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Portfolio Recovery Associates (NASDAQ:PRAA)

Q2 2008 Earnings Call

July 29, 2008 5:30 pm ET

Executives

Kevin P. Stevenson – Chief Financial Officer, Executive Vice President & Treasurer

Steven D. Fredrickson – Chairman of the Board, President & Chief Executive Officer

Jim Fike - Vice President of Finance and Accounting

Neal Stern – COO

Analysts

Bob Napoli – Piper Jaffray

Hugh Miller – Sidoti & Company

Mark Hughes – Centrix

John Neff – William Blair & Company, LLC

A. Hamagarn – Shaker Investments

Justin Hughes – Philadelphia Financial

Sameer Gokhale – Keefe, Bruyette & Woods

Operator

Welcome to the second quarter 2008 Portfolio Recovery Associates, Inc. earnings conference call. (Operator Instructions) I will now turn the presentation over to Jim Fike, Vice President of Finance.

Jim Fike

Thank you for joining Portfolio Recovery Associates second quarter 2008 earnings call. Speaking to you, as usual, will be Steve Fredrickson, our Chairman, President and CEO, and Kevin Stevenson, our Chief Financial and Administrative Officer. Steve and Kevin will begin with prepared comments and then follow up with a question-and-answer period. Afterwards Steve will wrap up the call with some final thoughts.

Before we begin, I’d like everyone to please take note of our Safe Harbor language. Statements on this call which are not historical, including Portfolio Recovery Associates or management’s intentions, hopes, beliefs, expectations, representations, projections, plans, or predictions of the future, including with respect to the future of Portfolio’s performance, opportunities, future space and staffing requirements, future productivity of collectors, expansion of the RDS, IGS, MuniServices, and Anchor receivables management businesses, and the future contribution of the RDS, IGS, MuniServices, and Anchor businesses to earnings are forward-looking statements.

These forward-looking statements are based upon management’s beliefs, assumptions, and expectations of the company’s future operations and economic performance, taking into account currently available information. These statements are not statements of historical fact.

Forward-looking statements involve risks and uncertainties, some of which are not currently known to us. Actual events or results may differ from those expressed or implied in any such forward-looking statements as a result of various factors, including the risk factors and other risks that are described from time to time in the company’s filings with the Securities & Exchange Commission, including but not limited to its annual reports on form 10K, its quarterly reports on form 10Q, and its current reports on form 8K filed with the Securities and Exchange Commission and available through the company’s website, which contain a more detailed discussion of the company’s business, including risks and uncertainties that may affect future results. Due to such uncertainties and risk, you’re cautioned not to place undue reliance on any forward-looking statements which speak only as of the date hereof.

The company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the company’s expectations with regard thereto, or to reflect any change in events, conditions, or circumstance on which any such forward-looking statements are based in whole or in part.

Now, here’s Steve Fredrickson, our Chief Executive Officer.

Steven Fredrickson

On today’s call, I’ll begin by covering the company’s results broadly, and then Kevin will take you through the financial results in detail. After our prepared comments, we’ll open up the call to Q&A.

I’d like to begin by looking at the quarter’s results and how they reflect the steps we’re taking to build long-term growth. To my mind, that’s what Q208 was really about, building a company that can produce growth, both now and in the future, not just for the next quarter or two, but year after year.

We accomplished this in Q2 in a number of areas despite the difficult economy. Briefly, we realigned our fee-based businesses in Q2, closing our Anchor fee-based collection business and announcing the acquisition of MuniServices, a California based revenue enhancement firm serving local governments. We see our fee-based businesses as an important diversification of PRA’s growth engine.

PRA also acquired $71.1 million dollars of defaulted debt during the quarter, which is a significant number and of course positions the company for future collections.

We have addressed start-up productivity issues at our Jackson, Tennessee call center to the point where its productivity in June was about 80% of our most efficient call center. Our Jackson staff has done a tremendous job in Q2 and I’m proud of the great improvement there.

We’ve been extremely vigilant on the cost front, bringing down operating expenses to cash receipts, which is a key ratio for us. We stood at 44.3% at the end of Q2 down from 45.9% a year ago and our best performance since Q107.

Lastly, in terms of our balance sheet, we have continued to lever the company as has been our stated goal. This leverage has allowed us to make the purchases that have positioned PRA so well for the future.

Making all this possible is the strong cash generation of PRA. In the second quarter of 2008, we had record cash collections of $85 million, up 32% from $64.6 million dollars in the same period a year ago. In addition, we produced fee-for-service revenue, $10.6 million dollars in the second quarter, representing 26% year-over-year growth and this was accomplished despite the winding down of our Anchor business.

In the difficult economy in which we find ourselves today, some competitors have begun to retrench either due to lack of capital or operating uncertainties. PRA is not. We have continued to stick to our overall strategy, seeking profitable and appropriately priced portfolio acquisitions, additions to our fee businesses when good opportunities arise, and continue operating in capital structure improvements.

Now let me round out our specific results. In addition to our record $85 million in cash collections and our $71.1 million in portfolio purchase in Q2, which I’ve already discussed, we saw an overall 16% increase in revenue to $63.6 million dollars. EPS was $0.75 cents versus $0.80 cents in the year ago quarter, which is a 6% decline. Net income fell 12% to $11.4 million dollars in the second quarter amidst fewer shares due to our 2007 stock buy-back; however, these earnings come in the context of net interest expense to total $2.6 million dollars in the quarter. That compares with a net expense of $200,000 in the same period a year ago representing an after tax expense wing of $1.5 million dollars or $0.10 cents of earnings per share impact.

We realize productivity of $134.56 per hour paid for the first six months of 2008, which compares with $135.77 for full year 2007. This includes the addition of 167 net new collectors to our company wide owned portfolio call center staff, inclusive of 24 new collectors in the Philippines.

