats

In contrast to the opportunities that Portfolio Recovery has in the near term, it has some headwinds related to the regulatory pressure from the Federal government that can hamper growth in terms of revenue and income.

  1. Pressure from the federal government to comply with stricter regulations has made the debt collection business less profitable. The decline in profit means debt collectors must spend more money to comply with regulation, increasing operating expense. The company observed an increase in the operating expense in the second quarter of 2013 by 17% year over year to $109 million. As a result, we assume that it can experience a rise in the operating expense going forward based on the increased regulatory pressures. Moreover, the number of debt collectors in the U.S. is expected to decline over the next two years based on the regulatory pressure. We believe many will sell themselves or their debt pools, giving Portfolio Recovery an opportunity to buy debt at reasonable prices, which negates the effect of the rise in operating expense.
  2. Another side effect of regulatory pressure has been less supply and less demand. We believe this continues to cause prices to rise as supply declines. We believe this has forced the banks to release less debt in the market. This will probably have a negative impact on the revenue for Portfolio Recovery as the company now will have to collect debt at higher prices. We also believe that increasing revenue from collections, as discussed above, and company efficiencies should allow it to grow profit at a decent pace for two more years.

Conclusion:

We believe that there is still an upside potential for this stock, even at the current levels. The earnings estimate for fiscal year 2013 is $3.36 per share. Based on the company's trend of regularly posting earnings higher than the own guidance, we can estimate the stock's target price. At the current price level, the current P/E and the forward P/E for the stock are 17.98 and 13.84 respectively. We assume a price to earnings ratio of 16.95 to the forward earnings estimate as we expect it to reach this level by end of this year. That gives us a price target of $56.95 by the end of this year.

Portfolio Recovery has been successful in beating the earnings estimate by an average of 7.7% over the last four quarters. Factoring in the average earnings surprise of 7.7% into the forward earnings estimate, we get a new target price of $61.34 for the end of this year. Considering that the stock is currently trading at around the low-fifties mark, there is still an upside potential of about 15% by the end of this year. Additionally, the stock is currently undervalued as the company's trailing twelve month price to earnings, or PE, ratio is 17.98 times compared to the Business Services industry's 29.6 times. This also indicates that the stock still has an upside potential. So, we believe that investors looking for assured gains should buy the stock.

Source: Portfolio Recovery: The Shining Debt Collector

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Shweta Dubey, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.