Happy Collections Day

Someone at Motley Fool Hidden Gems pick Portfolio Recovery Associates (NASDAQ:PRAA) has an interesting sense of humor. For the second straight year, the company's fourth-quarter and full-year earnings release was scheduled for Valentine's Day, after the market closed. Those who follow the company therefore had to make a tough decision -- take the significant other out for dinner, or listen to the conference call.

Either way, given the results the company released, I'm feeling the love.

The business and the results
A quick primer for newcomers. Portfolio Recovery buys defaulted consumer debt from credit card providers such as MasterCard (NYSE:MA), Visa, and Discover (a division of Morgan Stanley (NYSE:MS)); it also collects bankruptcy paper, telecom debt from providers such as Verizon (NYSE:VZ), auto loans, and so on. It buys up this debt for pennies on the (face value) dollar and then turns that debt over to its own collector workforce, which collects two to three times the purchase price over the next seven years.

Sounds simple, right? But the reality requires experience to appropriately value debt, discipline to purchase the debt only at reasonable prices, and well-trained collectors to work the paper. Overpaying for paper is akin to burning money, and excellent pricing models are of questionable use if the collector can't cajole debtors to pony up. Fortunately, disciplined pricing and collection has long been Portfolio Recovery's strength.

Enough talk ... how about some numbers?

Portfolio Recovery also has three fee-for-service businesses -- contributing that $25 million in other cash receipts for 2006. Anchor Receivables collects on debt owned by others, IGS Nevada specializes in "asset location" (i.e. skip-tracing), and RDS collects debts owed to local, state, and federal governments.

Collecting the love
Now into its fifth year as a public company, Portfolio has consistently delivered 20%-plus returns on equity. Cash collections have grown at a nearly 34% annual clip since the company went public in late 2002.

Still, looking at that table above, Fools might wonder about two items: the year-over-year decrease in new purchased receivables (that's newly purchased debt, expected to be turned into more collections tomorrow), and decreased operating margins.

The drop in new debt purchases looks odd only when you compare it against the same quarter last year. The fourth quarter of 2005 was a bit of a historical aberration -- new bankruptcy legislation enacted in October 2005 spurred mass charge-offs of debt. Consequently, Portfolio opportunistically bought a slew of (presumably) well-priced portfolios that it otherwise likely wouldn't have -- $89 million in that quarter alone, compared with the previous high annual total of $62 million. The $112.4 million of new debt purchased in 2006 is more than triple what the company bought five years ago.

As far as margins go, they were driven down by ongoing investment in new management (particularly for human resources), new IT systems, and hiring for Portfolio's new Jackson, Tenn., collection center. During the conference call, management went into excruciating detail concerning future occupancy costs. These incremental costs will continue to depress near-term operating margins, but these costs are largely fixed. Since this spending increases employee capacity from 1,300 to 2,000 -- you need a larger workforce to collect larger amounts of debt, after all -- it's arguably a good expenditure.

Love me not
About the only disappointing item for the quarter was the underperformance of Anchor Receivables, with which fewer third parties placed debt. Yet the three fee-for-service businesses generated record revenues in aggregate, spurred by the performance of IGS.

I continue to believe that Portfolio is relatively cheap today, even following an 8% uptick in its share price following the earnings news. Here's why. First, the debt-buying sector is largely out of favor. Bad-debt prices have been high for the past couple of years, and Portfolio's public competitors, such as Asset Acceptance (NASDAQ:AACC) and Encore Capital (NASDAQ:ECPG), have stumbled. Wall Street may be simply waiting for Portfolio to do likewise, but that's where the much-vaunted buying discipline of the company shines.

Second, this industry is not one that's easily understood. "Expected collections," "portfolio vintages," and "cash collections applied to amortization" are not terms that roll off the tongue. The Associated Press added to the general lack of understanding last month with a completely misleading article, which claimed that higher prices paid as a percentage of the original debt's face value was indicative of increased competition and lower returns for industry players. But not all debt is created equal. Debt purchasing is all about the ability to collect that debt in relation to price paid. If a company spends 10 cents on the face-value dollar for a portfolio on which it reasonably expects to recoup 300% of its outlay, is that not preferable to spending 5 cents on the dollar for a chance to recover 250% of its expenditure? Someone at AP certainly doesn't understand that math.

Hearts aflutter
What got conference-call participants in a tizzy the most, though, was not continued strong results, but rather the suggestion from CEO Steve Fredrickson that Portfolio is moderately overcapitalized and might consider employing some financial leverage -- in other words, debt. He may as well have waved a steak in front of a pack of hungry dogs. Portfolio has a net cash position (cash minus debt) of $24 million. Over the past two years, Portfolio has spent nearly $300 million on new debt portfolios and the acquisitions of IGS and RDS, all accomplished using internally generated cash. Intelligent use of leverage can boost earnings per share and financial returns, and in its history as a private company, Portfolio had occasionally run at a debt-to-equity ratio near 1:1.

So the question on everyone's mind was, to what would the proceeds from leveraging up be applied? Share repurchases? A special dividend? Massive new debt purchases? Before passions could become too inflamed, CFO Kevin Stevenson applied some grounding: "We would never entertain any kind of leverage that got us into a situation where we could not aggressively buy all [charged-off debt that meets internal hurdle rates] that we wanted to."

The Foolish bottom line
Portfolio Recovery is that rare company we seek in Hidden Gems -- small but growing strongly, generating wheelbarrows of cash, and steered by excellent management guiding its company for the long term. It also trades at just 17 times trailing earnings alongside nearly historical lows for all other valuation metrics. I find it bewildering that there's not more love out there for this company. Consider taking a free 30-day trial to our small-cap service to what other gems we've unearthed.

For related Foolishness, see "The Best Small Cap for 2007: Portfolio Recovery Associates."

Fool contributor Jim Gillies owns shares of Portfolio Recovery. He is also short Mar07 $45 PRAA puts. Portfolio Recovery is a Motley Fool Hidden Gems recommendation, and MasterCard is an Inside Value selection. Send Jim feedback. The Fool has a disclosure policy.