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HGS: Portfolio Recovery (PRAA)
A Recovery for PRAA?

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By Needelman
January 10, 2008

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I've been a holder of PRAA for a while and have touted it to several friends over the past couple of years. As such, I've been getting a few emails over the past six months checking to see if I'm still a believer. I got one today from a friend asking where my "bailout level" is and if I'd by more today.

In the spirit of full disclosure, I really believe in this company, have a fair amount of money invested in it. Therefore, I have an axe to grind and I AM a cheerleader for this stock.

That being said, here is what I wrote to my friends today in an effort to provide them with some perspective. Perhaps it will add to the lively discussion found on this board too......

My absolute bailout level is when the company demonstrates that it is actually losing money --- and probably over a couple quarters. Of course, if that were to take place, the stock would be down another 30-50% from here.

At this point the company has had 26 consecutive quarters of profitability dating back to pre IPO. Until recently, the trend line in profitability since 2002 has been about 45 degrees to the northeast. Even while the stock has literally declined 50% from its high over the last six months, the company has had returns on invested capital above 17%, net profit margins above 20%, and 15% TTM EPS growth. Even though these numbers trended down year-over-year, it doesn't exactly look like a company that is in trouble....

The big question is, "Will PRAA be able to collect during a recession?". The trend over the last two quarters show cash collection efficiency has gone down. In addition, the company has taken on a lot of debt on its balance sheet relative to its history. Obviously the market believes the decline in efficiency is an ominous sign that PRAA will have difficulty getting people to pay, and leveraging the balance sheet is dangerous if the future revenues won't be there to service the debt.

My belief (and my money is where my mouth is) is that the company can squeeze water from a rock. Sure --- the banks and credit card companies will have a tougher time collecting from people --- That's why they write the debt off and sell it!! But 100% of PRAA's business comes from this "uncollectible debt". That's precisely what this company needs! In fact, the primary concern about PRAA leading into 2007 was the lack bad debt in the marketplace at reasonable prices.

If PRAA's collection efficiency does get tougher to maintain during a recession, I believe the raw materials for their business (human capital and bad debt) will cheapen enough to help sustain margins. Even if collection efficiency and margins both shrink, I think the shear increase in collection volume will increase enough to pick up the slack and sustain EPS.

In addition, collections on these debt "vintages" take place over a matter of years --- well beyond the length of any recession (if not then we have more to worry about than just this stock!). If 2008 proves to be a difficult year of PRAA because of the economy, then it will certainly perform well whenever the economy gets back on track and the company collects on all the cheap debt acquired in the second half of 2007 and in 2008 (i.e. the 2002-2005 time period).

Right now I'm giving management the benefit of the doubt and attributing the decline in efficiency to the company's recent expansion and influx of new employees. Further, I'm viewing the increase in PRAA's debt as "dry powder" to purchase the deluge of bad debt coming on to the market. This company is positioning itself for rapid growth!

BTW ---- You should check out this report from the FDIC (as in FDIC insured banks) released in November.

In spite of all the press mortgages get, FDIC member banks reported CREDIT CARDS represented the LARGEST "contributor" to increased Loan Charge-offs during the 3Q (page 43). In addition, Credit Card charge-off rates have just started trending up from 10 year lows (page 48), and Net charge-offs as a percent of loans by credit card lenders is a mile higher than any other group in 2007 (page 52).

My overall cost basis is about $42-44. However, I already have significant exposure, so it's not like I would "double down". I'm tempted to buy more, but even if I increased my holdings by 40% -- which would ring diversification alarm bells in my head -- my average cost would only decline to $40ish. Not much different from where I am today, except for the fact that I'd have 40% more money at risk.....If it's worth anything, PRAA is still my largest individual stock holding by a mile, even if I don't put another penny into it.

Fundamentally the company looks great and the share price looks attractive considering it's very profitable, still growing, and only trading at 10x earnings. But the market, and financials in particular, are a total train wreck right now. You either need to have a long-term time horizon or need to be a seasoned trader to pick some up right now --- as there is no evidence of a meaningful bottom.

Hope this helps.

Mitch