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Testing My Resolve: Part I

By

Fil stress-tests his thinking...

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Last night I was chatting with one of our fellow professors about Portfolio Recovery Associates (PRAA) – which I have mentioned with skepticism several times over the last 6+ months – and he casually mentions that Bankstocks.com's Tom Brown loooves PRAA. For those who want to read up on Tom Brown take a look here; for the rest, let's just say that the dude is no dummy, and taking the other side of his trades is usually an uphill battle. I searched high and low for his analysis on PRAA, but I could only find some general commentary about the virtues of PRAA's management and their past financial performance, much of which I actually agree with.
If I had an ounce of common sense, I'd put my tail between my legs and turn coat like most self-respecting white-red-and-green blooded Italians would do. Alas, my masochistic tendencies prevail. I am going to stand here and take it like a man, but not before penning in detail the reasons for my foolishness, and giving birth to what will arguably be remembered as one of the most mind-numbing News & Views in the 'Ville's history. Loosen your tie, take off your shoes, and put a stick in your eyes, the "Boredom Express" is leaving the station.
The Valuation Case
As we often mention in the 'Ville, part of a stock's story depends on where a stock "sits" relative to its prospects. A trashed stock price may well discount a poor future and be a "smart" buy. While another stock may be shooting for the moon and already be discounting more than the business can deliver. IMHO PRAA falls in the latter camp. Pop a no-doze Minyans and follow me to the land of number crunching.
PRAA exited Q3 with cost-basis receivables on its balance sheet of $117M. In the 10-Q the company publishes the Estimated Remaining Collections ("ERC"). That's a figure derived from PRAA's models and past experience, and it estimates how much cash PRAA will be able to collect from its receivables. To date PRAA has been accurate, if not outright conservative, in its calculations. At Q3 the ERC for the $117M was pegged at $350M. The approximate period to monetize the ERC is 5-7 years. We'll use 6 years for purposes of our discussion.
To make practical sense of these figures I need to translate them into the present value (PV) of their overall EPS potential. Using the historical "realizable gross income" rate of 70% of ERC, over a 6 year period PRAA stands to collect gross earnings of $245M. After deducting the required operating expenses and Uncle Sam's loot, I am going to allow for a net profit margin of 27.5%. This is higher than PRAA's current 25% margins, but I want to allow for operating improvements and economies of scale. The 27.5% rate yields an NOI of $67.3M, or $4.16/share. This is what PRAA can expect to earn from its current receivables base over a period of 6 years.
Next we need to discount this EPS potential to its PV. Picking a discount rate is always an art. But considering a 10yr. Treasury rate of 4.50%, discount rates between 8% and 12% seem reasonable. Below are the PV EPS, and the PV price of the stock, if we attribute the EPS with a multiple equal to the expected long-term growth rate of the company:
8% Discount
9% Discount
10% Discount
11% Discount
12% Discount
EPS PV $2.62
$2.48
$2.35
$2.22
$2.11
Stk. PV $47.16
$44.64
$42.30
$39.96
$37.98
Oddly enough, using a much more mundane valuation scheme of 12 months forward EPS times growth rate, you get $2.64 x 18 = $47.52. The stock closed on Monday at $49.60.
Lest you accuse me of thinking that the stock appears fully, but fairly, valued, let's now put on our Graham/Dodd headgear. What would these elders pay for PRAA? We know the rough formula: they'd be looking to buy at a price that would pay them an earnings yield ("EY") of 9% - the current 10yr treasury rate of 4.50% plus a cushion of 4.50%. Here are the prices where they might get interested:
8% Discount
9% Discount
10% Discount
11% Discount
12% Discount
EPS PV $2.62
$2.48
$2.35
$2.22
$2.11
9% EY Price
9% EY Price
9% EY Price
9% EY Price
9% EY Price
$29.11
$27.55
$26.11
$24.66
$23.44
Lastly, when compared to similar players in this business – Asta Funding (ASFI) and Encore Capital Group (ECPG)PRAA trades at twice those companies' multiples.
I am not going to suggest to you which valuation model should be applied. I am keenly aware that one man's caution is another man's subject of hysterical laughter. I will submit to you, however, that the current stock price appears to discount some rosy possibilities. With this background, what follows is a laundry list of trap-doors surrounding the company, few of which pop up on the screens of PRAA's fans.
Idiosyncratic Risks, a/k/a "How Could PRAA Blow Up In My Face?"
Here we are going to look at the company specific risks that could put a serious wrench in its business progress.
Most obvious, but maybe least important, are the consequences of the Bankruptcy Code amendments ("BKA") enacted on October 17, 2005. In simple terms, the BKA have made it tougher for consumers to file for Chapter 7 liquidation relief. Under the old Chapter 7 code, the debtor walked away from its assets (typically none) and from all of its liabilities. The recent BKA instead require a Debtor to show that he/she does not have the means – i.e. income – to satisfy at least part of the liabilities over a certain period of time. Prior to the BKA no such showing was required.
Savvy debtors rushed to file for Chapter 7 in droves just before the October 17 deadline. But due to normal bankruptcy procedures, creditors likely did not find out about the filings until they received notice from the Bankruptcy Court, usually 30-45 days after the date of filing. This means that PRAA may not have been able to accurately determine how much of its receivables were vaporized – forever – by the mass filings, until well into December, or perhaps later if the Courts were backed up. Risk No. 1: There is a very real possibility that the ERC and/or the receivables on PRAA's balance sheet could show a nasty hit when PRAA reports the next quarter.
Whether this is deemed a one-time issue and should/can be discounted as such will likely depend on the magnitude of its impact.
Risk No.2: Receivables prices remain challenging, and recent account purchases will merely replace - rather than increment - existing loan pools. The sell-side (and sometime ago even PRAA's management) has been adamant that the BKA would result in a surge of non-Chapter 7 receivables available for purchase, and that such supply would logically push prices down. I ask you – non rhetorically – if you are a bank and the rules have been changed to make it tougher for debtors to walk away from debts, wouldn't you think those debts have more "more value" and should command a higher, rather than lower, bulk sale price? Maybe there was a fire sale on pre-BKA debt, because there was a real possibility that the latter would get completely wiped out by a Chapter 7 filing. But that too would have been a one time event.
Last month PRAA closed on a $75M line of credit to be used for receivable purchases. That fueled speculation that its future earnings will get a big boost from the bigger receivables base. But could it be that PRAA was simply buying new receivables to make up for those that were wiped out by the pre-October 17 Chapter 7 filings?
We will get a much better picture when PRAA reports. One thing we do know however: all things remaining equal, the costs of acquiring new receivables has been steadily rising, from $0.0144 per dollar of face value in 2004, to $0.0231 for the first nine months of 2005, and $0.037 for purchases in Q3 of 2005. The trend here is not PRAA's friend.
Risk No.3: Impact of Labor Problems. PRAA has often highlighted the skills and efficiency of its collectors. It plainly states in its filings that there is a tight direct correlation between collectors' seniority and their rate of collections per hour. PRAA has also acknowledged that during Q2 and Q3, it experienced disruptions with its collectors-employee base. There is a real risk that these disruptions may hit PRAA where it hurts the most, i.e. in lower cash collections. Moreover, if PRAA did go on an incremental receivable buying spree with its $75M line of credit, and it did purchase as much as $90M (rather than the more typical $10-20M) of new portfolios in Q4, does it have the employee base to start collections? If not, as receivables languish, they get incrementally less collectible...

Catch Part II of "Testing My Resolve" tomorrow...
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