Holding Portfolio Recovery Associates (PRAA) hasn't been particularly rewarding over the past few months, even though PRA remains the best-run receivables collection company out there. The stock enjoyed a good run as the company managed to exceed expectations, but performance has petered out as those expectations get dialed in more closely and the receivables market gets more competitive.
Now it looks like PRA is leaping ahead into its next phase of life. The company has been very slow to exploit its acquisition of UK-based MacKenzie Hall and drive real growth outside the U.S., but the $1.3 billion acquisition of Norway's Aktiv Capital shows a very real commitment to becoming a global collection champion. There isn't quite enough information available right now to fully value the contribution that Aktiv can make, but the valuation seems reasonable and PRA management has more than earned the benefit of the doubt. Even with no contribution from Aktiv in the numbers, PRA remains meaningfully undervalued today.
Q4 Was Better Than It Looked
PRA didn't seem to have the sort of great quarter that investors have come to expect. Revenue was up 20%, but that was actually a little less (about half a percentage point) than sell-side analysts expected. Cash collections were up 22% from the year-ago level, but about 3% below expectations despite strong growth in bankruptcy (up 26%) and internal legal (up 42%). PRA slightly tweaked its amortization rate (39.5% versus 39.8%), the lowest level in quite some time (the amortization rate is typically over 40%).
Management laid out some credible explanations for the shortfall. First, the holiday season saw more long weekends and that hurt collections. PRA also saw a delay in bankruptcy trust fee remittances to the tune of $5 million.
Even with those setbacks to revenue, I'd call this a solid performance. Operating expense growth was limited to 13%, leading to 31% operating income growth and a modest (around 2%) beat relative to sell-side expectations. As a partial testament to how well things are going, sustained outperformance of expectations in the legal collections business is leading management to change its ROI hurdle for collections - a move that is going to lead to higher legal costs expensed upfront (bad for 2014 earnings), but larger profits down the line.
The Purchase Environment Is Not So Great
Perhaps some of the recent weakness in the shares can be tied to recent negative news pertaining to purchases. Pricing has been tracking up (bad for purchasers like PRA), with management commenting that some of the buyers are behaving desperately and paying prices that are all but certain to lead to poor returns.
PRA is not going along with the madness, and purchases fell by half from the year-ago level and 30% from the third quarter.
Buyers' desperation may be being fueled by a "still evolving" interpretation of new regulations by the sellers. These regulations have made sellers of charged-off receivables more responsible for what happens when they sell them to collectors like PRA, and the end result is new rules (no reselling, no offshoring, and guidelines for legal collections) and inconsistent sales activity. These rules will ultimately benefit high-quality operators like PRA, but until Wells Fargo (WFC) and JPMorgan (JPM) return to selling in force (they represent about 20% of potential supply), this could be a challenge.
I think many shareholders have been frustrated by the slow pace PRA has taken with its British business, Mackenzie Hall, since the acquisition in 2012. Management has talked of "learning the market" and so on, but it has yet to make a really meaningful contribution to the company's business. With the aforementioned challenges in the U.S. purchasing market, increasing the international profile is becoming more important.
PRA is taking a big step forward, announcing the acquisition of Norway's Aktiv Capital for $1.3 billion ($880 million for the equity and the assumption of $435 million in debt). Allowing for the country-by-country differences in collections, I think it's still fair to say that Aktiv is in the same basic business as PRA. The company has $1.9 billion in estimated remaining collections (about 75% the size of PRA's) across 15 markets, 13 of which will be new to PRA. The U.K. represents 31% of Aktiv's ERC, with Germany/Austria representing 28%, and Nordic countries adding another 25%.
Management was scanty with details on Aktiv's historical yields, so it's hard to assess just how similar these businesses are. PRA management clearly thinks they are similar, though, and commented more than once about shared viewpoints and policies regarding the collections market.
On at least one superficial level, I think PRA is getting a good deal. If you look at a ratio of enterprise value to ERC, Aktiv would be worth more than $2 billion at PRA's pre-deal multiple. Moreover, PRA management has usually been pretty tough and disciplined about buying charged off paper, so I would be surprised if they suddenly turned profligate when it came to M&A. It also does not hurt that Aktiv's senior management will be staying on after the deal.
The Bottom Line
I don't have enough information to integrate Aktiv's financials into my PRA models, but I can say that PRA's stand-alone value is still compelling. I haven't changed any of my basic assumptions after this quarter, and a long-term free cash flow growth rate of 8% and long-term ROE of 20% point to a DCF-based fair value of over $65 and an excess returns-based fair value of over $60.
I can't calculate a definitive value-add for Aktiv, but directionally I like the deal. PRA has thrived in part on understanding the receivables market and exploiting attractive opportunities, but the larger you become the more you become the market and the opportunity to outperform shrinks. Along similar lines, I like the capital deployment flexibility this deal offers - if results in one market aren't attractive enough, purchasing can be weighted to more attractive markets.
All told, then, I'm still quite happy to be a shareholder of Portfolio Recovery. I also believe there is worthwhile appreciation potential here for new investors, but obviously not as much as before this deal was announced.