Now let’s discuss our operations in detail beginning with our Q2 portfolio purchases and overall market conditions. During the quarter, we acquired 58 portfolios from 21 different sellers. The majority, about 95% of our second quarter purchase volume in terms of dollars invested was a combination of Visa, MasterCard and private label credit card asset classes. The remainder came from pools of medical, utility, and installment loan accounts.

The majority of the bankrupt accounts acquired during the quarter are included in the Visa, MasterCard and auto categories. Bankrupt accounts accounted for about 40% of our purchase activity in terms of dollars invested. Our bankrupt purchases in Q2 included a significant portion that were aged from their initial bankruptcy filing and as a result of already generating significant cash flows. These financial characteristics should create a relatively low ERC to purchase price ratio for these types of accounts; however, taking together with low collection cost and financial leverage we look for attractive returns nonetheless.

In terms of our overall portfolio strategy, our intent is to continue to aggressively pursue charged off debt in what we view as an attractive albeit complicated market. We have significant cash flow and available financing to accomplish this.

We’re extremely vigilant of our bidding in relation to observed competition as we have no desire to set the market in terms of pricing. Our bid success rate remains low and in historical ranges, which tells us we have plenty of rational and healthy competitors since pricing appears to be at more reasonable levels than we have seen in some time.

We spend a great deal of time modeling various buying and capital scenarios to be ready for whatever attractive buying opportunities may come our way. The bad debt sale and purchase market is dynamic and is driven by a number of variables that are extremely difficult to predict, including seller strategies, capital needs, and charge-off volumes. On these topics, we do not have a clear crystal ball than the next guy.

We do feel strongly about making prudent levels of attractively priced buys as time goes on. Not putting too much faith in a better day of pricing that may or may not come. We intend to be a regular trusted buyer for our client sellers and we continue to work closely with our lenders so that they can understand our market, our competitive position, and future opportunities that may come along.

Now let’s move on to collections. As I mentioned earlier on the owned portfolio collection front, Portfolio Recovery Associates recovered a record $85 million dollars in the second quarter, up 32% from $64.6 million dollars a year earlier, offering a bit more granularity. Call center collections were a record $48.8 million dollars up more than 30% from the same quarter last year.

Legal collections were 26% of total cash collections in Q208 coming to a record $22.5 million dollars. This compares with 32% in Q207, which represented $20.9 million dollars for a 7% year-over-year gain.

Excluding bankruptcy collections, legal was 32% of collection sin Q208 versus 36% in Q207. As I have mentioned for the past several quarters, we’re very focused on improving our year-over-year legal collection growth rate during 2008.

Cash collections for our purchased bankrupt accounts were a record $13.7 million dollars, up 120% from Q207.

Overall, as you know, we track productivity in terms of recoveries per hour paid, the core metric that measures the average amount of cash each collector brings in. As I said earlier, this metric finished at $134.56 for the first six months of 2008 compared with $135.77 for the full year 2007.

Excluding the effect of trustee administered purchased bankruptcy collections, PRA’s productivity for the first half of 2008 was $115.71 versus $123.10 for the full year 2007. When excluding legal and trustee administered bankruptcy collections, productivity for the first six months of 2008 was $78.75 per hour paid versus $79.26 for all of 2007.

During our Q1 call, I mentioned that the dilutive effect of our Jackson office on overall hourly productivity was about 6%. During Q208, this dilution was halved to about 3%. Jackson productivity improved each month during the quarter finishing in June at just a bit less than 80% of our top performing center. At this point, the Jackson office is performing in line with our other offices at the same points in their evolution.

Across all our call centers in Q2, productivity was solid despite the weaker economy, a fact supported by the core call center productivity metric we introduced with our Q1 results. As a reminder, this figure looks only at hourly paid productivity by collection reps. It excludes not only legal and bankrupt collections, but also any non-owned inbound generated collections or collections coming from external activity such as collection agencies.

Using this metric, we saw consecutive quarterly productivity increase of 13% during the second quarter in Jackson, 1% in Hampton, 1% decline in Kansas, and a 3% decline in Norfolk.

On an absolute basis, Kansas remains our top call center. During the quarter, Jackson improved from about 64% of the Kansas standard in Q1 to 74%, while Norfolk and Hampton remained at about 88 to 89%. What’s most encouraging about the Jackson numbers is the productivity improved even as hours paid increased 16% from Q1.

For comparison, hours paid moved up 1% at Hampton, 7% in Kansas, and 3% in Norfolk. Since hourly productivity is generally inversely related to hours worked, moving both statistics up is a real feat.

Indeed, net domestic staffing increased in Q2 more than we have seen in some time, principally due to the closing of our Anchor operation and the migration of most of these employees to owned portfolio collections prior to quarter end.

As a result, we have a new owned portfolio collection center in Birmingham, Alabama, an office Anchor previously shared with RDS that now houses about 50 collectors.

Together with the increase in staff, we continue to rely upon increased use of predictive dialers and enhanced account level work prioritization to improve productivity. In fact, when the midst of increasing significantly the number of predictive dialers seats that we’re utilizing and anticipate this project will be completed in early Q4.

Our Philippines office continue to develop but slowly. About 5% of all paid hours came from our Philippines office with an ending employment of about 74. We still believe it is far too early to make with any precision or prediction of the potential for long-term productivity from this office. At this point, as with all new offices at this stage in their development, productivity in the Philippines office is far below our domestic centers; however, we expect to improve this substantially during Q3.

Company-wide, at quarter’s end, our owned portfolio collector headcount was 1,275, up about 15% from the end of Q1. As it relates to staffing, please remember that a significant amount of our recent buying was related to pools of bankrupt accounts, which require relatively low levels of staff to handle. Please also note that our bankruptcy staff is not included in the collector headcount numbers I just shared with you.

Now let’s turn to PRA’s fee for service business, IGS, Anchor, and RDS. During the quarter, these fee for service businesses saw revenue increases 26% from the same period a year earlier to $10.6 million dollars. This growth rate was negatively impacted by our decision to wind down the Anchor receivables management business. This wind down of Anchor is now complete. Essentially all of the Anchor workforce has been redeployed to owned portfolio work by the end of June. As a result, Anchor revenue and income fell significantly in June, although Anchor did post a small positive operating income number for the quarter.

