Portfolio Recovery Will Be the Mother of All Short Squeezes

Feb.25.08 | About: PRA Group, (PRAA)

PRAA "missed" eps estimates by a few cents in Q4. This is completely meaningless however if you're an investor versus a speculator. The stock was down a bit, and I think it is quite attractive.

Management continues to do the right things to build long-term shareholder value. They have repeatedly stated that they do NOT manage for quarter to quarter results, but look towards building long-term value. They are focused on driving ROE and ROIC, not on quarterly estimates. Yet, they say this long-term focus is not an excuse for poor short-term execution. In my book, this is exactly how you want your businesses managed.

As I expected, the current credit environment has provided an increasing supply of charged-off debt for PRAA to buy, and buy they did, purchasing a record $104M-worth ($3.7B face value) of debt, or $264M-worth for the year, versus the previous record of $150M. These portfolios should generate tons of cash for the next 5-7 years. Interestingly, a large portion of these purchased portfolios were bankrupt portfolios which begin cash-flowing immediately and require less staffing to collect. This should help improve margins.

Management commented that not only has supply increased and pricing improved, but also that the current credit markets have "drastically thinned the debt buying herd" - marginal players with questionable underwriting skills (i.e., the ability and discipline to price debt pools so that they will yield profitable collections) and which are struggling in a tougher collections environment. Too, they are unable to access the capital markets for funds to buy more debt. This puts PRAA in the catbird's seat, with over 100M available on their revolving credit line. According to management, underwriting conditions are "treacherous" for players that, unlike PRAA, lack pricing expertise and discipline.

The sudden onset of attractive buying conditions forced PRAA to press their new Jackson TN call center into service before it was up to snuff. Last quarter, Jackson collectors were only performing at 40% of the level of their best collectors. That number was up to 58% by the end of the year and continues to improve. They also announced a new initiative to test an off-shore call center for the first time, starting in Q2.

The earnings miss was partially due to .09/shr of interest charges (pretax) due to the 168M of debt now on the balance sheet.

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Management made a decision in early 07 to adjust their capital structure to drive value. They paid a $1 special dividend, and spent $50M buying back shares. Combined with the large debt purchases this quarter, leverage is way up, but still at modest levels relative to book. While they began paying interest on this debt immediately in Q4, the cash flow from the purchased portfolios takes some time to get going, so they were temporarily penalized for doing what is right for the long term.

Revenues from their contingency collection businesses (fee for service) rose sharply (48% yoy) to more than 15% of total revenues. These businesses should continue to do well and provide a more diversified revenue stream. Overall cash collections for the year were up 12% to more than $265M. However, profitability was down due to increased staffing and accompanying decreased productivity; and interest charges. As I have previously stated, being successful in this business requires several unique skills. Almost anyone can bid on debt, so there is no barrier there other than access to capital (which is in fact becoming more and more of a problem in this environment). It sounds very attractive - you can buy billions of dollars of debt for pennies on the dollar - that's gotta be a sure thing right? Well, just ask the companies that blew up spectacularly several years ago how much of a sure thing it is. These companies MUST be able to look at a pool of credit card receivables for example, and know what to pay for them. This is truly a black art that requires a great deal of experience and discipline, and PRAA has it. They must then be able to follow up on their underwriting assumptions by collecting on these pools of debt efficiently. This is a very tough business that is heavily regulated, and hence once again requires expertise, experience, and careful management.

PRAA has demonstrated over the years that they can do this effectively, and that their underwriting and accounting assumptions are conservative. Their history of allowances (due to portfolios underperforming predictions) is excellent. They also avoid selling portfolios, a practice that can generate near-term accounting profits at the expense of future value creation.

At less than 11x trailing earnings, and <10x likely 08 earnings (which may be ratcheted up due to the large portfolio purchases), this is a cheap stock. It is heavily shorted, because it is assumed these guys are just like the bad actors that have come and gone (and some of whom are still around). It will be the mother of all short squeezes one day as short interest equals about 26 days of average volume. At some point they will reduce buying while cash collections should go up dramatically as the economy improves and the current large purchases "season". I expect to be on board that rocket ship, even if I have to wait a while.

Disclosure: Long PRAA