Portfolio Recovery Associates has been an outstanding performer in the past, but is now facing headwinds affecting the entire industry.
The Aktiv merger is an opportunity that may not be currently priced in to the stock.
Valuation is compelling if the company can meet - or at least come close to - its ROE and growth targets.
Portfolio Recovery Associates (NASDAQ:PRAA) is in the midst of some major changes for the company and for the industry as a whole. Because of recent "guideline" changes from the OCC (Office of the Comptroller of the Currency) and the improving U.S. economy, the supply of debt has decreased and the cost of it has increased. This has caused operating costs for PRAA to go up. PRAA has also had increased costs due to expanding its call center operations and due to legal fees connected to its upcoming merger with Aktiv.
PRAA will pay $880 million in cash for Aktiv, while also assuming about $435 million in debt. Considering that PRAA has a current market cap of $2.8 billion, Aktiv will constitute a large percentage of the combined company and this merger is very important to the future of PRAA.
Looking at the Past 10 Years
First, we will take a look at PRAA vs S&P 500 for the past 10 years:
Clearly the company has performed fantastically since 2004. Not only did it outperform the S&P during good times, but during the Great Recession as well. However, for the last eight months the stock has gone sideways.
The earnings growth of this company has been extremely impressive:
Management has stated goals of 20% ROE and 15% annual EPS growth. Here's a look at how well they have met those two specific goals in the past.
Management has been solid on achieving their stated goals, which is as we would expect for a company that has blown away the S&P by such a wide margin. The goals they set were lofty, but they did a great job in meeting them. PRAA has grown into a premier player in the industry and their management team has earned high marks for what they have accomplished.
Looking at the Past Year
In the past year, PRAA has seen challenges in the industry, mainly due to the rising cost of the debt that they buy. There have been new guidelines from the OCC, and now banks are re-evaluating how they sell debt. CEO Steve Fredrickson had this to say about the recent developments in the April 30, 2014, PRAA conference call:
The supply available debt for purchase in the U.S. continues to be affected by three very large credit grantors who have sidelined their debt sale strategy. We believe these issuers are currently scrutinizing and enhancing their respected debt sell processes, and we expect each one to eventually return to the market.
This has had a direct impact on the stock price. There is uncertainty concerning the supply and cost trends of the available debt for purchase and investors have responded accordingly. Meanwhile, PRAA has continued to report solid results largely on the strength of a recovering U.S. economy. PRAA benefits when more people are able to pay the debts that they owe.
While the supply of debt is a concern for now, management believes that supply will begin to pick back up at some point. As per Fredrickson:
We are optimistic that at least one of the three credit grantors will start selling again this year, although that's simply an opinion.
Later in the conference call he noted that:
...the first issue deals more with the sellers and that revolves around the OCP and the interpretation of the OCC's best practice guidelines by the various selling banks. And in our opinion we've seen quite a variety of interpretation to those guidelines and I think if those guidelines were turned into rules with less room for interpretation that it would be helpful for everyone because quite honestly we've seen a wide variety of interpretation...
For most of 2014, it is expected that the guidelines from the OCC will remain murky. However, PRAA's management believes that once the OCC clarifies the "guidelines" and firms them up into actual "rules," then the environment will improve. Naturally, nobody really knows the timetable for more clarity, so this looms over the stock at the moment. Meanwhile, PRAA has reiterated its stated goals of 20% ROE and 15% annual EPS growth. The merger with Aktiv is expected to be accretive and will give a solid boost to EPS helping PRAA meet its growth target.
Strangely, the upcoming merger has done little for the stock price. The stock did gap up about 15% when the announcement was made, but it was at a near-term low at the time and since then has drifted lower. It now sits right in the middle of the range that it has been in for the last eight months. In other words, the upcoming merger has made essentially no impact on the stock price of PRAA.
Thanks to the uncertainty of the present environment, PRAA currently trades below fair value according to my calculations. Assuming a growth rate of 15% for the next seven years, followed by 5% growth for 20 years, followed by 0% growth, I reach a fair value of $89 per share. This does not take the tangible book value of $15 per share into account.
Even if PRAA only grows EPS by 11% over the next seven years (all other inputs the same as above), fair value is $72 per share. The stock currently trades at about 12x expected 2014 EPS.
Clearly PRAA is undervalued compared to:
- What it has done in the past
- What it targets for the future
- What analysts are predicting for the future
I believe that the upcoming merger with Aktiv represents an excellent catalyst for the stock as it will add value that has not yet been priced in to the stock.
The current price of PRAA ($56.40 as of this writing) represents an excellent chance to buy the stock at an inexpensive valuation if the company can meet the current challenges well. Interesting times, indeed. But it is times like these that are often the best opportunities. For the last 10 years and more, management has proven themselves and I personally believe that they will prove themselves again in the future.
Disclosure: I am long PRAA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.