During the quarter, our remaining fee businesses continue to grow offering us not only incremental revenue income, but also diversity in our earnings. IGS continue to perform strongly during Q2 as the market it served continue to struggle with high rates of delinquency. Although RDS did not grow revenue or income as rapidly as IGS did, it too improved nicely on a year-over-year basis, especially on the bottom line.

On July 1, 2008, we closed on the MuniServices acquisition, which we first announced in June. MuniServices represents the second government revenue enhancement firm PRA has acquired. The first was RDS. MuniServices is based in Fresno, California, and it served government entities for the past 30 years. It operates in three broad areas, revenue enhancement and protective services, information services and systems, and economic development and fiscal consulting.

In the revenue enhancement and protective services arena, MuniServices assists government clients in making sure they’re collecting all of the tax revenue that is due to them. This encompasses all general sources of municipal tax revenue, including sales and use tax, business license tax, and utility users tax and franchise fees.

MuniServices employs a variety of audit reviews, many of them highly automated and data base intensive to ensure that clients and tax payers are remitting fully and that clients are being allocated full amounts by tax oversight authorities. This work is preformed on both a contingency and hourly basis, although the majority of revenues comes from contingency work.

The vast majority of the MuniServices revenue and income comes from these products and services. The information services and systems area provides local government agencies with sophisticated tools to analyze the revenue streams, which helps them make more informed policy decisions. These services are based on some of the same technology MuniServices uses to complete audits in its revenue enhancement work and are generally billed on an annual fixed fee basis.

Finally, MuniServices economic development and fiscal consulting services area provides government clients with a variety of services, including revenue forecasting tools, economic research analysis, studies and strategies, business retention and attraction strategies, and tax program design and administration. These are all tailored to improve processes and reduce fiscal management problems. These services are generally billed on an hourly or fixed fee basis.

MuniServices has approximately 120 employees and ten offices across four states in the District of Columbia.

Together, RDS and MuniServices have a complimentary and established client base and product offering. There’s little redundancy between the two companies and going forward we will focus on opportunities for synergies both operationally and from a corporate support perspective.

Now onto our balance sheet. During the quarter, we continue to increase outstanding borrowings against our line of credit drawing $17.5 million dollars to help finance our portfolio purchases of $71.1 million dollars. This left our quarter end outstandings at $234.3 million dollars. We produced return on equity of 17.8%.

Shareholder’s equity totaled $260 million dollars at quarter’s end and our debt levels while increased remained relatively modest and less than our equity account.

With that, let me turn the call over to PRA’s Chief Financial and Administrative Officer to take you through the financials. Kevin?

Kevin Stevenson

Our second quarter 2008 financial performance reflected our focus on building long-term growth for PRA.

Net income in the quarter fell 12% to $11.4 million collars, while EPS declined 6.3%. Total revenue for the quarter was $63.6 million dollars, which represents growth of 16.1% from the same period a year ago.

Operating income was $21.3 million dollars, which is essentially flat year-over-year. While net interest expense grew from $218,000 dollars one year ago to $2.6 million dollars in Q2 and up sequentially from $2.5 million dollars.

Our average interest cost on the acquisition line during the quarter was 4.63%. Breaking our second quarter revenue down into three components, once again the majority of total revenue or $53 million dollars came from income recognized by finance receivables. This is revenue generated by our owned debt portfolios.

Income on finance receivables is derived from the $85 million dollars in cash collections we recorded during the quarter which is a new record and represents growth of 31.6% over Q207.

Second quarter cash collections were reduced by an amortization rate, including allowance charge of 37.6%. This amortization rate compares with 33.7% in Q108, 28.2% in Q207, and our full year 2007 rate 29.6%.

During the quarter, PRA record allowance charges totaling $4 million dollars, which compares to $2.8 million dollars in Q1. Life to date, reserves, since the change to SOP03-3 now stand at just $11 million dollars.

As I’ve done in the past, I’d like to take a few minutes to walk through these charges and provide a bit more granularity. First, remember that effective January 1, 2005, PRA began booking revenue under the guidance of SOP03-3. Prior to SOP03-3, we used the guidance of practice bulletin 6. As it related to allowance and impairments, the key difference between these two pronouncements is that SOP03-3 removed the company’s ability to reduce yield on a pool once it’s set. Furthermore, if a pool experiences better than expected results the yield is correspondingly moved up, that increased yield becomes the new baseline that cannot be subsequently reduced.

The guidance of practice bulletin 6 allowed companies to move the yield up or down in order to amortize a pool at the end of its expected economic life. SOP03-3 prohibits lowering that yield, even if that current yield is significantly higher than that originally set.

The only mechanism companies are afforded to ensure that a deal amortizes in its expected economic life is that of allowances. Allowances are taken so that the then current yield amortizes a pool of accounts during its expected economic life.

So onto the specifics. Of the nearly $4 million dollars in allowances taken in Q208, approximately $960,000 was attributable to older pools, those dating from Q204 and back. This compares to $240,000 of allowance charges in Q1.

These deals currently bear very high yields, in excess of 300%. When yields are this high, any negative variance in cash collections, even of a relatively modest size, can create the need for allowances. All in all, these pools are collecting well in excess of original underwritten expectations. So the reserves are really more function of its high yield environment coupled with some weakness in current cash collections rather than mis-pricing or underperformance relative to original expectations.

Approximately $460,000 dollars at the current paid allowance was attributable to higher yielding bankruptcy pools, which compares favorably to the allowance charges taken in Q1 of $995,000 dollars. While the yields on these bankrupt pools are not nearly as high as the pools referenced previously, the yields are currently in excess of their original book yields. From a financial investment perspective, these are very good deals, which should produce financial results that exceed their expectations.

