It would have been difficult for Portfolio Recovery Associates (NASDAQ:PRAA), a two-time Motley Fool Hidden Gems recommendation, to top last quarter's blockbuster results. So it didn't.

Shares fell 12% for the day. Of course, last quarter, those same shares rose 14%, driving investors into a buying frenzy. With such gyrations, it's nice to be a lazy long-term investor who views short-term drops as buying opportunities.

A business review
Portfolio Recovery buys defaulted consumer debt for pennies on the (face value) dollar. Its sources and purchases include:

  • Credit card debt, from providers like MasterCard (NYSE:MA), Visa, or Discover Financial Services (NYSE:DFS), which was recently spun off from Morgan Stanley (NYSE:MS).
  • Bankruptcy paper
  • Telecom debt from companies like Verizon (NYSE:VZ)
  • Auto loans
  • Medical debt
  • Unpaid utility bills

Wringing this debt through its own collector workforce, PR collects two to three times the purchase price over the next seven years.

It sounds simple, but the reality requires the ability to appropriately value debt, the discipline to purchase debt only at reasonable prices, and well-trained collectors to work the paper. Overpaying for debt is akin to burning money, and excellent pricing models aren't much good if collectors can't cajole debtors to pony up.

So what happened?
Results weren't too bad, really, with a few truly impressive aspects. But mix in a few cockroaches with the chocolate truffles, and most people lose their appetite.

($millions)

Q2-07

Q2-06

Growth

Cash Collections

$64.6

$59.4

8.7%

Portfolio Amortization Rate

28.2%

32%

N/A

Cash Collections Recognized as Revenues

$46.4

$40.4

14.8%

Other Cash Receipts

$8.4

$5.8

51.3%

Total Revenues

$54.8

$46.2

18.6%

Net Income

$13.0

$11.1

17%

EPS (Diluted)

$0.80

$0.69

16.4%

New Purchased Receivables

$63.3

$26.6

137.6%

Operating Margin

38.8%

38.5%

N/A

The key points from the quarter fall into two camps.

The good
Portfolio Recovery made massive debt acquisitions -- the second-largest quarterly purchases in the company's history. In the first half of 2007, PR purchased nearly $102.3 million in debt; that's nearly as much as the $105.8 million it bought in all of 2006. Management indicated that its most recent purchases come with higher collection expectations than those from the past 12 to 18 months. Higher purchases are very good news, though perhaps not too surprising, since PR's "suppliers" -- big credit card companies like Capital One (NYSE:COF), Bank of America (NYSE:BAC), and Citigroup (NYSE:C) -- have all been charging off debt at greater rates this year than last.

Also, the growth of Portfolio Recovery's three wholly owned fee-for-service businesses has been outstanding, even though one of the three (Anchor Receivables Management, which collects cash on behalf of third parties) still faces headwinds.

Finally, the steadiness of PR's profit margins is a happy sign, especially given how well the fee-for-service businesses have done. These subsidiaries are inherently lower-margin, so you'd expect them to squeeze overall margins as they grow. The healthy margins are also good news, in light of productivity problems at Portfolio Recovery's newest call center. (More on this in a moment.)

The not-so-good
Cash collections growth slowed notably, and ominiously fell compared to the first quarter. Collections typically have a seasonal lull, with the first and second calendar quarters outpacing the third and fourth. Up till now, overall business growth has been enough to mute this seasonal lull -- but not anymore. Portfolio Recovery's strong new debt purchasing should eventually mitigate this, but it rattled investors in the short term.

The portfolio amortization rate was curiously lower than expected. At the risk of putting Fools to sleep, let me briefly explain that the amortization rate demonstrates how much of each collected dollar is counted as revenue, and how much goes to write down the value of previously purchased debt.

The second quarter's 28.2% amortization rate means that, for every $100 collected, the company recognized $71.80 as revenue and applied $28.20 to portfolios. In last year's quarter, this split was $68 (revenue) versus $32 (amortization). Higher revenue produces higher earnings; had the amortization rate stayed constant from last year, reported earnings per share would have missed analysts' expectations.

There are many reasons why the amortization rate might fall. Some are positive -- increased collections expected from previously purchased portfolios. Some are potentially disconcerting -- more collections coming in from older, mostly amortized portfolios, suggesting that more recent purchases might be underperforming. And some are highly negative -- management tweaking this number to meet expectations.

Collections on "bankruptcy portfolios" unexpectedly fell in the quarter, too. Such portfolios have a very high amortization rate, so lower collections here would contribute to a lower overall blended rate.

Finally, productivity at the most recently opened call center in Jackson, Tenn., has been very poor -- roughly one-third that of the more established centers. Had this center been running at even two-thirds the productivity of the others, it would have added more than $1 million to total collections for the quarter. Still, this call center is very new, staffed with neophytes to the collections game. In time, the headcount here will ramp up, and the operation will become more efficient.  

So now what?
At less than $52, I think that Portfolio Recovery offers good value. As an owner, I've enjoyed the paper gains of the past quarter, when the stock traded at more than $65. But as a long-term acquirer of the stock of good businesses, I like to buy on the cheap. As of the end of 2006, my valuation model (originally introduced here) pegged fair value at $51. The company's performance in the first half of the year has only deepened that value. And at current prices, shares are trading toward the lower end of historical multiples.

P/E Ratio

Enterprise Value/Cash Collections (trailing)

Enterprise Value/Expected Remaining Cash Collections

Current

17.2

3.07

1.38

Average*

21.2

3.47

1.61

Median*

20.7

3.37

1.55

Minimum*

15.8

2.62

1.21

Maximum*

29.5

5.22

2.23
*Since December 2002 IPO.
All calculations use month-ending prices, and are calculated on a rolling 12-month basis.

The Foolish bottom line
Looking at this quarter's results, we see the nascent solution (big purchases of new debt) to the current problem perceived by the market (slowing collections). Collections on this new debt will eventually propel the company forward, and the new call center will improve its efficiency as its staffing and experience grows. While its current slump may be painful to watch in the short term, for the first time in several months, Portfolio Recovery is a suitable "buy" again.

We've recovered further Foolishness:

Portfolio Recovery is a Motley Fool Hidden Gems recommendation. Bank of America is a Motley Fool Income Investor pick. MasterCard is a Motley Fool Inside Value selection. Try any of our Foolish newsletters free for 30 days.

Fool contributor Jim Gillies owns shares of Portfolio Recovery. He is also short Sep07 $45 PRAA puts. Send him feedback. The Fool's disclosure policy always pays its debts.