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Making Money off of Bad Debt - A Recovery Play
This article previously appeared at Stone Street Advisors.
During the Great Recession plenty of money was made betting against the consumer. John Paulson, David Einhorn and other short sellers were vilified for profiting from the demise of the economy. They were ultimately vindicated as their analysis proved correct and consumers defaulted on a record amount of debt. In 2010, the number of non-business bankruptcy filings grew by 8.8% to 1.5 million. While this number may seem high, it is significantly lower than the 31.5% jump in 2009. Further, it is worth noting that last year’s filings are 32.7% below the 2.0 million filings in 2005. You may recall changes to the Bankruptcy Code went into effect in October 2005.
Bankruptcies are not a cure all for individuals’ unwanted debt. In fact, they don’t necessarily go away – but they do get smaller. In the shadow of these bankruptcy lead defaults lies Portfolio Recovery Associates, Inc. (NASDAQ: PRAA). With a market cap of $1.4 billion, PRAA is the leading receivables management company. They proudly proclaim: “We’re giving debt collection a good name.®”
If you believe the economy is turning the corner, continue reading about a company that is poised to benefit from increasing cash flows from a recovering consumer.
Background
Founded in 1996, the company is headquartered in Norfolk, Virginia. PRAA has stockholders’ equity of $491 million and total assets of $996 million. The company’s primary business is the purchase, collection and management of portfolios of defaulted consumer receivables. These are unpaid obligations of individuals to banks, consumer and auto finance companies and retail merchants. The company had $831 million in finance receivables at year end which had a face value of $8.1 billion.
PRAA also provides fee-based services, including collateral-location services, revenue administration, audit and debt discovery/recovery services and related payment processing. Fee income in 2010 was $63 million or 17% of total revenue.
Operations
PRAA’s debt purchase business specializes in charged-off receivables by the credit originator. Since inception, the company has acquired over 2,000 portfolios with a face value of more than $54.8 billion for a total purchase price of $1.7 billion (approximately 3% of face). The company acquires portfolios from debt owners (think MasterCard, Visa and Sears) through auctions and negotiated sales. In addition, PRAA also acquires accounts in forward flow contracts where it agrees to purchase defaulted receivables on a periodic basis. To purchase the receivables, the company utilizes two models, one internally developed and another externally developed. The company has an Investment Committee which approves the maximum purchase price for these portfolios.
Once PRAA collectors prioritize their accounts based on internal analysis, they focus efforts on customers most likely to pay. Most collections occur after telephone contact. The company also employs letters and legal activity to generate cash collections. Collectors are given incentives to have customers pay the balance in full. However, they are given flexibility to increase the likelihood of repayment such as a 20% down payment with the remainder paid over time (recall, the average purchase price of the portfolios is approximately 3%). Legal remedies, used when necessary, include garnishing wages or attaching assets to the claims. PRAA has over 2,400 full-time employees, most of which work on the company’s owned portfolio. The industry is labor intensive and has a high level of turnover. It should be noted that the collector turnover rate in 2010 for PRAA was 39%. Thus, the ability to quickly train new collectors increases the effectiveness of the workforce.
The fee-for-service business include: (1) Skip tracing for auto finance companies for a fee generally dependent on outcome; and (2) processing tax payments and tax forms, collecting delinquent taxes, identifying taxes not being paid and auditing tax payments for commissioned based billings or fee for service transactions.
PRAA, unlike many of its competitors collects for its own accounts. This allows for better control over the entire process and ensures compliance with Bankruptcy laws. Further, it gives the company an opportunity to integrate its results into its proprietary models.
Funding
The company funds its business partially through a $357.5 million revolving credit facility that matures in 2014. $107 million of the facility was unused at year end which is up from $46 million at the end of last year. There are several negative covenants associated with the debt. These covenants include, among others: borrowing cannot exceed 30% of eligible assets plus 75% of eligible accounts receivable; capex cannot exceed $20 million in any year; stock repurchases cannot exceed $100 million and PRAA must maintain positive consolidated income from operations. As many firms learned in the past, if liquidity is compromised, business could be negatively impacted.