In Q108, we described that approximately $850,000 dollars of the Q1 allowance was related to the Q105 pool that we had discussed before. We also mentioned that we had taken significant steps in terms of writing down its estimated remaining collections.

During Q2, we did not incur any additional reserves on this deal. Life to date, we have taken allowances equal to $2.3 million dollars related the Q105 pool, primarily associated with one purchase transaction within that quarter, which had an associated $4.5 million dollar purchase price. We will continue to keep you apprised as time moves on relative to this deal.

Additionally, I’d like to take a moment to mention that we have incurred no allowance charges on paying pools that we last discussed in Q107 call. Looking back into Q107, you would see a few quarters in 2006 and end of Q107 that had some allowance charges on those paying pools. These pools seem to be performing along the updated estimated remaining collections projection we set over a year ago.

Lastly, 2006 and early 2007 pools, required additional reserves. During Q2, we incurred $2.5 million dollars of reserves against these pools. $650,000 of which was related to Q107 acquisitions.

The pricing environment in 2006 and early 2007 was challenging leaving little room for underwriting or operational error. During Q1, we saw some weakness in these pools and took allowance charges. This weakness expanded somewhat in Q2. As in Q1, given the economy we face, we wanted to take aggressive action and hopefully set these pools on a correct course by taking these allowances early.

In aggregate, buying done in 2006 and 2007 is performing in excess of original booked accounting assumptions, however, some individual pools have shown underperformance and necessitated the allowance charges we’ve discussed. Our practice is to take quickly take allowances on those pools where we see weakness and wait to move up projections on those pools that outperform until that over performance is very well established.

As I’ve remarked repeatedly, I think it’s realistic to assume that some modest percentage of any debt buyers amortization will always be allowance charges. SOP03-3 simply creates an environment that supports this, based on the directive to increase yields on over performing transactions and the prohibition on lowering yields once they’re increased.

Further, given the relatively tougher collection environment faced any economic downturn, we feel it is imperative to take an appropriately large allowance expense when we see weakness. If such a move proves to be too conservative down the road, we can always reverse the allowance. By delaying the allowance charge, one only increases the risk of an even greater charge in the future, an event that needs to be avoided or at least minimized through conservative implementation.

During the second quarter, cash collected on fully amortized pools was $5.4 million dollars, down from $6.3 million dollars in Q207 and down sequentially from $6.3 million dollars in Q108.

Through the first six months of 2008, cash collected on fully amortized deals stand at $11.7 million dollars . This compares to $24.8 million dollars in full year 2007. $29.6 million dollars in full year 2006, and full year 2005 collections of $26.7 million dollars .

In referring to fully amortized pools, on purchase pools with no remaining basis on our balance sheet. Eliminating those pools from our amortization calculation gives us a core amortization rate for Q2 of 40.2% up from the 31.3% we saw in the second quarter of 2007 and up sequentially from 36.6%.

We continue to believe that as a byproduct of SOP03-3 in effect since January 1, 2005, the quantity of zero basis cash collections should gradually decline over time, due primarily to the fact that under the guidance of SOP03-3, we aggregate all similar paper types acquired in a quarter in order to calculate revenue. These larger groupings allow us to forecast more accurately and generally keeping the purchased finance receivable asset on our books for a longer period of time than we have historically.

During Q2, commissions and fees generated by our fee for service businesses, Anchor, IGS, and RDS, fell $10.6 million dollars. This compares with $8.4 million in a year ago quarter.

In May of this year, we announced that we plan to exit the business of contingent fee third party portfolio collections, which was overseen by our Anchor receivable management unit. Most employees of Anchor have been redeployed into PRA’s owned portfolio business as of June 30.

The Q208 results contain a full quarter of Anchor impact, albeit in lower levels compared with Q108.

In addition, we completed our previously announced MuniServices acquisition on July 1, 2008. Because of this, the transaction had no impact on our Q2 financials.

To remind everyone of the transaction details, the purchase price was initially set at $24.6 million dollars, which was comprised of $22.5 million dollars in cash and $2.1 million dollars in common stock. The purchase price can increase by a total of $4.5 million dollars in stock through contingent payments in 2008 and 2009 related to specific operating goals.

The third component of total revenue, cash sales of finance receivables, was once again zero for the quarter, as it has been in every quarter since our IPO in late 2002. On the operating expense side, we were relatively flat at $42.4 million dollars, versus $42.2 million dollars in Q108.

In the past, I’ve discussed our efforts to move forward in a couple of interesting areas in terms of efficiency of our operations. First we’re continuing to invest in technology and strategy to help our existing collectors move more debt through the system. In this regard, beginning in Q1 and then continuing into Q2, we’ve changed our predictive dialer and account calling strategies. This helped us work 18% more accounts per hour in June 2008 than in December of 2007. When I discussed this in our Q1 call, that number was 17% more accounts worked in March 2008 as compared to December 2007. We’re planning continue investing in technology to help us push productivity.

Second, during Q2, we began an experiment using call center agents based on the Philippines. This experiment began with 25 reps in mid-March 2008 and has of our last conference call we were 50 reps. We ended Q2 at 74 reps. We had planned to remain at 50 reps during this experiment; however, we saw an opportunity to expand the test from 50 to 75 reps during Q2. The additional 25 people were deployed to a particular technology based collection strategy. We currently plan to continue at this level until we have a better indication about the kind of productivity we can expect from this workforce. It is still too soon to provide much more feedback on this experiment.

Operating margins during Q2 were 33.4% compared with 34.1% in Q1-8 and 38.8% in Q207. This compares with full year 2007 operating margin of 36.8%. Without the margin dilution caused by the fee businesses, the operating margin would have been about 39% in Q2.

As we’ve stated repeatedly in the past, we will make further investments in professional and collector staff throughout 2008 to assure we have the talent on hand to best exploit the many long-term opportunities we see.

Operating expense to cash receipts, as I mentioned before, is perhaps a more insightful efficiency ratio since variations in purchase price amortization rates caused our revenue ratios to fluctuate, regardless of true operating efficiency levels.

