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Testing My Resolve: Part II

By's Tom Brown likes PRAA and Fil stress-tests his thinking.

Editor's Note: The complete Part I can be viewed here.

From Part I:

...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...

...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...

...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.

Which brings me to…

Risk No.4: Slowing Growth. The critical metric to measure PRAA's business is its growth in "cash collections on owned receivables (CCOR)." CCOR grew 47% in 2003 over 2002, and 31% in 2004 over 2003. But growth slowed to 27% in Q2 '05, and further to 22% in Q3. Hell has no wrath like slowing growth for a go-go growth company.
Risk No. 5: Does PRAA face a trend of poorer quality receivables? In its 10-Q's PRAA publishes a table (updated quarterly) of its "Total Estimated Collections to Purchase Price" for each calendar year purchase period. Again, these are not numbers manufactured out of thin air. There is a good historical correlation between PRAA's estimates and future actual data. Like the slowing CCOR, the trend here could be better. On the 2001 receivable pools PRAA expects a recovery of 435%, on the 2002's 356%, 307% on the 2003's, 242% on the 2004's, and 206% for the YTD 2005 purchases. These numbers do tend to get adjusted up as time passes, and as PRAA gets more and better feedback on collection trends; but, still, the drop-off shown is rather steep. Also, I analyzed all the yearly receivable pools to see how each performed after an equal number of collection years: the collection rates for the 2002-2004 receivable pools are meaningfully underperforming their elder brethren.
No.6: Geographic Risk. At year-end 2004, 15% of PRAA's receivables (face value) were from Texas, 12% from California, and 10% from Florida. Texas and Florida had "weather issues" as we all know. Anyone think that paying 1-yr.+ old debt was probably not front and center on the minds of people being chased by hurricanes? Maybe you can call this a "seasonal" issue, but don't forget that the older a receivable gets, the more poorly it tends to perform.
Risk No.7: Rising collection costs. It may not be this quarter's story, but legal collections as a percentage of totals are rising; so much so that PRAA has put together a small in-house legal department. These collections are inherently more expensive and hence carry lower margins.
Does your estimate of fair value for PRAA's stock discount any or all of the above risks?
But wait, there is more . . .
Macro-economic risks: The mountain of debt accumulated by consumers has been discussed ad nauseam in the 'Ville. With imminent higher payments on mortgages and HELOC's, courtesy of rate resets and the start of principal repayments, will payments to PRAA fall down the food chain? If you say that PRAA's debtors probably don't have to worry about mortgages, you may be right. Unfortunately that would work against PRAA even more, because as the home buying mania cools, chances are that the rental market will tighten and rental rates will increase. I think we can agree Debtors are likely to pay their rent before their debts to PRAA.
Interest rate risks: Now that PRAA has started borrowing money to purchase receivables, it is exposing itself to rising interest rates. It may seem trivial, but 5% interest on $75M equals 3.75M the first year. Assume a 25% cost amortization of receivables per year, and after 4 years PRAA will have forked over $9.4M in interest payments. If we model total cash collections of $225M, gross income of $157M, and 27.5% net margins, we'd get NOI of $43M. But back out $9.4M in interest payments and your net margins have just dropped to 21%. Not bad of course, but not a recipe for growth.
Are any of these risks factored into your estimates of FV for PRAA's stock?
Final (I promise) thoughts.
The impetus for this piece truly was the revelation that Tom Brown and I do not agree on the prospects for PRAA. Much as Toddo begs us to respect the Minx' price action, but not to defer to it, I respect Mr. Brown's resumé, track record and opinions. When someone with his credentials speaks, it usually behooves one to listen. But in this instance I am not inclined to defer to his opinion. Most of my previous comments on PRAA have been somewhat general and sarcastic. With Mr. Brown challenging my thesis, I felt I owed the Minyanship the details behind my views, painfully boring as they are.
The real PRAA story should reveal itself to everyone sooner rather than later. Within the next two quarters we should know if any of my concerns are legitimate. If they come to pass, I'll take the lessons of this "learning" exercise (and hopefully a little coin) and move on to the next idea. If I am proven wrong, hopefully I'll still take the lessons of this "learning" exercise and move on to the next idea.
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