Accounting
PRAA accounts for investments in receivables under ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” Under this method, static pools of accounts may be established. They are aggregated based on common risk criteria and is recorded at cost – which includes certain direct costs of acquisition. ASC 310-30 requires that the excess of the contractual cash flows over the expected cash flows, based on the company’s estimates, not be recognized as an adjustment of revenue or expense or on the balance sheet. ASC 310-30, utilizing the interest method, initially freezes the yield, estimated at the time of acquisition as the basis for subsequent testing. Significant increases in expected yield are recognized through an upward adjustment of the yield over the remaining life of the portfolio. Conversely, if collection estimates are not met, rather than lowering the estimated yield, the carrying value of a pool would be written down to maintain the current yield. This would be shown as a reduction in revenue on the income statement and a corresponding valuation allowance offsetting receivables on balance sheet. Cash flows greater than interest accrual will reduce the carrying value of the pool (lower cash flows will accrete the pool). A pool can become fully amortized while still generating cash collections – this would be recognized as revenue when received. The company establishes valuation allowances for all acquired accounts subject to ASC 310-30 to reflect only the losses incurred after acquisition.
The company uses the cost recovery method when collections cannot be reasonably predicted. Under this method, no revenue is recognized until the company has fully collected the cost of the portfolio (or when collections become estimable).
The company issued Form 4549-A from the IRS related to an income tax examination for the years 2005 – 2007. The IRS alleges that cost recovery for tax revenue recognition does not clearly reflect taxable income and that the unused line fees paid on credit facilities should be capitalized and amortized rather than taken as a current deduction. The company has filed a protest; however, if unsuccessful, it will have to pay the related deferred taxes and potential interest.
Portfolio Performance
The table below, from the Form 10K, shows the purchase price and estimated collections of both the Core Portfolio and Bankruptcy Portfolio.
The results of the Core Portfolio demonstrate the company’s ability to extract value from its purchases. Looking at the yearly acquisition data, you can see that the purchase price (as a % of the expected collections) has increased from the early years when competition was less. Nonetheless, the company has been able to generate steady double digit returns on equity.
Total cash collections to date are already 185% of the purchase price ($2.0 billion) – and management expects to collect an additional 90% of the purchase price ($1.0 billion). The risk is that the company will not be able to collect the entire amount projected. During 2005-2008, management took write downs based on revised collection assumptions. While this represents 6% of their total purchases, on a yearly basis the numbers are significant.
The Purchased Bankruptcy Portfolio does not appear as profitable as the Core Portfolio at first glance. However, collections from the Bankruptcy Portfolio are generally through efforts of the U.S. bankruptcy courts. As a result, overall costs are much lower for the company when liquidating a pool of bankrupt accounts as compared to the Core Portfolio. Thus, PRAA pays more for BK portfolios or stated differently, expects to collect less as a percent of the purchase price.
Looking at the numbers, it appears that collections have improved as the economy digs its way out of the Great Recession. Logically, one would expect collections to pick up along with the economy. As you can see from the table below, after falling in 2007 and then again in 2008, collections have increased each year since. With the job situation still at recession levels, it is quite possible that collections could grow even more as the unemployment rate decreases.
Parsing the financials further, another positive trend seems to be developing. Cash collections as a percent of the purchase price are occurring quicker for both the Core Portfolio as well as the Bankruptcy Portfolio.
Corporate Governance
For those interested in a high profile shareholder base, take comfort. Top holders of the company’s stock are Capital Research Global Investors (10%), BlackRock (7%), Waddell & Reed (7%) and Riverbridge Partners (5%). In addition, all executives and directors of the firm hold another 3% of the company’s shares. Together, this represents over 30% of the outstanding shares. While large holdings by high profile investors is usually seen as a positive, should they decide to exit, large share sales could weigh on the stock price. On the corporate governance front, PRAA has a staggered board and a poison pill – both are not considered particularly shareholder friendly.
Valuation
The most direct publicly traded competitors, while smaller than PRAA, include Asta Funding Inc. (NASDAQ: ASFI) and Asset Acceptance Capital Corp. (NASDAQ: AACC). Asta stumbled in its purchase of a large portfolio in 2007, just as the economy was starting to slide into the depths of the recession. Its stock currently trades at 0.75x book value, well off its historical valuation of 2.50x book value. However, the stock has rebounded over 250% since January of 2009. Asset Acceptance trades at 1.33x book value and is flat over the past 2 years. As you can see from the table below – there are a number of valuation metrics to consider. On a Price/EBITDA (earnings before interest taxes depreciation and amortization) and price-to-earnings basis, PRAA appears fairly (if not under) valued. On a price-to-book basis the company appears overvalued. It is also worth noting that the stock is trading less than 1% below its 52 week high.
