As the American economy recovers, we might ask if there will be enough defaulted loans for the debt recovery business to maintain its momentum, and in particular, for Portfolio Recovery Associates Inc. (PRAA, Financial) to continue growing.
PRAA comes to our attention through its appearance on the Undervalued Predictable and Buffett-Munger screens at GuruFocus.
As the following chart shows, its stock price registered a sixfold gain between March 2009 and October 2013, then pulled back strongly (in what appears to be an overreaction to the Third Quarter 2013 Results). Since then, it's been essentially rangebound:
So, let's take a look at the company, to see whether it's really undervalued and likely to continue climbing, or whether changing times will push it further down. (unless otherwise noted, information and data here come from the PRAA website)
PRAA History
- 1996: Business starts, with four employees;
- 1999: Opens first call center and sets up headquarters in Norfolk, VA;
- 2002: Begins trading publicly on NASDAQ under symbol PRAA; listed as one of Inc. magazine's 500 fastest growing companies;
- 2004: Acquires IGS Nevada and enters the vehicle location services business;
- 2005: Acquires RDS and enters government revenue-enhancement services;
- 2008: Acquires MuniServices and BPA, to expand government services;
- 2010: Acquires controlling interest in CCB, to enter class action servicing claims;
- 2012: Acquires certain National Capital Management, LLC (NCM) claims, and expands into secured bankruptcy debt;
- 2012: Acquires first business in United Kingdom, and enters into the European debt-buying market;
- 2013: 3-for-1 stock split by means of a stock dividend;
- Issues $287.5 million in convertible senior notes; collects more than $1-billion from existing portfolios for the first time;
- 2014: Agrees to purchase the equity interest in the Norwegian company, Aktiv Kapital for $880-million plus assuming $435-million in debt; this acquisition gives PRAA access to 13 European markets.
Takeaways: In addition to its organic growth, PRAA has entered various other markets through acquisitions; most notably, it has entered the UK market and is posed to expand into Europe.
Business Model
- Debt purchase: buys portfolios of loans - through auctions and negotiated deals - that have been charged-off by the credit originator, at substantial discounts; since inception it has bought debts with a face value of $78.6 billion for a total purchase price of $3.3 billion, or about 4 cents on the dollar - the lion's share of its business;
- Contingency operations: collects debts for third parties on a fee basis.
- Apply sophisticated processing systems and well trained staff to effectively and efficiently collect those debts.
- The following table, from the PRAA 10-K report for 2013, shows where these debts originated:
PRAA Growth Strategy
In the 2012 Letter to Shareholders, Steve Frederickson writes, "In 2002, when we first looked at acquiring and servicing bankruptcy claims, we decided to devote several years to mastering this business. We refined our analytics and purchased successively larger portfolios. We gained experience filing proofs of claim in bankruptcy courts and developed proprietary systems to effectively manage these claims throughout their lifecycle. All of this was accomplished before we fully committed resources to what has become one of our most profitable businesses."
Frederickson goes on say PRAA is currently taking the same approach to entering the UK market. He adds, "This careful experimentation characterizes each of our operations today, and the rationale is straight forward: The more we know, the better our forecasts. The better our forecasts, the more value we can return to our shareholders."
Takeaways: Underlying its diversification and expansion is PRAA's use of analytical tools and hands-on experience to grow sustainable businesses.
Management
- Chairman, President and CEO: Steve Frederickson co-founded the company in 1996 with Kevin Stevenson (see below). Earlier, he held senior positions at Household Recovery Services’ (HRSC) Portfolio Services Group, and Household Commercial Financial Services;
- Executive Vice President, Chief Financial and Administrative Officer: Before co-founding PRAA, Kevin Stevenson held senior financial positions at Household Recovery Services;
- Lead Director: David Roberts is a Senior Managing Director of Angelo, Gordon & Co., which is described as a leading alternative investment money management firm with approximately $23 billion of capital under management;
- Board of Directors: directors have backgrounds in: money management, credit cards, IT consulting, institutional management, government/public policy, and financial consulting.
- The company receives a good rating on the ISS Governance QuickScore. Here's how ISS describes the rating hierarchy, "Scores indicate decile rank relative to index or region. A decile score of 1 indicates lower governance risk, while a 10 indicates higher governance risk." PRAA receives two red flags, for Takeover Defences and Voting Formalities, and two stars, for Board Practices and Voting Issues.
Takeaways: strong credentials in most areas of company operations, and a good rating for governance.
