Portfolio Recovery Associates
Analyzing the Quarterly Report

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By texasking
May 1, 2008

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First quarter earnings came out this evening, and I listened in to the conference call to see what I could make of it. Of all the Hidden Gems, this is one I've come to watch every quarter -- the leadership here is quite open with their results, explaining the pluses and minuses in terms a business layperson with only a basic business-school finance class can understand.

The earnings go something like this:

Net income of $.78 per share vs. market expectation of $.83. At first that sounds like a bad miss, particularly given that it means net income is fairly flat, but the conference call yielded some further data.

Net of taxes, an additional $.02 per share went to interest expense above what was spent last quarter. I assume the market built in an expectation of the same amount of interest. That higher expense is actually a very good thing, because the higher interest was due to drawing from their credit line to spend $95 million on portfolios this quarter (~70% in their traditional business, 30% in bankruptcies). As with last quarter's increase in purchases, it means they're accelerating their growth. And, at prices that are the most favorable they've seen in several years.

They did mention that they increased their internal rate-of-return (IRR) hurdle for purchases this quarter. On the one hand, the change in their IRR probably reflects lower prices for the debt they buy, but it also reflects their perception that collections are slowing down because of the economy -- which isn't such a good thing.

I'm not too worried about slowing collections, though, because their increased portfolio buying has been paying off -- softening collections per portfolio have been eclipsed by portfolio growth, and top-line revenues jumped to a new record. That implies a higher cost-of-revenue in terms of portfolio amortization, but still at profitable levels despite a faltering economy and a traditionally slow season. And it means they're still on a strong growth track even in difficult economic conditions. That's the sign of a company leading its market.

Their other metrics -- productivity, call centers, etc. -- seemed in line with last quarter. The new U.S. call center improved marginally (but still has substantial room for improvement), and they've been adding staff in their Philippines call center.

The fee-for-services businesses continued very strong growth, something like 30-50% over last year. With $11 million in revenues this quarter, those businesses now account for a material-enough part of the business that we'll see the difference in the top and bottom lines every quarter if they sustain their growth rate.

The other outcome of the conference call that leaves me scratching my head is the significant amount of portfolio write-downs this quarter. $2.8 million in portfolio "allowances" this quarter, compared to $2.9 million for all of last year. Granted, it isn't the $7 billion write-downs we've seen in the rest of the financial sector, but it works out to something between $.11-$.18 per share depending on how it's treated for tax purposes.

Sure, they sugarcoated it as best as they could, but they did give some reasonable rationale. The markdowns were spread across portfolios purchased in the 2004-2006 timeframe.

- $1 million of it was due to a purchasing mistake -- one of the portfolios bought in 2006 just flopped, and accounting rules require them to mark it down to reflect collectability going forward. With the massive increase in buying they've done since 2004, they only made 1 mistake?

- Another big chunk of it was directly related to their entry into the bankruptcy-debt market in 2006. They have since discovered that the bankruptcy debt collection curve is more front-loaded than they expected. The money comes in faster in the earlier years and tails off faster than their models had predicted. [It sounded like they met their profitability targets on those portfolios, but they see a need to fine-tune their estimating models.] On the one hand, their business plan depends on accurate models -- or at least a better model than their competitors. On the other hand, it means their very strong growth in bankruptcy buying is likely to collect sooner than they had planned, which saves us, the stockholders, the interest on the credit they're using to carry those portfolios.

When I do the math, I interpret it to mean that net income reported in 2006 was probably $.10 above reality (sometimes called "ongoing operations" in the magical world of financial imagineering), and this quarter's number is probably $.12 below. So, PRAA's actual growth rate has been larger than the numbers imply, and ongoing operations are significantly better than the analysts' estimate for the quarter.

And how big was the $2.8 million in the grand scheme of things? Those charges were taken on some $50 million of portfolios, so they were off by 5% on the portfolios where their models didn't match actual performance, and more like 1% across all the portfolios they bought in the 2004-6 timeframe. I've done predictive models before (although not in finance), and they don't get any better than that. I'm not happy to see the write-down, but it can happen once to any company, and these guys have always interpreted the accounting rules conservatively in the past - in shareholders' favor. A lot of it depends on next quarter - if they write down $2 million again, then I'm going to think twice about my opinion of their accounting practices.

In all true fairness, I've been long PRAA for 2 years, and added to it at $40 last week. I'll know whether my analysis is right in a few days, after people have a chance to digest the quarterly report in depth -- it usually takes 2-3 days for this stock to react to the quarterly numbers.

I still don't understand why this stock doesn't trade at $52 given current growth & trailing P/E. Oh wait. It's because PRAA's management applies that rational behavior theory they taught us about in Microeconomics class -- you maximize long-term stakeholder returns by planning for the long term. Irrational markets? Is that possible? :-)