PRAA – Undervalued Predictable Companies

PRA Group Inc (PRAA) is a current selection of GuruFocus’ Undervalued Predictable Companies screen. The company has a long history is consistent earnings growth, with operating income growing at a ~34% CAGR over the past five years, with only one period of decline since 2001.

Additionally, the company has shown a sustained ability to convert earnings into distributable cash, with free-cash-flow (FCF) continually outstripping net income over the past decade.

What has made PRAA so successful in the past and how likely is this to persist in the future?

The business:

PRAA’s primary business involves purchasing non-performing consumer debt (such as credit cards) and managing the future collection efforts. It’s essentially a value investing business where they buy distressed or non-performing loans at cents in the dollar in the hopes they can collect more than their aggregate purchase price.

Their services are attractive to potential sellers as they can immediately realize value for distressed receivables and focus on their primary businesses. While they’ve invested a total >$4.3 billion in portfolios thus far, management believes that there is ~$2 trillion of consumer debt outstanding in PRAA’s domestic addressable market.

Purchasing process:

The company participates in both debt auctions and negotiated sales (it does not break out the split). In an auction process, the seller will assemble a portfolio of receivables and will either broadly offer the portfolio to the market or seek purchase prices from specifically invited potential purchasers. In a privately negotiated sale process, the debt owner will contact known purchasers directly, take bids and negotiate the terms of sale.

In order to determine a purchase price, PRAA uses two separate internally developed computer models (see Competitive Advantages below). The company analyzes the portfolio using a proprietary multiple linear regression model and an adjustment model, which uses its collections results from similar portfolios PRAA previously purchased. This allows the company a growing advantage given its long history of acquiring debt portfolios.

Competition:

PRAA’s core markets have seen increased competition post-2008 from private equity firms, hedge fund investors and other collection agencies causing portfolio purchase prices to increase. The chief worry was that this would result in smaller profit margins for bad debt buyers.

While PRAA did see some negative effects from this post-recession (in addition to a tougher ability to collect), the company has show a proven ability to avoid over-paying for debt portfolios, with profit margins remaining in the low to mid 20%’s.

In addition, there are various pending regulations that should make it more difficult for outside pools of capital to enter the debt-buying industry.

Competitive advantages:

PRAA believes they have a variety of competitive advantages including:

1. Strong Relationships with Major Credit Originators – Because they’ve done business with most of the largest consumer lenders in the United States, they are in contact on a regular basis with major existing and potential sellers of defaulted consumer receivables.
2. Established Systems and Infrastructure – Pricing non-performing debt is as difficult as accurately pricing insurance. You need a reliable method of estimating future losses and collectability. The company believes they have devoted significant effort to developing proprietary systems, including statistical models, databases and reporting packages, to optimize portfolio purchases and collection efforts.
3. Disciplined and Proprietary Underwriting Process – Leveraging the above advantages, PRAA has been able to consistently collect more than their purchase price and costs over the collection life cycle of the acquired defaulted consumer receivables. In short, the company has a proven ability to “buy-low, sell-high”.

Current portfolio:

Since inception, the company has acquired over 44 million accounts from 150 different originators for an aggregate purchase price of ~$4.3 billion. PRAA estimates that they still have ~$4.5 billion left in remaining collections on previously acquired portfolios. Its current portfolio is weighted heavily toward consumer credit card debt as seen below:

Geographically however, the company is well diversified across various markets in the U.S.

Financial Strength:

While GuruFocus currently ranks PRAA a 6/10 on financial strength, this is primarily due to its recent purchase of Aktiv Kapital which is attractive for numerous reasons (see Growth Opportunities below). The company plans on gradually reducing its recent spike in leverage through strong internal cash flows and returns on capital (PRAA ranks 9/10 on Profitability & Growth).

Growth opportunities:

PRAA’s largest growth opportunity stems from the 2014 acquisition of Aktiv Kapital, a Norway-based company specializing in the acquisition and servicing of non-performing consumer loans throughout Europe and in Canada. The deal was for $880 million in cash along with the assumption of approximately $435 million in debt (EV of $1.3 billion). This acquisition gives them access to a market worth ~$1.6 trillion in European non-performing consumer loans.

European markets are attractive for multiple reasons:

1. Markets less mature than the U.S. market, possibly leading to higher returns
2. Financial restructuring is driving increased debt sales (e.g., Spain, Greece)
3. Regulatory capital requirements (including Basel III) are pressuring banks to improve ROE, cut costs, and monetize distressed investments.

This purchase diversified PRAA’s portfolio across continents and significantly increased their debt portfolio:

Valuation:

Despite consistent and rapid FCF growth, PRAA has traded at an average ~8% FCF yield over the past decade, roughly where it’s at today.

Using GuruFocus’ Peter Lynch charting tool, PRAA looks to have ~33% upside should continue to grow as it has in the past.

Furthermore, looking at Gurufocus’ new Reverse DCF tool, PRAA looks to be significantly undervalued. At current prices, the market is only expecting EPS growth rates at ~1/2 PRAA’s 10-year average and less than 1/3 its 5-year average. PRAA’s recent Aktiv Kapital acquisition should help the company outpace the expected growth rates currently priced into its shares.

Risks:

Below are the key risks selected from the company’s 10K:

1. “We may not be able to collect sufficient amounts on our defaulted consumer receivables to fund our operations.” – While this remains a risk for anyone involved in the debt-purchasing industry, PRAA’s multi-decade history or driving attractive returns off portfolio purchases (even in times of increased competition) mitigate concerns of this risk.
2. “We may not be successful at acquiring and collecting receivables of new asset types.” – Again, PRAA has a long and consistent history of mitigating these issues. Their recent Aktiv Kapital acquisition gives them an improved ability to buy additional portfolios in less efficient markets at attractive prices.
3. “Our ability to collect on portfolios of bankrupt consumer receivables may be impacted by changes in, or interpretations of, federal laws or changes in the administrative practices of the various bankruptcy courts. Changes in governmental laws and regulations could increase our costs and liabilities or impact our operations.” – While the company lists this as a risk, increased regulation my actually benefit PRAA long term as it would drive away potential competition when bidding on defaulted debt portfolios.
4. “Our international operations expose us to additional risks which could harm our business, operating results, and financial condition.” – This seems to be the most relevant risk at this point. While the Aktiv Kapital acquisition is attractive for multiple reasons, the company does have limited experience in these foreign markets.

Conclusion:

While PRAA appears attractive at current prices should it be able to grow at anything near historical rates, future growth does depend largely on tapping new markets (primarily Europe). Should management execute, PRAA looks to be undervalued.