Operating expenses as a function of cash receipts during Q208 were 44.3%. This compares very favorably to Q108 at 46.5% and also with 45.9% in Q207. This is the best expense to cash receipts ratio we have seen since Q107 and Q206 before that.

We will remain keenly focused on operating expenses in 2008 and some of what you’ve seen in terms of operating expenses to cash receipts ratio improvements in Q2 have emphasized that focus; however, I want to be sure that everyone understands that we will not cut corners that could impact our long-term cash generation. An interesting metric, please understand that we’re not running our business solely based on operating margins, we feel that earnings efficiency rations such as return on equity, return on invested capital, and growth in earnings are much more important to the long-term health of the company. Should we need to invest in people, data, services, or other items that drive up our expense ratios in an effort to improve ROE, ROIC, and earnings growth over the long-term, that’s what we’ll do.

Our balance sheet remains strong during the quarter, despite significant purchases of new portfolios and subsequent draws on our line of credit.

Cash balances increased slightly to $16.3 million dollars at the end of the second quarter. Rounding out the balance sheet, we had $515.4 million dollars in finance receivables, $26.6 million dollars in property, equipment, and other assets, $18.6 million dollars in goodwill, and $4.3 million dollars in intangible assets all related to our business acquisitions.

During 2008, we are incurring intangible amortization expenses of approximately $350,000 a quarter. This does not include any intangible amortization related to the MuniServices acquisition, which was completed on July 1, 2008.

We have about $234.3 million dollars of short and long-term debt and obligations in our capital leases, with total liabilities both long and short-term of $321 million dollars. The majority of this debt is at $234 million dollars outstanding under our line of credit. At June 30, 2008, shareholder’s equity totaled $260 million dollars.

Our current balance sheet is approaching one to one leverage relative to shareholders’ equity.

At our current committed line of credit and existing equity account, our leverage could go up to just over 1.3 times. We would be more than willing to take leverage up that far or even modestly further for the right investment opportunities. I do want to state, however, that management feels strongly that our business should not be highly levered and that we are watching closely our performance metrics as we add leverage from here.

We are very focused on the long-term growth of PRA. While we are interested in driving all key metrics that measure our progress, we will not substitute short-term goals for long-term goals. At the same time, I also want to make it clear that a long-term view will not be used as an excuse for poor short-term execution. We are closely watching productivity and operating costs and believe we have our opportunities for improvement in both during 2008.

With that, I’ve completed my prepared comments. I’d like to open the call up to Q&A. Steve and I will both be available to answer your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Bob Napoli from Piper Jaffray. Please proceed.

Bob Napoli – Piper Jaffray

Question on the impairments in trying to forecast impairments. You didn’t have any impairments from 05 and we’ve been most concerned about 05, 06, and early 07, and the way SOP03-3 works, I understand there’s likely to be more. It is $0.16 cents per share if you had a quarter where your impairments were, we’re far lower obviously which changes the numbers and it looks like volatility may be for awhile as those 06 and early 07 pools sort out could be high. I don’t know if you could put some color around other than ripping apart the queue, which we do, but even doing that it’s hard to say, because we don’t have the individual pools that you’re looking at, Kevin. How can we get a feel for what you feel could be left in the impairments in those pools and when you would decide to move up yields in say the 08 pools?

Kevin Stevenson

I can answer part of that. Some of what you’re asking is giving you some guidance on your modeling, which you know we don’t do; however, as you pointed out we did not incur allowances on that Q105 deal, which I think was excellent news. Additionally, the allowances on the bankruptcy pools were about halved, which again I think is also good news. The 2006 and early 2007 pools as you mentioned certainly come from a high price environment and leaves little room for price or operation error. The way this works is that as we see data coming in, what we’re trying to do is match these curves that are forecasted to the data points we have, so every month goes by we know something more than we did in the prior month. One of the reasons I’m trying to give you guys a lot of granularity as to where these allowances are coming from and actually where they’re not coming from. I think as time moves on, I’m going to keep providing that data for you guys to digest.

Bob Napoli – Piper Jaffray

Essentially, what you’re doing is you’re putting on pools, you’re paying apples for apples, theoretically 30% less or maybe even more at the same evaluation as these pools where the evaluations are much tighter. Is that a fair characterization?

Steven Fredrickson

That’s an excellent observation. As we go into 08, we believe we’re buying the higher IRRs than we have in the past 18 to 24 months, but we are booking them from an accounting perspective as prudent projections. That’s a good place to start.

Bob Napoli – Piper Jaffray

The Philippines going from 50 to 74 and expecting a significant increase in productivity in the third quarter, maybe explain why?

Steven Fredrickson

Again, so the test was suppose to be 50 people. The extra 25 was kind of a separate thing. It was a situation where we saw the ability to put these guys on a technology based collection solution.

Bob Napoli – Piper Jaffray

What is the revenue out of MuniServices?

Steven Fredrickson

We haven’t disclosed that. We did say it was accretive to earnings though, Bob.

Operator

Your next question comes from the line of Hugh Miller of Sidoti & Company.

Hugh Miller – Sidoti & Company

I was wondering if you could give us a little bit of color on how long the employees from Anchor that are coming over, how long do you anticipate it will be before they really establish a meaningful book of business and talk about the productivity ramp-up for these types of collectors relative to a new hire.

Steven Fredrickson

Hugh, we actually invited Neal Stern, our new COO for the owned portfolio business to sit in. So it’s probably an appropriate question for him to take a shot at.

Neal Stern

I think I would say that our Anchor employees obviously have some collection experience. So this is not like hiring someone off the street with little or no collection experience. I think they will ramp up the pace of our best collection center, but early on that pace is modest. So we shall see.

Hugh Miller – Sidoti & Company

Maybe if I could ask a follow-up question. As you’ve been there at PRA now for close to six months, can you talk about what initiatives you see for productivity enhancements near and longer term?

