PRAA – A Recovery Play

During the Great Recession plenty of money was made betting against the consumer. John Paulson, David Einhorn and other short sellers were vilified for profiting from the demise of the economy. They were ultimately vindicated as their analysis proved correct and consumers defaulted on a record amount of debt. In 2010, the number of non-business bankruptcy filings grew by 8.8% to 1.5 million. While this number may seem high, it is significantly lower than the 31.5% jump in 2009. Further, it is worth noting that last year’s filings are 32.7% below the 2.0 million filings in 2005. You may recall changes to the Bankruptcy Code went into effect in October 2005.

Bankruptcies are not a cure all for individuals’ unwanted debt. In fact, they don’t necessarily go away – but they do get smaller. In the shadow of these bankruptcy lead defaults lies Portfolio Recovery Associates, Inc. (NASDAQ: PRAA). With a market cap of $1.4 billion, PRAA is the leading receivables management company. They proudly proclaim: “We’re giving debt collection a good name.®”

If you believe the economy is turning the corner, continue reading about a company that is poised to benefit from increasing cash flows from a recovering consumer.

Background

Founded in 1996, the company is headquartered in Norfolk, Virginia. PRAA has stockholders’ equity of $491 million and total assets of $996 million. The company’s primary business is the purchase, collection and management of portfolios of defaulted consumer receivables. These are unpaid obligations of individuals to banks, consumer and auto finance companies and retail merchants. The company had $831 million in finance receivables at year end which had a face value of $8.1 billion.

PRAA also provides fee-based services, including collateral-location services, revenue administration, audit and debt discovery/recovery services and related payment processing. Fee income in 2010 was $63 million or 17% of total revenue.

Operations

PRAA’s debt purchase business specializes in charged-off receivables by the credit originator. Since inception, the company has acquired over 2,000 portfolios with a face value of more than $54.8 billion for a total purchase price of $1.7 billion (approximately 3% of face). The company acquires portfolios from debt owners (think MasterCard, Visa and Sears) through auctions and negotiated sales. In addition, PRAA also acquires accounts in forward flow contracts where it agrees to purchase defaulted receivables on a periodic basis. To purchase the receivables, the company utilizes two models, one internally developed and another externally developed. The company has an Investment Committee which approves the maximum purchase price for these portfolios.

Once PRAA collectors prioritize their accounts based on internal analysis, they focus efforts on customers most likely to pay. Most collections occur after telephone contact. The company also employs letters and legal activity to generate cash collections. Collectors are given incentives to have customers pay the balance in full. However, they are given flexibility to increase the likelihood of repayment such as a 20% down payment with the remainder paid over time (recall, the average purchase price of the portfolios is approximately 3%).  Legal remedies, used when necessary, include garnishing wages or attaching assets to the claims. PRAA has over 2,400 full-time employees, most of which work on the company’s owned portfolio. The industry is labor intensive and has a high level of turnover. It should be noted that the collector turnover rate in 2010 for PRAA was 39%. Thus, the ability to quickly train new collectors increases the effectiveness of the workforce.

The fee-for-service business include: (1) Skip tracing for auto finance companies for a fee generally dependent on outcome; and (2) processing tax payments and tax forms, collecting delinquent taxes, identifying taxes not being paid and auditing tax payments for commissioned based billings or fee for service transactions.

PRAA, unlike many of its competitors collects for its own accounts. This allows for better control over the entire process and ensures compliance with Bankruptcy laws. Further, it gives the company an opportunity to integrate its results into its proprietary models.

Funding

The company funds its business partially through a $357.5 million revolving credit facility that matures in 2014. $107 million of the facility was unused at year end which is up from $46 million at the end of last year. There are several negative covenants associated with the debt. These covenants include, among others: borrowing cannot exceed 30% of eligible assets plus 75% of eligible accounts receivable; capex cannot exceed $20 million in any year; stock repurchases cannot exceed $100 million and PRAA must maintain positive consolidated income from operations.  As many firms learned in the past, if liquidity is compromised, business could be negatively impacted.

Accounting

PRAA accounts for investments in receivables under ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” Under this method, static pools of accounts may be established. They are aggregated based on common risk criteria and is recorded at cost – which includes certain direct costs of acquisition. ASC 310-30 requires that the excess of the contractual cash flows over the expected cash flows, based on the company’s estimates, not be recognized as an adjustment of revenue or expense or on the balance sheet. ASC 310-30, utilizing the interest method, initially freezes the yield, estimated at the time of acquisition as the basis for subsequent testing. Significant increases in expected yield are recognized through an upward adjustment of the yield over the remaining life of the portfolio. Conversely, if collection estimates are not met, rather than lowering the estimated yield, the carrying value of a pool would be written down to maintain the current yield. This would be shown as a reduction in revenue on the income statement and a corresponding valuation allowance  offsetting receivables on balance sheet. Cash flows greater than interest accrual will reduce the carrying value of the pool (lower cash flows will accrete the pool). A pool can become fully amortized while still generating cash collections – this would be recognized as revenue when received. The company establishes valuation allowances for all acquired accounts subject to ASC 310-30 to reflect only the losses incurred after acquisition.

