The Best Small Cap for 2007: Portfolio Recovery Associates

I can't believe we're even having this competition.

Portfolio Recovery Associates (Nasdaq: PRAA  ) is far and away your best small-cap pick for 2007. The other contenders, fine companies all, do not share Portfolio Recovery's combination of market opportunity, business performance, outstanding management, and low price. This two-time Motley Fool Hidden Gems selection is the very definition of what we call a "Home Run" stock.

Market opportunity
Portfolio Recovery (PRA) buys defaulted consumer debt -- from credit cards, bankruptcy paper, or auto loans, for example -- for pennies on the (face value) dollar, and then collects two to three times the initial purchase price over the next seven years. Where's the opportunity, you ask?

Start with the American consumer, with a negligible savings rate, and facing higher gas prices, higher interest rates, negatively amortizing mortgages, tapped-out home equity, and the possibility of an economic downturn. Then consider Americans' collective use of debt to finance their lifestyles -- to the tune of $2.37 trillion as of November 2006, according to the U.S. Federal Reserve. But to be raw material for the PRA, or competitors such as Asset Acceptance (Nasdaq: AACC  ) or Encore Capital (Nasdaq: ECPG  ) , that debt needs to default, and be charged off and sold into the market. And it is, in hefty amounts -- $128 billion in 2005 according to The Nilson Report. How's that for opportunity?

Business performance and management
Bad debt buyers, by definition, buy someone else's problems. This requires a shrewd understanding of which debts may truly be worthless, and which may yet yield cash. But collecting that cash is all about relationships, either person-to-person (collector-to-debt) or through legal channels. A good debt buyer and collector requires great management that can identify and purchase profitable portfolios of debt, but also manage a large workforce of collectors who are, let's face it, not dealing with clients on the happiest of subjects.

PRA management is almost universally lauded for being best-in-class. But successful investing isn't a popularity contest. What earns PRA management these accolades?

  • Refusal to overpay for charged-off debt: Purchases are made targeting a specific rate of return that will provide long-term value to the business. If the prospective purchase will provide this return, the debt will be bought. If not, it won't.
  • Focus on continuous improvement: Collector productivity, as measured by cash collections per hour paid, has risen 53% since the company went public in late 2002.
  • Focus on cost containment: Needing to grow, PRA recently bought a new call center in Jackson, Tenn., which will allow the headcount to increase by roughly one-fourth. Why Jackson? Lower labor costs and state tax incentives.
  • Aligned with shareholders: My favorite line from PRA's Annual Report: "Management should be owners, not hired guns ... Our senior managers have a significant portion of their net worth invested in the Company. We expect our senior managers to retain substantial stock ownership positions -- common stock, not just options -- throughout their terms of employment."

A great business at a low price
Here's the best part. Even though management has done an A+ job with the business, the stock price is essentially unchanged from the start of 2006 (and I thought the price then was just fine). Yet the metrics have all tilted in our favor:

($millions)

Trailing Twelve Months

2005 Results

Total Cash Receipts*

$247.4

$205.2

Finance Receivables

$211.8

$193.6

Expected Remaining Collections

$533.2

$492.9

Share Price

$46.82 (12/5/06)

$49.19 (2/15/06)

Enterprise-Value to Cash Collections

2.9

3.9

Enterprise-Value to Expected Remaining Collections

1.35

1.61

P/E Ratio

17.5

21.6

PRA is cheaper today because it's part of a sector that's largely out of favor. Bad debt prices have been high for the past couple of years, and PRA's public competitors have stumbled. Wall Street simply may be waiting for PRA to do likewise. I wouldn't hold my breath; they're more likely to wake up in six months, as PRA continues to chug along, and proclaim that the company is worth buying again.

The Foolish bottom line
Portfolio Recovery is the best small-cap stock for 2007. Agree? Disagree? Let us know what you think in our new Motley Fool CAPS community intelligence database. If you agree, rate Portfolio Recovery outperform (as I have). If you disagree, seek help before you rate it underperform. Get going and make your voice heard by clicking here. Based on your responses, we'll declare 2007's best small-cap stock early next week.

Seen our other contenders for best small cap? If not, click here.

Fool contributor Jim Gillies owns shares of Portfolio Recovery. He is also short Portfolio Recovery $45.00 Mar07 puts. The Fool has a disclosure policy.


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