Neal Stern

Sure. So we’ve been doing everything we can to leverage the massive data set that we have to do everything we can to maximize cash collections and maximize the return on investment that we have and a number of things, you know, make sure we’ve got the right account to the right person at the right time and give appropriate treatment and as Kevin mentioned we’re doing a lot in terms of collection technology and leveraging.

Hugh Miller – Sidoti & Company

I know it’s very hard from a quantitative standpoint to pinpoint, but from a qualitative can you talk about the impact from the tax rebates it may have had on the cash collections?

Steven Fredrickson

I’d say it’s difficult to extract exactly what we were getting from the rebate and what we were getting from other sources. We did run some specific mailing programs that were targeted at people getting rebates and again as to whether they would have taken those with or without the rebate, it’s difficult for us to know, but on those specific programs we received about three quarters of a million dollars. So again, some of that is probably net left from rebate, some of it we would have gotten otherwise, and obviously there’s other rebate impact scattered throughout the quarter just as there would have been normal tax return monies in Q1.

Kevin Stevenson

And I would just add that the three quarters of million was incremental to our control group. So it’s something north of that in total.

Hugh Miller – Sidoti & Company

You guys have talked about the initiatives you have to try and really bolster the legal collections. Can you give us some insight as to what those are, what you’ve seen possibly that is working, what may not be working, and what you plan to do going forward?

Steven Fredrickson

So we are aggressively trying to model which accounts are going to respond best to that treatment and again model at what point in their lifecycle they’ll best respond to that treatment. So we’re quite prepared to make an investment in legal when we can quantify that we’re going to get an appropriate return.

Hugh Miller – Sidoti & Company

Legal accounts through the system as quickly as you could have done, has that been remedied? Is that something that’s going to be worked on?

Kevin Stevenson

That’s what I was alluding to. So we’re again trying to determine when in the life cycle to place an account and so we’re trying to make sure we’ve had appropriate calling attempts before we place the account and then making sure that those accounts are getting their other right accounts. So there’s been an enormous amount of effort and I think that will show up for us.

Steven Fredrickson

We’re really looking at two broad examples. One would be a situation where an account may be pushed into the legal channel too early by a collection rep and so that is a non-optimal strategy in many cases and one that we’re working closely on trying to pull into line. Another, almost opposite situation, would be an account that is placed in the legal channel but for whatever combination of circumstances isn’t pushed through as rapidly or as aggressively as would be optimal and the key there is suing the right accounts not suing every account, it’s an expensive process, and working on our modeling and our optimization strategies there is something that we’ve been spending a great deal of time on.

Hugh Miller – Sidoti & Company

Last question. Can you talk about whether or not you’re seeing significant opportunities out there in the resale market?

Kevin Stevenson

Actually we’re seeing very little activity in the resale market as a continuation of what we saw in Q1. I don’t know if it’s just that prices in that resale market have dropped to a point that people are saying I’m not going to sell at these levels and that the need to make those sales hasn’t risen to the point where they’re willing to bite the bullet and move them at market prices yet or not, but we’re just seeing very, very little happening in the resale market right now.

Operator

Your next question comes from the line of Mark Hughes of Centrix.

Mark Hughes – Centrix

What was your guidance in terms of your tolerance for debt. I think you used 1.3 times. Is that the equity?

Steven Fredrickson

Yes, that’s correct. I did way we would consider going somewhat higher than that, depending on the opportunity for the investment.

Mark Hughes – Centrix

Anything you can say regarding monthly collection trends through the quarter?

Kevin Stevenson

Pretty steady, Mark. We didn’t see anything too unusual in one versus the other. It was generally fairly related to a number of work days.

Operator

Your next question comes from the line of Richard Shane of Jeffries.

Richard Shane – Jeffries & Company

Just one detail, you mentioned the rebate mailing that you did. What was the timing of that during the quarter?

Kevin Stevenson

Our goal was to try to hit the consumer with the mailer as close to the kind of pre-advertised rebate mailing dates as possible. So we were trying to hit them within a couple of days of those mailers and they were fairly sprinkled throughout the period, but I can’t give you much more than that.

Steven Fredrickson

The IRS posted a schedule of when people with different social security numbers could expect to get their checks. Our mailing schedule would have approximated that schedule.

Richard Shane – Jeffries & Company

So you didn’t see any particular variance during the quarter, because the benefits were spread out from the rebate checks.

Steven Fredrickson

That’s right. The rebate checks continued to be mailed even into early Q3.

Richard Shane – Jeffries & Company

When I do a big picture sources and uses of cash, $85 million dollars from collections, $17 million dollars from borrowing, $102 million of basically gross sources. You bought $71 million and I estimate the cash operating expenses at about $40 million. So $111 million of cash operating expenses, cash was flat for the quarter and the difference is in the deferred tax liability, which makes sense. Can you help us understand what the difference between GAAP and tax accounting that causes that creation of the deferred tax liability and how long you expect to be able to maintain that before you actually have to start paying cash taxes?

Kevin Stevenson

Sure. I don’t have the history of the balance sheet in front of me, because there was a period at some point in our past several quarters ago where we did start to either start to slow down or reverse that liability, but your question specifically is for tax purposes, we report revenue to the IRS under the cost recovery method, which simply is that every dollar goes against that portfolio is amortization until the full cost of the deal is recovered and then every dollar is revenue. For financial, SOP03-3. So I think we know the financial side and the M1 adjustment, which is the adjustment of the tax return, is the difference between that and cost recovery. That help out?

Richard Shane – Jeffries & Company

That helps perfectly and realistically, because over the last couple quarters and given the big portfolio purchases you would expect to see this, it has started to grow again. Where do you reach a steady state where that would either flatten out or actually start to go down?

Steven Fredrickson

You’ve exactly hit on the head. As buying ramps up, that number would theoretically grow as well and then as buying slows down, that would start to level out and start to get repaid and you start to burn into that. If you back, 18 months ago, I just don’t recall, and look at those balance sheets, you’ll see it and you can plot that against buying. You’ll see that works.

