PRA Group Back On Firmer Footing
Summary
- PRA's fourth quarter results should restore a little more confidence that management has the company back on track, as cash collections continue to recover.
- Lower expected yields on new purchases are still an issue and likely will be for the foreseeable future, but the supply seems good enough to support worthwhile returns.
- Between buying more paper and hiring more collectors, PRA has put itself back on track to deliver long-term growth, and a fair value into the low-$40s looks reasonable now.
The recent past hasn't been pretty at PRA Group (NASDAQ:PRAA), but with a couple of better quarters in hand, it seems reasonable to think that this collector of charged-off receivables is back on track. I don't believe it is realistic to expect the company to get back to the ROE levels of yesterday - the market has changed, and PRA is a much bigger share of the market now - but double-digit ROEs seem possible again, as well as a return to healthy free cash flow generation.
PRA Group is a tough company to analyze, but I expect to see improving collection efficiency metrics, as well as increasing supply, in the coming years. That supports a fair value in the high $30s to low $40s today and makes this a name worth considering on pullbacks.
A Better End To The Year
Although PRA Group's fiscal fourth quarter results were not extraordinary on a standalone basis, what they offer insofar as trend improvement is arguably more meaningful. PRA Group isn't back to where it needs to be in terms of its operating metrics, but it's back on a healthy trajectory.
Revenue rose 32% in the quarter, but reported revenue isn't really a good metric to use. A better one is cash collections, which increased 8% as reported and 5% in constant currency - again, not great numbers (and down about 1% on a two-year stack), but continuing a multi-quarter run of sequential improvement. Core Americas collections grew 6%, with 16% growth in call center collections. Insolvency collections were up 12% in the Americas, while core Europe rose 2% in constant currency.
The amortization rate declined significantly from the year-ago level but was pretty much exactly what I thought it would be. Impairments also continue to improve, with a sequential decline of about $1M, while zero-basis collections continue to improve as well (an especially profitable type of collection).
Although PRA Group has gone on a hiring binge, the timing of that added spending meant that there wasn't a big impact in this quarter. Opex increased only about 2%, as lower legal costs offset the increase in higher compensation/employee costs.
What Can Drive Better Results?
There are a lot of moving parts to the PRA business model, but improved results basically come down to a few central items - improved collection efficiency, increased supply, and improved supply quality. The first one is the one that management has the most control over, as well as a pretty good long-term track record. PRA management knows how to improve collector efficiency over time, and while collection efficiency is almost certainly going to be below long-term averages for a little while (due to the surge of new collectors hired), I believe we will see significant improvements as those hires mature in their jobs over the next two years. In the meantime, "volume over value" should help boost collections, as the sheer number of new collectors (up 70% year over year) will outweigh their initial inefficiencies.
In terms of supply, PRA's purchases increased 87% yoy in the fourth quarter, with strong growth across the business and nearly equal purchasing in Americas core and Europe core. Quarterly comparisons on purchasing are more misleading than helpful, but I think the 20% growth for the full year is significant. The purchase multiples weren't as attractive as they've been in the past, but that's not really a surprise given that Encore (ECPG) and PRA are such large players, they don't really have many opportunities to cherry-pick.
Improved supply quality is a wait-and-see factor. Clearly, management believes it can earn a good return on the paper it bought; it has shown a willingness to reduce purchases (sometimes significantly) when the expected returns were too low, so I don't believe it is buying junk just to make the collections pipeline appear more attractive. Still, an ongoing decline in the profitability of purchased collectables (relative to historical rates) is an ongoing headwind and risk factor that investors have to monitor.
In terms of possible changes to supply, nobody really knows. Every quarter, somebody on the earnings call asks management about whether there are any indications that three of the largest banks (the threesome of JPMorgan (JPM), Bank of America (BAC), and Wells Fargo (WFC)) will return to the market to sell paper, and every quarter, the answer is "we don't know". If this happens, it would be great for supply into the market. But even if it doesn't, the overall trend in the card/consumer credit world is positive for PRA - consumer credit has expanded significantly, many banks are trying to crowd into the card business to drive loan growth, and charge-off rates are starting to tick higher as we've moved past peak credit quality. Sooner or later, that means more charged-off paper for PRA and Encore to buy.
The Opportunity
PRA has returned to double-digit net expected receivables growth, and I'm cautiously optimistic that the company could see some modest improvement in expected yields on recent vintages. The bigger driver, I believe, will be ongoing improvements in collection efficiency, supplemented with growth in areas like legal/insolvency collection (especially auto bankruptcy, which management previously tapped as an under-penetrated growth opportunity).
I don't expect PRA to ever be as efficient as it was in the past, back when it was a smaller part of the market and could cherry-pick paper. The company also didn't have its European operations then - a business that generates returns well below what PRA's stand-alone U.S.-based business used to generate, again on account of a more competitive market. Even so, I expect improvements in collections (as a percentage of receivables), with the U.S. moving back toward 20%. All told, I expect long-term revenue growth in the mid-single-digits, with stronger growth in the next few years - that's a little better than my prior outlook, but largely just because the tougher 2017 year is now not part of the future numbers.
Although I think the inefficiencies of the new collectors will weigh on margins in 2018, PRA has shown in the past that it can get collectors up to speed very quickly - collectors are typically six times more productive in their 13th month on the job compared to their 3rd - and I expect that this will continue, allowing for the company to eventually get back into double-digit ROEs and FCF margins in the 20%s.
Discounted back, those assumptions support a fair value range of $37 to $42 with a double-digit discount rate; the lower of the two is my ROE-driven model output, while the higher is the DCF-based output.
The Bottom Line
PRA shares are responding well to earnings as of this writing, and I would expect sell-side estimates and price targets to head higher. PRA isn't completely out of the woods yet, but the trees are thinning out, and I believe the company is back on a better trajectory. Management obviously has to show that it can drive further improvements from here, and the larger macro factors (consumer credit, employment, income, etc.) have to cooperate, but PRA is looking better now than it has in a while.
This article was written by
Analyst’s Disclosure: I am/we are long JPM, PRAA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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