Portfolio Recovery Associates: The Shorts Will Be Proven Wrong

Oct.29.07 | About: PRA Group, (PRAA)

I recently added to my position in Portfolio Recovery Associates (NASDAQ:PRAA), a stock I have owned in other portfolios for years. I have only purchased it a few times and have yet to sell a share. In general it's done quite well but has been pulling back substantially lately.

This is a company about which I could write a very lengthy report, but I'll keep to the most important facts here. PRAA buys charged-off debt from credit card companies, banks, etc. for pennies on the dollar and tries to collect 2-4x the amount they payed for it. It is a collection agency, a business with a dirty reputation.

Dirty because of abuses by collection agencies in the past, as well as because of spectacular blow-ups of some public companies in the late 90s. I have a lot of confidence in PRAA however, as they are the leaders in industry compliance, accounting transparency, and operations. Management absolutely knows what they are doing and are singularly focused on creating value. I have spent a fair amount of time with the CEO and CFO at investment conferences, and I believe these guys are straight shooters.

On the surface this is a simple business. There are zero barriers to entry. All you need is some capital to buy some charged off debt, and some people to man the phones and try to collect a lot more than you paid for the debt.

But therein lie the problems. What do you pay for the debt? How much will you collect? The companies selling the debt have already given up on collecting it, how will you collect it? If you pay too much, you're in trouble. If your collectors can't collect, hate the job and quit, bend the rules, you're in trouble. This business appears simple and lucrative, but there have been many casualties who haven't been able to answer the above questions properly.

PRAA has incredible expertise and discipline in pricing and acquiring debt. They will not overpay, and their proprietary pricing models have proven consistently conservative over time. They have also shown that they are able to continually increase the efficiency of their collectors (as evidenced by steady increases in cash collected per man-hour). They have the purchasing side and the operations side down cold. Too, they focus on the "won't pays" in their portfolio instead of the "can't pays", so their business is not as unpleasant as it might seem.

What about the shorts? This stock has carried a huge short interest the entire time I have owned it. It is a somewhat illiquid stock with about 16 million shares out. Currently 44% of the stock is sold short. At current average daily volume of about 300,000 shares, it would take about 23 trading days to cover this short interest!!

This is a prime example of what I call a dumb short. I don't care how much conviction you have that the company will fail or the stock will go down, if anything good happens the shorts will get squeezed to death - they will not be able to cover and the stock will rally strongly. It has happened in the past, and I believe it will happen again, possibly as soon as Tuesday, since PRAA will report results after the close Monday. A well respected short seller recommends steering clear of any stock with more than a 5% short interest. I really can't understand why the shorts in question here are willing to take the risk, especially when the strategy has failed repeatedly in the past.

Why are so many shorts betting against PRAA? Because it's easy to do so. I believe it is a matter of weak analysis. It is easy to point to past blowups in this industry. It is also easy to assume that management is using aggressive accounting to make quarterly numbers. One quirk of this industry is that accounting rules require management to make assumptions about future collection rates, and revenues are based on these assumptions. In other words, if they use aggressive collection predictions, revenues will be higher - for a while. Eventually, it will catch up to them and they will be forced to pay the piper.

PRAA bends over backwards to disclose all relevant metrics and has a ten year history of beating their conservative assumptions. They have never had to take a writedown as a result of too aggressive assumptions. Some players in this industry clearly don't operate the way PRAA does, and probably deserve to be shorted. I believe PRAA is the exception, and that the shorts will again be proven wrong.

Over the past five years, PRAA has grown earnings at nearly a 29% annual rate. Yet the stock is trading at about 12x next year's estimates. They don't have to grow anywhere near as fast as in the past to look cheap at these levels.

Disclosure: I own PRAA in many of my managed portfolios, and positions may change at any time for a variety of reasons.