Richard Shane – Jeffries & Company

How long does it take before you reach a zero basis from a tax perspective?

Steven Fredrickson

To some degree you can see that in our filings and will be filed shortly, but in the supplemental data section we give you the cash collections and the purchase price. I will warn you that from a tax perspective, we don’t aggregate the deals like we do for financial. So for financial statement purposes we can aggregate portfolios together of common risk characteristics in a quarter. For tax purposes, we leave them at the deal level we call it and the deal level simply represents one purchase from one seller at one point in time of relatively modest accounts. So there could be some noise in there, but you can use that supplemental data section to maybe get a beat on that.

Operator

Your next question will be from the line of John Neff of William Blair.

John Neff – William Blair & Company, LLC

The blended rate of $7.4 cents highest in quite a while and I know that’s not a price barometer, but what does it say of anything about the mix in your strategy in recent purchases?

Steven Fredrickson

What it speaks to, number one, is the bankruptcy buying in the quarter. As we stated, we are buying a lot of cash flowing deals on the bankruptcy side at 40% of the overall dollar spent. That definitely sends the blended rate up. In addition, we have been buying more, because we’re seeing more of it for sale of pressure paper, especially as sellers work through some of the agency pipeline and are left with lesser old paper and more fresh paper. So we’re seeing more fresh paper than we may have seen in other periods. Back to the earlier question about the resale market, we see very little happening in the resale market which tends to be a lower priced market as well as some of the deeper recall paper that we would normally buy and so those purchases of low weight paper that typically are part of our purchase blend simply aren’t there and thus you’re left with this higher blended rate that you see in this period.

John Neff – William Blair & Company, LLC

Kevin, total collectors and supervisors. At the end of the quarter, the comparable number from last quarter was 1,305?

Kevin Stevenson

1,490.

John Neff – William Blair & Company, LLC

You did cite a couple of times a tough economy during your comments. I’m just wondering, is there any quantifiable or anecdotal impact in terms of what you’re seeing in terms of your ability to collect?

Kevin Stevenson

Our observation is really a continuation of what we have talked about in the past. Relatively speaking, if you look at our three long-term sources of cash collections being payments in full, where we get paid everything all at once. Settlements in full, where we take a compromise, but we’re done with it all at once. Or payments, which tend to be ongoing payments stream. We’ve seen a continued subtle shift from the balance in full, containments in full, into the payments, although the average payment size continues to be above our historical averages. So it would tell us we’re seeing less ability for people refinance out of a say a sub prime mortgage or something like that which may offer them increased liquidity to pay off accounts like ours and those same consumers still seem to have the desire to repay, they’re just doing it in payment streams opposed to larger one-time payments.

John Neff – William Blair & Company, LLC

Is that a phenomenon you’re seeing most often in 06-07 paper where most of the reserves were concentrated?

Kevin Stevenson

I don’t have granularity in front of me, John, as it relates to breaking that data into our various purchase trounces.

John Neff – William Blair & Company, LLC

You said $2.5 million dollars of the impairment charge in the quarter was for 06 and 07 pools and it included some sort of sub sector to that $2.5 million, but I didn’t catch what it was.

Steven Fredrickson

It was $650,000 of that $2.5 million was related to Q107 deals.

John Neff – William Blair & Company, LLC

We got a little bit of distance on those purchase vintages. What about those vintages, I should maybe not vintages, because you said in aggregate they are outperforming initial expectations, but what about some of the portfolios within those vintages? Can you pinpoint a specific change or what has been different from your initial expectation?

Steven Fredrickson

Just to make sure I’m clear, if you look at 06 for the entire year and lumped everything into one big pool, that is performing in excess of accounting assumptions; however, individual aggregate pools might not be. From a pricing standpoint, 06 was very competitive right into the first part of 07 and it just left, I mean from an operational standpoint or from a pricing standpoint, there’s relatively no margin for error and so you might be onto something. Maybe there’s something in there with the percentages, but from my perspective, all I know is that it’s not tracking to where I need it and I’m taking allowances against them at this point.

Operator

Our next question comes from the line of A. Hamagarn from Shaker Investments. Please proceed.

A. Hamagarn – Shaker Investments

Will you give us an indication as to what you think your amortization rate is going to be quarterly on your new acquisition?

Steven Fredrickson

I don’t have the final breakout of the numbers yet.

A. Hamagarn – Shaker Investments

Do you have an idea of what the amount of the intangible is?

Steven Fredrickson

Not yet.

A. Hamagarn – Shaker Investments

Regarding your bankruptcy, you really stepped them up over the last three quarters, do you expect the collection patterns of second year, third year to be similar on those portfolio purchases as the past data was on much smaller purchases?

Kevin Stevenson

We’ve been looking at pretty large purchase amounts for quite a while now on the bankruptcy side. As we underwrite these deals, especially the deals that are cash flowing, we’re generally able to peel that data right back to the dividend rates that are included in each case for each account that we acquire and we are closely looking at the cash flows from those in the cash flow trends and feel as though we’re underwriting conservatively and appropriately.

A. Hamagarn – Shaker Investments

I’m just trying to say is there any difference in, you know, given the fact that these amounts are so large and if you follow past patterns you would expect to see pretty significant ramps over the next few quarters in the amount of total bankruptcy. Is that a reasonable assumption?

Kevin Stevenson

We had an increase year-over-year in bankruptcy collection of 120% and obviously as we continue to ramp up that bankruptcy buying, cash collections from bankruptcy will ramp up accordingly.

Operator

Your next question comes from the line of Justin Hughes of Philadelphia Financial. Please proceed.

Justin Hughes – Philadelphia Financial

On the impairment charge, essentially an MPV calculation, I was wondering are you lowering the amount that you expect to collect or pushing out the timing or both?

