Sluggish Collections As PRA Group Begins A New Era

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About: PRA Group, Inc. (PRAA)
by: Stephen Simpson, CFA
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Summary

PRA Group misses again on revenue and earnings, with the slowdown in call center collections continuing.

Purchase activity remains challenged with major sellers still on the sidelines, but management's collection expectations continue to head higher and collection productivity is improving at a double-digit rate.

Giving partial credit to Aktiv, I increase my estimate of fair value to $71.50, with an underlying assumption of high single-digit long-term FCF growth.

Receivables collection specialist PRA Group (NASDAQ:PRAA) (formerly known as Portfolio Recovery Associates) continues to do reasonably well in a more challenging environment. Concerns about new regulatory standards have shrunk the supply of charge-offs available for purchase, while management's decision to expand its legal collection efforts continues to require accelerated spending ahead of revenue. On a more positive note, though, the Aktiv deal is done and the company's collections estimates continue to increase for recent vintages. Although the slower pace of call center collections is a concern, PRA Group continues to offer worthwhile upside at these levels.

Second Quarter Results Missed, But Not By A Lot

For a company that used to routinely report beat-and-raise quarters, PRA Group's new two-quarter trend of earnings misses is a troubling development and one that will no doubt fire up the bears. While the magnitudes of the misses are small and the reason(s) behind them soften the blow, the reality is that Wall Street is often about optics and expectations and this isn't the type of performance many investors want out of a "growth stock".

Revenue rose 8% this quarter, missing expectations by around 2%. Cash collections growth continues to slow, with second quarter collections up 8% and about 1% shy of expectations. Call center collections in particular have slowed down noticeably - up 23% a year ago, up 16% in the fourth quarter of 2013, up 8% in the first quarter, and now up 5%. Legal collections continue to fill much of that gap, though, with 10% growth in external legal collections and 48% growth in international collections. Bankruptcy collections declined 1% this quarter and the tiny fee-based business was up 3%. For the quarter, the company's amortization rate declined 40bp sequentially and 30bp year over year (a sequential decline is normal).

Operating expenses rose 14% and were ahead of analyst expectations, leading to a 2% decline in reported operating income and a 6% miss relative to sell-side expectations. Most analysts do not seem to factor the Aktiv transaction-related operating costs into their models, so the "like for like" miss is not quite as serious (in fact, it was pretty close to in-line). That said, adjusted operating income growth of less than 4% isn't great and the company is literally paying a price for growing its legal collections business, as legal collection efforts involve meaningful costs incurred ahead of collections.

Purchases Having An Impact

Looking deeper at collections, management noted a 10% increase in payment volume and a 1% decline in payment amounts. PRA Group management would argue that the decline in payment amounts isn't a particularly useful statistic given the changing nature of the business mix; collected amounts per score point increased 9% (which management asserts is a better like-for-like metric).

Management also reported that purchases declined 46% yoy and 28% qoq this quarter, to $109 million. Purchasing has always been lumpy, but PRA Group's ability to recharge its collections portfolio is increasingly emerging as a talking point. It's true that PRA Group's growth has made it a larger player in the space and it is also true that growth in total revolving credit outstanding (ultimately the source of most of PRA Group's paper) has been anemic.

I still think a few points are worth consideration here. First, the OCC just released its third-party collections risk management guidance on August 4 and many sellers have pulled out of the market awaiting more regulatory clarity. JPMorgan (NYSE:JPM), Bank Of America (NYSE:BAC), and Wells Fargo (NYSE:WFC) have historically represented more than a third of the market and are among those not selling at present. Though there is a risk that these companies choose to go entirely in-house, that still seems unlikely and these banks could have upwards of $60 billion in stored up charge-off inventory to sell whenever they come back to the market (which increasingly looks like 2015). I'd also note that Equifax reported earlier this year that there were 3.7 million credit cards issued to sub-prime borrowers in the first quarter, up almost 40% yoy and representing about a third of the new issue market.

I would also point out that PRA Group's collection efforts remain strong. Collector productivity was up 12% as reported by the company, and management once again increased its estimates for collection. Total estimated collections as a percentage of purchase price for the portfolio has increased from 239% in Q2'13 to 241% in Q1'14 to 243% in Q2'14, with the 2012 vintage estimate moving from 186% to 200% to 204%. The 2013 vintage is also marching higher, up from 180% to 186% this quarter.

Aktiv Brings New Options

It took longer to close the Aktiv transaction than management expected, but as of mid-July it is a done deal. Management wasn't particularly forthcoming with details about Aktiv or new guidance/expectations, but they did mention that Aktiv saw cash receipts of $183 million for the first half of 2014 (or about 30% of PRA's standalone results). Aktiv is going to significantly expand management's options for allocating capital (increasing purchase activity in good markets, while pulling back from weaker markets) and also gives management an opportunity to implement its industry-leading practices across a larger business footprint - in other words, driving better earnings by bringing Aktiv's collections and margins more in line with PRA Group's historical results.

The Bottom Line

With Aktiv in hand, I'm increasing my cash flow-based fair value estimate to $71.50. While I have said in the past that Aktiv could bring $20/share or more in value, and I still believe that, I'm going conservative with my assumptions regarding cost synergies until I see more numbers, I'm decreasing my near-term margin assumptions for the U.S. business, and I'm increasing my discount rate slightly to account for uncertainties and integration risk tied to Aktiv.

Slowing call center collections is a concern and something I continue to watch. I think it is premature to say that PRA Group is in trouble, though I will note that more and more importance is shifting to those large charge-off sellers coming back to the market. All told, I continue to believe that this is a transition period for PRA Group and that the slowing performance metrics are temporary and not a "new normal". This isn't a dirt-cheap stock, though, so I will not soft-peddle the risks that the company is seeing a more significant decline in its growth prospects. I believe the shares offer enough potential to offset that risk, but investors need to do their own due diligence and decide accordingly.

Disclosure: The author is long PRAA, JPM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.