The company uses the cost recovery method when collections cannot be reasonably predicted. Under this method, no revenue is recognized until the company has fully collected the cost of the portfolio (or when collections become estimable).

The company issued Form 4549-A from the IRS related to an income tax examination for the years 2005 – 2007. The IRS alleges that cost recovery for tax revenue recognition does not clearly reflect taxable income and that the unused line fees paid on credit facilities should be capitalized and amortized rather than taken as a current deduction. The company has filed a protest; however, if unsuccessful, it will have to pay the related deferred taxes and potential interest.

Portfolio Performance

The table below, from the Form 10K, shows the purchase price and estimated collections of both the Core Portfolio and Bankruptcy Portfolio.



The results of the Core Portfolio demonstrate the company’s ability to extract value from its purchases. Looking at the yearly acquisition data, you can see that the purchase price (as a % of the expected collections) has increased from the early years when competition was less. Nonetheless, the company has been able to generate steady double digit returns on equity.

Total cash collections to date are already 185% of the purchase price ($2.0 billion) – and management expects to collect an additional 90% of the purchase price ($1.0 billion). The risk is that the company will not be able to collect the entire amount projected. During 2005-2008, management took write downs based on revised collection assumptions. While this represents 6% of their total purchases, on a yearly basis the numbers are significant.

 

The Purchased Bankruptcy Portfolio does not appear as profitable as the Core Portfolio at first glance. However, collections from the Bankruptcy Portfolio are generally through efforts of the U.S. bankruptcy courts.  As a result, overall costs are much lower for the company when liquidating a pool of bankrupt accounts as compared to the Core Portfolio. Thus, PRAA pays more for BK portfolios or stated differently, expects to collect less as a percent of the purchase price.

Looking at the numbers, it appears that collections have improved as the economy digs its way out of the Great Recession. Logically, one would expect collections to pick up along with the economy. As you can see from the table below, after falling in 2007 and then again in 2008, collections have increased each year since. With the job situation still at recession levels, it is quite possible that collections could grow even more as the unemployment rate decreases.

Parsing the financials further, another positive trend seems to be developing. Cash collections as a percent of the purchase price are occurring quicker for both the Core Portfolio as well as the Bankruptcy Portfolio.

  

 

Corporate Governance

For those interested in a high profile shareholder base, take comfort. Top holders of the company’s stock are Capital Research Global Investors (10%), BlackRock (7%), Waddell & Reed (7%) and Riverbridge Partners (5%). In addition, all executives and directors of the firm hold another 3% of the company’s shares. Together, this represents over 30% of the outstanding shares. While large holdings by high profile investors is usually seen as a positive, should they decide to exit, large share sales could weigh on the stock price. On the corporate governance front, PRAA has a staggered board and a poison pill – both are not considered particularly shareholder friendly.

Valuation

The most direct publicly traded competitors, while smaller than PRAA, include Asta Funding Inc. (NASDAQ: ASFI) and Asset Acceptance Capital Corp. (NASDAQ: AACC). Asta stumbled in its purchase of a large portfolio in 2007, just as the economy was starting to slide into the depths of the recession. Its stock currently trades at 0.75x book value, well off its historical valuation of 2.50x book value. However, the stock has rebounded over 250% since January of 2009. Asset Acceptance trades at 1.33x book value and is flat over the past 2 years. As you can see from the table below – there are a number of valuation metrics to consider. On a Price/EBITDA (earnings before interest taxes depreciation and amortization) and price-to-earnings basis, PRAA appears fairly (if not under) valued. On a price-to-book basis the company appears overvalued. It is also worth noting that the stock is trading less than 1% below its 52 week high.

 

If you believe in the recovery thesis, one could assume that the purchase price of receivables will continue to increase. As such, the inherent value of the company’s portfolio should increase. Further, cash collections could be underestimated if PRAA’s collectors are able to generate higher recoveries. The question is whether or not PRAA will be able to generate the same type of returns it produced in the past. While supply of company’s primary “product” may be reduced in the coming years, it is not likely to go away. As long as PRAA’s competition maintains pricing discipline, margins should be able to hold steady in an improving economy. You may ask – is the discount on ASFI warranted? That’s a post for another time.

Full disclosure, I have no position in any of the stocks mentioned and have no plans to initiate positions within the next 72 hours.

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