Kevin Stevenson

In the situation of these allowances, you’re right, it is an MPV calculation. I would say in the vast majority of these cases, there would be a lowering of the future ERC and essentially curving. So if that helps you, we’re trying to fit this to data points and we’d be lowering that curve somewhat to try to fit the existing data points and just recomputed the IRR.

Justin Hughes – Philadelphia Financial

So it sounds like you’re saying the lifetime collections of the pools will be lower?

Kevin Stevenson

It depends. So if you look at the older deals. That might be the million dollars of the 960 we booked on the older higher yielding deals. That may be more of a timing issue. On the 06 and 07 deals, I would say that the situation would be a lowering of the curve. So the area of the curve would be less.

Justin Hughes – Philadelphia Financial

We’ve seen a lot of research of pricing down 30 to 40% this year, but given the economy and collection trends, if you’re looking at the same portfolios today versus a year ago, if pricing is down 40%, how much is your expected collection down when you’re looking at pools?

Kevin Stevenson

We are underwriting to what we believe are very conservative assumptions and as you can see based on the multiples that we’re booking, we’ve got some pretty conservative multiples out there. So even though we’re buying at lower prices, we’re factoring in substantially more conservative assumptions I believe.

Justin Hughes – Philadelphia Financial

Same multiples today that you were before, but more conservative?

Steven Fredrickson

The multiples for 2008 thus far are actually down a little bit from where we had been the last couple of years even though we are buying at lower prices.

Justin Hughes – Philadelphia Financial

Can you give us a total estimated remaining collections on the entire portfolio?

Steven Fredrickson

No, I don’t have that in front of me right now. It shouldn’t be long. You won’t have to wait long in the queue hopefully.

Justin Hughes – Philadelphia Financial

It sounds like it will be similar numbers as first quarter.

Steven Fredrickson

You have it, Jim?

Jim Fike

We do have it. It’s a billion, 065.

Operator

Your next question will be from the line of Sameer Gokhale from KBW. Please proceed.

Sameer Gokhale – Keefe, Bruyette & Woods

The first one I have is basically Aero Financial, they’re trying to figure out what to do with that business. It’s a pretty large collections operation. I was wondering if you would be open to doing some sort of business combination with them? What would be some of the factors you would take into account?

Kevin Stevenson

As it relates to any business combination between us and another debt buyer, especially a debt buyer that does a lot of the same kind of thing that we do, we don’t see a lot of value in a combination like that. We believe that any debt buyer is really value kind of in two broad chunks. One is the platform, the technology, the underwriting, and the operation, and the second is the portfolio. We feel like we have the former and so we would only really be able to pay for the latter and it would be the rare transaction that we’d run into that somebody would be willing to part with the entire organization for just the value of the portfolio. Should that occur, we’d certainly be interested in the portfolio, but we’d have a difficult time in paying much if anything for someone else’s platform, especially for a similar level of expertise to what we have.

Sameer Gokhale – Keefe, Bruyette & Woods

When you look at year-over-year, there’s a pretty significant increase in that other category. What is in that other category of paper that you buy?

Kevin Stevenson

The primary secondary table, Sameer?

Sameer Gokhale – Keefe, Bruyette & Woods

That’s right.

Kevin Stevenson

Like warehouse kind of paper, quads, quints, believe it or not.

Sameer Gokhale – Keefe, Bruyette & Woods

So it’s older paper, but we should not necessarily assume that out of stat paper?

Kevin Stevenson

No, probably not, and I just want to remind everybody. On that table, that’s the life-to-date purchase price that we put out from inception. What I tend to tell people to do is kind of shift those people together and subtract them, which it sounds like you did.

Sameer Gokhale – Keefe, Bruyette & Woods

Yeah, I was looking at the year-over-year comparison and it looked like there was an increase in the number of accounts and face value also. So I was just kind of piece out what kinds of accounts are in there, but it sounds like the majority of those are not out of stat. And then, it seems like every quarter since the implementation of SOP03-3 obviously there’ve been a lot of discussion about impairment charges and the effect on amortization rates and the like, but have you considered potentially or can you switch to the cost recovery method for GAAP purposes and then maybe provide some pro forma disclosure with amended PD6 so that investors can piece out what the economics of the business are versus all the impact of these impairment charges, which to a large extent seem to be non-cash in nature. Is that something you considered doing?

Kevin Stevenson

I think under SOP03-3, if you look through the evolution of what has ultimately become SOP03-3, I actually omitted guidance on cost recovery for years and it wasn’t until very late version of this, finally got approved that they actually put the words in there that they do approve cost recovery and actually early, early versions of it said we think the management teams can always predict something and so again thankfully they removed it and gave us the ability to put things on cost recovery. So there’s cost recovery, there’s cash method. Those two methods are really only approved for timing issues or for portfolio you really don’t know. So if there’s something we really aren’t comfortable with, we’ll put it on cost recovery. One individual deal. We will not aggregate that with the other yielding deals. Or if there’s something out of the gate and we’re timing perspective and we converted something, you know, it took us a month for some reason to convert something and we can put it on cost recovery or cash method for a period of time. So I think from a GAAP perspective, we’d probably be prohibited from doing what you suggest.

Operator

This concludes the Q&A session.

Steven Fredrickson

First I’d like to thank all of you for participating in our conference call. Before we go, I’d like to reiterate a few key points about our second quarter. As I mentioned at the outset of the call, I look at the quarter in terms of building future growth for PRA, not just for the next quarter or two, but year-after-year.

In this regard, we realigned our fee-based businesses in Q2 ending fee-based collections via Anchor and acquired MuniServices. We acquired $71.1 million dollars of defaulted debt, addressed start-up productivity issues at our Jackson call center to the point where its productivity was about 80% of our most efficient call center in June, brought down operating expenses to cash receipts to 44.3%, our best performance since Q107, and continued to modestly lever the company to make the purchase that has positioned PRA so well for the future.

Thanks again for your time and attention. We look forward to speaking with you again next quarter.

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Source: Portfolio Recovery Associates Q2 2008 Earnings Call Transcript
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