Unsavory Business And Murky Accounting Undervalue Portfolio Recovery

| About: PRA Group, (PRAA)

By Stephen D. Simpson, CFA

At the risk of climbing on a soapbox, isn't it interesting how people generally expect others to honor their obligations to them, but they get quite resentful when they are held to account on their own obligations? Portfolio Recovery Associates (Nasdaq: PRAA) is the largest publicly traded pure-play in a very unsavory business – debt collection. Not only does PRA have to contend with trying to get money from people who either cannot or do not want to pay, but the company is further burdened with an ever-shifting legal, legislative, and accounting environment. Perhaps it's little wonder then that these shares look quite cheap.

A Vital, But Disliked, Link In The Credit Chain

The availability of capital is predicated on the idea that lenders get their money back and/or can avail themselves of legal remedies to secure repayment. If borrowers are allowed to default and walk away too easily, the price of money shoots up and the availability drops. To that end, Portfolio Recovery occupies an important niche in the credit chain – PRAA buys up receivables that creditors could not not collect, takes the risk upon itself, and profits if it can be more successful in securing repayment.

Said differently, PRAA allows companies like Capital One (NYSE: COF), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC) or other credit providers to offload uncollectable debt, getting pennies for the dollar but averting complete losses and reducing operating costs.

In some respects, Portfolio Recovery operates a business that is not unlike insurance or banking. Banks make and price loans on the basis of expected repayment rates, while insurance companies write policies with certain implicit loss assumptions built into the price. PRAA does the same – the company buys pools of receivables with certain recovery assumptions and profits (or loses) if the company's efforts exceed or fall short of the assumptions.

Plenty Of Opportunities … And Challenges

With the huge spate of defaults in 2008-2010, it is perhaps not so surprising that Portfolio Recovery had ample opportunities to buy up receivables. Since the lows of 2009, in fact, pricing has roughly doubled. This is one of the risks of receivables management (debt collection) – not unlike banking or insurance, PRAA has to contend with rivals that may not demonstrate much price discipline and the auction-style sales process gives the company little control over pricing other than to accept it or walk away. While companies like Encore Capital (Nasdaq: ECPG), Asset Acceptance (Nasdaq: AACC) or Asta Funding (Nasdaq: ASFI) tend to be relatively responsible, it's not uncommon to see newly minted companies come into the market, mess up pricing, and go bust when they cannot collect enough to stay in business.

PRAA also has plenty of operational challenges. The company has been accused of various violations of collection laws in the past, though it has a rather solid record in court. Portfolio Recovery, like Encore, Asset Acceptance, and Asta, also has to contend with a volatile regulatory environment – generally speaking, changes in collection laws don't favor the lenders/collectors as politicians don't win votes by siding with the “rich bankers” against the debtors.

It's also worth noting that this is not an especially easy business and employee training and retention is crucial. Good collectors are worth a lot and PRAA has to keep them motivated and compensated to continue in what can be a stressful line of work. That can present some pressure on margins, particularly in those times where new competitors are rushing into the market. Likewise, the company's efforts to expand its legal collections efforts won't come without some higher personnel costs.

Want some more challenges? Like other receivables managers, Portfolio Recovery's accounting is a little complicated and confusing to the uninitiated. PRAA is not trying to be deliberately obtuse or misleading, it's just that the accounting methodologies for recovery businesses are messy and not particularly intuitive at first glance. Unfortunately, the IRS wants to change this and is pushing the company to change its methodology – this dispute will ultimately likely end up in court, but doesn't represent a huge long-term risk for the company.

Solid Opportunities For Growth

Although the U.S. will hopefully not see another burst of charged-off debt like it did in 2008-2010 for some time, there's almost always enough debt out there for a company like Portfolio Recovery to make a buck. The question, though, is whether this company can continue to find enough to fuel ever more growth as the company grows.

In recent years the company has moved into purchased bankruptcy receivables in a big way and this has been a profitable expansion so far. While the company can do more here, there may be a question in play as to whether the company should tilt its business much more in that direction, as it could be more vulnerable to further legislative changes.

PRAA also has an opportunity to grow its fee-for-service business. Instead of buying the receivables and taking the risk (and profit) all on itself, fee-for-service basically means trying to collect for others without taking on the risk. Curiously, PRAA has not been so successful here yet, and it remains an under-developed growth opportunity.

The Bottom Line

As is the case in insurance, disciplined players almost always win in the end as the more aggressive competitors burn themselves and flame out. Investors interested in this stock should follow the cash collections, the margins, and the cost of new purchased receivables as key metrics.

To those ends, PRAA is doing well of late and has plenty of room for future growth. Cash collections were up 33 % in the last quarter and 36% in the trailing nine months (and up about 3% sequentially), while operating margins climbed four points from last year. New purchases were interesting - the company paid about $0.02 on the dollar this quarter compared with more than $0.06 a year ago, but purchased bankruptcy receivables were actually more expensive.

Investors should also note that collections on the 2008-2010 vintage purchases are already looking pretty strong. It's worth wondering, then, whether some banks like Wells Fargo or Capital One were a bit too hasty in disposing of bad debts at a time when pricing was low just to speed up their own balance sheet clean-ups.

Valuation is not perfectly straightforward and investors can choose between cash flow or excess returns models. By an excess return model (which are commonly used in banking and insurance), Portfolio Recovery is slightly undervalued on the presumption of a high-teens ongoing return on equity. A free cash flow model readily suggests a price target, but investors should question whether the company will truly be able to produce and support the significantly higher ROEs that suggests.

Disclosure: I am long PRAA.