Ownership
- Gurus: Only two of the gurus followed by GuruFocus own stock in PRAA, Jim Simons (Trades, Portfolio) with 330,000 and RS Investment Management (Trades, Portfolio) with 1.4 million shares. Three other gurus: Steven Cohen (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), and Joel Greenblatt (Trades, Portfolio) have closed out their positions since the beginning of this year;
- Institutional Investors: This group, including pension funds, mutual funds, insurance companies, banks, hedge funds, and other vehicles owns a whopping 96% of PRAA's outstanding shares. And if we include shorts, that goes up to 111% (according to nasdaq.com);
- Shorts: GuruFocus puts the short interest at 20.3%; assuming that institutional investors hold 15% in short positions, that means other investors have shorted a bit over 5%;
- Insiders: Own about 2% of the company. A scan of recent transactions shows only sales, in relatively small amounts, indicating company execs are selling off some of the options they've earned.
Takeaways: A fairly strong showing by the shorts, but interestingly, a majority of the shorts are institutionals, while at the same time, this group as a whole owns 96% of the long positions (assume different funds hold the long and short positions).
Risks
- Economic conditions: Everything from unemployment to inflation can affect the number of bad loans, loan repayments, and collection success;
- Volume: One of the consequences of corporate growth is a growing army of costs, ranging from number of employees (currently 3,500) to fixed costs for buildings and facilities;
- Government regulations: For example, some selling banks cut back the number of portfolios for sale after new guidelines came out of the Office of the Comptroller of the Currency (OCC) in 2013. Portfolio Recovery Associates, Inc. operates in a highly regulated environment; expansion into the U.K. and Europe will increase the costs and complexities of compliance;
- Exchange rates: tied to international expansion is the risk that exchange rates may affect revenue and earnings;
- Interest rates: the company notes that changes in the interest rate could affect expenses and net income, despite hedging precautions.
- Many companies takes an 'everything but the kitchen sink' approach to listing risks (for obvious reasons), and PRAA is no exception. You can see a full list of these risks, and the company's comments, in the 10-K report for 2013.
PRAA by the Numbers
Takeaways: I'm taking particular note of the 21.5% ROE, and share buybacks of almost 2.5% in 2013.
Financial Strength
As the following summary boxes indicate, Portfolio Recovery Associates, Inc. shows acceptable financial strength, while at the same time delivering exemplary profitability and growth ratios:
As one of its operating principles, the company says it likes to keep debt as low as possible. But, we can see within the balance sheets of the 10 Year Financials that the size of the debt load has soared since 2012. CEO Steve Frederickson explains a debt offering from 2013 this way, "To take advantage of what we view as generationally low interest rates, PRA also completed our first convertible debt offering. In August 2013, PRA raised $287.5 million at a coupon rate of 3.00% for seven years, with a 30% convertible premium." (2013 Annual Report)
Takeaways: Generally strong financially, and the Profitability/Growth data give us some confidence they will remain strong; as to the new debt load, it was taken on strategically and at a reasonable price.
Valuations
Looking at the GuruFocus summary of valuations, we see this range:
- Projected Free Cash Flow: $54.39
- Median Per Share: $53.51
- Peter Lynch valuation: $87.50
Turning to Discounted Cash Flow, we see a valuation of $93.77:
Trailing P/E is currently 17.13; last September, before the correction, it reached 20.76.
Also last September, P/B reached 3.92, compared to 3.30 on July 3, 2014.
Takeaways: Depending on the flavor you choose, PRAA is slightly overvalued to seriously undervalued. Given that revenue, EBITDA, and EPS are all growing at more than 20% per year, I'm inclined to favor the currently undervalued numbers. Even the DCF does not seem unrealistic with the kind of growth we've seen.
Outlook
We've seen some debate about whether or not Portfolio Recovery Associates, Inc. can continue to post these booming numbers. And while we cannot know the future, we can try to anticipate it by looking at some history:
The history, as indicated by the chart, suggests the company should continue to grow profitably, and we take note of other factors;
- No indications of managerial changes emerge through our readings of the annual reports and 10-K reports;
- Economic conditions will change for better and for worse, but PRAA has managed its way through two boom and bust cycles successfully;
- Absence of a dividend gives the company more room to weather difficult conditions and pricing challenges.
Takeaways: Portfolio Recovery Associates, Inc. seems positioned to continue its profitable growth.
Conclusions
Investors looking for a growth stock will want to give PRAA a closer look. If earnings do pull prices up, then this is an opportune entry point.
A couple of important caveats would be that it does not offer the comfort of a dividend to investors waiting for capital appreciation, and that markets don't necessarily march to the beat of a rational drummer.
