It’s been a while since I’ve updated my thoughts on PRA Group (NASDAQ:PRAA), and a lot has been going on at this underperforming debt collector in the meantime. When I last wrote about PRA, I thought the company was in for a rough 2023 ahead of better results in 2024 and 2025. As it turned out, “rough” didn’t really cover it, and the company’s 2023 results (and share price) were hammered by operational inefficiencies and poor collections performance.
The shares are down about 40% since that last article, reflecting a lot of the self-inflicted pain the company has gone through and that ultimately led to a change at the top (a new CEO). While Encore Capital (ECPG), PRA’s biggest rival, is also down over that period, the notably worse performance at PRA accurately captures the level of operational underperformance.
The past is the past, but PRA Group seems to be on a better path now. Management has been taking some big swings at improving the operational efficiency and cost structure of the business, as well as making some personnel changes aimed at improving portfolio purchases. Coupled with stronger flows from increasing consumer credit charge-offs, PRA should be looking improved performance in the second half of 2024 and beyond, and mid-single-digit core growth support a fair value around $30.
Slow Improvement Is Still Improvement
The efforts management has made to improve collections performance have already started paying dividends, as portfolio income (which basically measures the company’s “yield” on its portfolio of receivables) has improved about 4%, 3%, and 3% sequentially over the last three quarters (Q1’24, Q4’23, and Q3’23) after a multiyear stretch of sequential declines driven by ineffective collections approaches and poor purchasing decisions.
Even with these improvements, portfolio income is only about 80% of where it was in mid-2020, and there’s definitely ample room to improve further. Management has been homing in on operational efficiency and execution issues, looking to make corrections to improve both call center and legal collection performance, and the results are starting to show. Cash collections have already started to improve, up 9% in Q1’24, 5% in Q4’23, and 2% in Q3’23, and a double-digit growth target for FY’24 doesn’t seem unreasonable.
Management is also looking to drive more efficient overall operations, with a target of 60%+ cash efficiency (basically cash collections minus operating expenses divided by cash collections). The company reached 58% last quarter, down from 65% in the year-ago quarter and down slightly from 58.6% in Q4’23, but management believes improving collections and low expense growth (as the company realizes the benefits of those cost actions) will drive the number over 60% for the full year, so there should be a noticeable upswing in 2H’24 profitability.
Improving The Portfolio Takes Time And Money
While operational shortfalls explain some of the issues that PRA has been having, I believe poor pricing and risk selection with purchases has also played a significant role.
If you’re not familiar with PRA’s business model, it’s basically this – banks and other creditors who have given up on trying to collect on receivables (typically credit card balances) package and sell those charged-off receivables to buyers like Encore and PRA who then make their own efforts to collect. They basically pay pennies on the dollar knowing that much of the debt will prove uncollectable, but a lot of the value-added in this business comes from being able to properly score (essentially determining the likelihood of repayment) and price the purchased receivables.
Some years are good and some are bad, but 2021 has been looking like an uncommonly weak vintage for PRA, and writedowns for that part of the portfolio have certainly played a role in the weaker results (portfolio revenue is basically collections on the portfolio of receivables and changes to the estimated recoveries from the portfolio). Since the change in CEO, there have also been some changes in leadership, with a new head of Global Investments and a new head of European Investments, and more recent vintages (like 2023) are performing better.
Looking ahead from today, PRA should be in line to see stronger flows of quality charged-off receivables as card delinquencies and charge-offs continue to rise. Not to make excuses for past mistakes, but post-pandemic vintages like 2021 were likely impacted meaningfully by the economic disruptions caused by the pandemic, and I think it’s fair to assume that the 2023-2025 charge-offs will behave more like typical years.
Another important part of the puzzle is making sure that the funnel of collections (the estimated remaining collectibles or ERC) stays strong. You can’t draw water from an empty well and you can’t grow collections if you’re not replenishing the portfolio with new purchases. The ideal, of course, is to lean in and buy more when the supply of paper is attractively-priced and step back when it isn’t. PRA used to be good at that, and I’m not sure if the recent issues are attributable to mismanagement, unpredictable shifts in the nature/quality of the debt (like the 2021 vintage), or a sense of desperation – the need to “buy something” even in leaner years to make sure the ERC balance continues to grow.
One item of note here – while PRA has quite a bit of debt, they do at least have better access to capital than many small players in the market. With interest rates so much higher now and banks pulling back on risk in their lending portfolios, smaller players are getting squeezed out of the market, leading to less competition and better terms for purchases.
The Outlook
I do believe that the new CEO has the company on better footing, and I think we’re only just starting to see the benefits of the operational changes being made. Consider just one point – Encore has long outsourced some of its call center needs to lower-cost countries like India and Costa Rica, but PRA is only just starting to go down that road. With improvements to the collection process still fresh, not to mention improvements in the portfolio purchasing process, and moves to structurally lower costs (like outsourcing), I think PRA is in the very early innings of driving better results.
Prior to the last CEO’s tenure the company used to generate free cash flow margins in the low 20%’s and ROEs in the mid-to-high teens. I’m not expecting a return to those levels, and certainly not right away, but just getting back to high single-digit/low double-digit ROEs and high-single-digit free cash flow margins would be enough to support a fair value in the $27 to $30 range. If those are plausible expectations, I expect normalized earnings and free cash flow growth on the higher side of the mid-single-digits.
The Bottom Line
Few businesses are easy or quick to turn around, and PRA definitely isn’t one of those. It also remains a difficult stock for casual investors to follow, as the accounting is atypical and often confusing. Still, for those willing to wade into murky waters, I see credible arguments for owning the shares as the changes made to improve the business start to take hold and really bear fruit in the coming years.
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