|Shares Out. (in M):||46||P/E||16.8||0|
|Market Cap (in $M):||1,256||P/FCF||n/a||0|
|Net Debt (in $M):||1,690||EBIT||95||0|
Market data 10/27/2017 via Bloomberg. 2017 metrics TTM GAAP
52-Week Range: $23.15 - $42.70
5-Year Avg ROE: 19.75%
Estimated Remaining Collections: $5,325m
Year-end 2019 ‘normalized’ Target Price: $60
Year-end 2019 ‘no-growth’ Target Price: $43
Catalyst: Declining amortization rates. Every dollar allocated to or freed up from amortization charges drops directly to pre-tax earnings, creating optics of tremendous operating leverage and growth of GAAP results.
Specifically, I believe amortization rates are artificially high currently as management is booking purchases at overly conservative assumptions to save on cash taxes paid in 2017 while waiting for clarity on corporate tax reform and/or free cash flow generation to catch up to the improved purchasing environment in the United States. I expect amortization rates to begin to fall in Q1 2018, or as soon as clarity on tax reform is reached, and to be significantly lower by 2019-2020. This will create growth in reported GAAP numbers in excess of fundamental cash collection growth.
Thesis: PRAA is a cyclical company with complicated accounting currently trading at a no-growth valuation. The fundamental economic cycle for most of the business bottomed in 2015, but we are being offered the same investment opportunity today. A combination of government regulation, lag in company results, and conservative management have masked improvements in company results that will result, at some point, in improved reported results and significant growth in EPS. As a new oligopoly in the US due to CFPB regulation, PRAA stands to benefit from an up cycle in the industry. No one can predict the specific date when results will improve due the difficulty of forecasting amortization rates, creating opportunity to invest ahead of others if you have a longer time horizon or a trigger if you prefer to wait for a trend to start.
Revenue Model/Accounting & Terminology
This is available in filings, but typically generates the most questions, so feel free to skip forward if not needed. I’d particularly direct your attention to slides 16-17 of the September 2017 investor presentation for more detail.
First and foremost: GAAP accounting obscures the economic underpinnings of the business. Revenue is a metric of gross profitability for PRAA, materially understating cash generated by the company. A typical revenue cycle looks like this:
Purchase charged-off debt and record at purchase price on the balance sheet as Net Finance Receivable (NFR)
Estimate the cash to be collected over an assumed 10-year life. This is management's primary location to make assumptions on how much will be collected and in what year. Total dollars collected peak in years 2-3 of collections and trail off much like an oil well decline curve over time. The sum of all estimated cash collections is Estimated Total Collections (ETC). ETC / Original purchase price (NFRs) = Purchase Price Multiple. The portion of ETC not yet collected or written off is Estimated Remaining Collections (ERC). These items are disclosed as supplementary information in 10-K and 10-Q reports on a vintage year basis
Start collections. Perform an IRR calculation on the NFR purchase price and estimated cash flows from ERC over the remaining life of the debt. This IRR is the Gross Yield (IRR) of the vintage. Gross yield and cost to collect are the primary purchasing decisions for management, and I believe 30-40% IRRs are management’s minimum hurdle rate for purchasing of credit card portfolios. In periods of limited supply (2015) they may reach to 25%.
Report results via GAAP. Period-start NFR balance * Gross Yield (IRR) = Revenue recognized for the period. Note that revenue from existing portfolios is determined at the beginning of the reporting period by the Gross Yield, itself derived from cash collection estimates. Cash Collections less Revenue = Amortization. Most amortization is “cash applied to NFR balance” but also includes any Allowances or write-offs of NFRs deemed uncollectable during the period. Cash Collections less Amortization less Allowances = Revenue reported on GAAP statements
Readjust ERC cash collection assumptions, impacting ETC and Purchase Price Multiple. Calculate a new Gross Yield (IRR) using the remaining unamortized NFR balance and estimated ERC cash flows. Rinse and repeat.
No-Growth Valuation / Current Situation
Several factors over the last few years have impacted each of the four reported segments of PRAA and left the business with no- or negative-growth rates on all important metrics. The market has not responded favorably.
Americas Core – 56% of cash collections FY2016. Growth in small Brazil & Canada operations has not offset decline of domestic credit card collections. Tight credit after the financial crisis limited supply of new charged-off debt, hurting PRAA’s profitability. Low supply and/or high competition lead to higher purchase prices and lower returns. CFPB regulation/uncertainty further limited supply as 3 major sellers of charged-off debt (Wells Fargo, Chase, Bank of America) suspended debt sales, representing ~30-40% of total annual charged-off credit card debt. Supply bottomed in 2015 per my calculations. Large allowances (write-offs) of NFRs were recorded in 2015-2016 for debt that was deemed no longer collectable under new CFPB regulations. Cash collections were (1%) YoY in FY2016
Americas Insolvency – 17% of cash collections FY2016. The OCC updated/muddled regulations on the sale of bankruptcy auto loan debt in 2014. PRAA essentially stopped all bankruptcy purchasing due to low supply/high prices in 2H 2014 resulting from OCC changes through Q1 2017. In FY2013, this segment represented 41% of total cash collections. Cash collections were (27%) YoY in FY2016.
Europe Core – 26% of cash collections FY2016. The 2014 purchase of Aktiv Kapital came with known slower portfolio recovery rates than US collections (ie: lower gross yields), and the takeout premium of the purchase lowered the expected return on Aktiv’s sizable existing Europe portfolio. European pricing environment has worsened since 2014, and collections here have been unable to do more than offset the decline of Americas Insolvency business. Cash collections grew 14% YoY in FY2016.
Europe Insolvency – 1% of cash collections FY2016. Fast growing but too small to move the needle. Cash collections were up 99% YoY in FY2016.