Peter Lynch's One Up on Wall Street is one of the most popular books in Fooldom, and Fool co-founder Tom Gardner is a self-described "Lynch disciple." Full of timeless investing wisdom, the book is written so that anyone with an investing interest can understand its precepts. It also offers hope that, yes, you can beat the market.
Characteristics Lynch advocated -- and that the Motley Fool Hidden Gems team searches for -- are found in one of the newsletter's quieter recommendations: Portfolio Recovery Associates (Nasdaq: PRAA ) , selected by Rex Moore in June 2004. This stock has returned more than 65% over the past year, yet it is no more expensive today when valued on a P/E basis.
Learning from the master
Lynch sought boring-sounding companies and/or ones that had disagreeable-sounding business models -- Healthcare Services (Nasdaq: HCSG ) , for example, which launders the linens at nursing and retirement homes. Tom recommended the ultra-boring Mine Safety (NYSE: MSA ) , and it has returned more than 190% for investors since September 2003.
How disagreeable does this job sound? Portfolio Recovery repeatedly calls defaulted debtors, hounding them until they finally pay their bills. Lynch would approve.
Lynch sought investments that could be fully explained by a two-minute drill: the reason to buy the stock, the path to the company's success, and the potential pitfalls along that path. In One Up, Lynch does the drill to explain his lucrative buy of General Mills (NYSE: GIS ) .
Portfolio Recovery is elegantly simple to describe: it buys defaulted consumer debt for pennies on the (face value) dollar, and then collects 2.5 to 3.0 times the initial purchase price over the next seven years through a variety of means (none of which involve shadowy men with tire irons). Again, Lynch would approve.
Three keys to Portfolio Recovery's future
Portfolio Recovery's continued outperformance of the market and of competitors -- such as Asset Acceptance Capital (Nasdaq: AACC ) and Encore Capital (Nasdaq: ECPG ) -- depends on very disciplined debt-buying and the ability to train and retain effective collectors.
Since debt portfolios remain on the balance sheet for seven years, Portfolio Recovery's management must practice disciplined buying in order to avoid future unpleasantries. Portfolio Recovery repeatedly demonstrates its awareness of this fact, most recently by calling 2004 "A Year for Discipline and Performance." Discipline was also the first word in the annual letter to shareholders, and it is one of the company's greatest strengths.
Collector effectiveness depends on quality training and limited turnover. Portfolio Recovery measures effectiveness through its "collections per hour paid" statistic. It was $118 last year; now it's at $136. Score us two-for-two.
Finally, Portfolio Recovery must collect 2.5 to 3.0 times its portfolio purchase price. How has it fared?
|Purchase Period||Purchase Price||Estimated Collections||Collections to Purchase Price Ratio|
It seems something has gone awry, with recent estimates lower than historical results. I suspect, however, that things are not as they seem; management is simply exhibiting that aforementioned discipline.
Until 2005, management would estimate an expected return on a portfolio at purchase and then adjust that expected return up or down to match actual collections over time. However, new accounting rules forbid adjusting expected returns down once collections have begun. Thus, an underperforming portfolio would be subject to a write-down and a charge against earnings. As a result, I think management is estimating more conservatively to avoid future write-downs. Just look at how prior estimates have been revised upward as collection certainty improves:
|Purchase Period||2002 Annual Report||2003 Annual Report||2004 Annual Report||2005 (Q1)|
The numbers are rising -- and the numbers don't lie.
Follow the free cash
Heading into earnings season, I'm looking for Q2 cash collections of $45 to $50 million. This should conservatively translate to recognized revenue of $34.5 to $38 million, and diluted earnings of $0.53 to $0.58 per share. Although Lynch liked to "follow the earnings," I prefer to "follow the free cash." That means tracking Portfolio Recovery's enterprise value-to-free cash flow ratio (EV/FCF).
Using owner earnings (net income plus depreciation/amortization, minus normalized capital expenditures) as a proxy for FCF, we see that at the end of June 2004, Portfolio Recovery traded at 18.7 times EV/FCF. As of last Friday's close, Portfolio Recovery traded at an EV/FCF of 19.7. That's a negligible increase during a time when investors have been rewarded with a nearly 60% return.
But if you're a financial masochist like me, you can also analyze the company's cold-hearted business as one large time-value-of-money problem. My personal model pegs the company's fair value just north of $50 per stub -- a 19% premium over today's price.
The last word
Lynch was a fan of unpretentious companies that focused on business, not appearances. On that note, I leave you with this excerpt from Portfolio Recovery's 2002 CEO letter to shareholders:
There are no mahogany-lined executive suites or executive dining rooms at PRA. I share an office with Kevin Stevenson, our Chief Financial Officer, and Craig Grube, our Senior Vice President of Acquisitions, who is responsible for purchasing our debt portfolios. The three of us sit at the same metal desks we bought when we began the company.
Lynch would approve.
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