If you believe in the recovery thesis, one could assume that the purchase price of receivables will continue to increase. As such, the inherent value of the company’s portfolio should increase. Further, cash collections could be underestimated if PRAA’s collectors are able to generate higher recoveries. The question is whether or not PRAA will be able to generate the same type of returns it produced in the past. While supply of company’s primary “product” may be reduced in the coming years, it is not likely to go away. As long as PRAA’s competition maintains pricing discipline, margins should be able to hold steady in an improving economy. You may ask – is the discount on ASFI warranted? That’s a post for another time.
Full disclosure, I have no position in any of the stocks mentioned and have no plans to initiate positions within the next 72 hours.
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The Sherman moniker is years out of date. The name was changed to LVNV Funding.
Also I think they may have had several unusually good years with low bankruptcy in their portfolios due to BAPCPA in 2005. I would expect their future performance to look more like their bankruptcy portfolio than their core portfolio.
Sherman Financial is the leader in distressed debt recovery simply because they ignore bankruptcy laws as do the banks as they are very successful collecting on discharged bankruptcy debt. What public records show ;
In 2002: they bought 7 Billion (face Value) of discharged credit card debt for 7 million. They collected 395 Million on it. Fast forward to Q2 of 2008 and they had the same results. That would suggest that it's a multi-billion dollar company now.
I imagine privacy has it's rewards as selling discharged bankruptcy debt from the standpoint of TBTFs is a trivial amount; unless they have personal shares in the company which pay dividends to the officers personally. That would also tend to give them the inside bid on the debt.
The companies that went public along with the many private companies are not without substantial risk as they are all bidding up the value of the debt while Sherman remains quiet and outperforms everyone. Two public companies in 2004 had substantial shares in Sherman. Both companies were set to announce unexpected losses totaling 50 million +/- 2 for the quarter. Sherman paid dividends to them from 2004 which covered their losses then proceeded to buy them out for 240 million in an all cash transaction.
Yes it is illegal as a civil offense but the fines are minimal at $1000 each. Generally settlement is made before it goes public. Checking the PACER federal court electronic record system, it is notable they have had only 9 suits filed against them in the the last decade and all were settled before going to trial.
One of there best tricks was to buy a tiny little shit bank. Then the collectors would call recent bankrupt individuals and ask them if they wanted a credit card. That was the bait. They slowly reeled them in by saying "why don't we put 50% of the debt you owe TBTF bank and we'll in turn give you that much over it as a credit limit?" What they effectively did was turn a discharged debt into a new debt payable to them at 30% interest and that credit line? Right on top of the amount owed to maximize fees.
So we now have debtor prisons in the process of being revived and as usual the TBTFs have turned another body of longstanding law into dust with the help of regulators who look the other way. This is the final indignity for people who were forced to file for a "fresh start" only to find third party collectors hounding them the day they got discharged.
If one finds investing in regurgitated steaming piles of dogshit rewarding , then by all means take this article's recommendation up. Be wary though because they have small and large competitors bidding up debt out of their ass. As long as they are unable to pay cash for the debt out of equity then they to are a bankruptcy waiting to happen with a revolving line of credit no doubt owed to a TBTF.
Very interesting. The new debt collection laws are more stringent. Hopefully, that will reduce the fraud. One note, however, this article is not a suggestion to invest in any of the companies mentioned. It is merely a suggestion that people do their own homework and determine if it makes sense to add to their portfolio.
Ten years ago or more, a child of mine used my credit card. I got the bill eventually but did not pay it, for I being male could not use the items bought. My thinking it was a mistake. Nothing happened.
Years later Profolio calls. I agree to monthly payment on my account if they would confirm the months to be paid, the monthly amount, and total bill. In return they could deduct from my bank account. When I got the papers it was for the full amount with a unlimited time period on the monthly take down. I immediately changed accounts, new cards, etc.
And I notified them. I agreed once again to pay if they would send me a written agreement as agreed upon. Otherwise I would not let them automatically deduct. I told them I would pay the monthly amount agreed to for the duration agreed to, by check. Their answer was that checks wouid require twice the amount to be paid per month.
I told them you know what. Now they call, at first I hung up, but now I just lay the phone aside. This has cut down on the phone calls.
One thing I did do was email our conversations agreements, but as noted in the emails, their answers differed in the emails. Occassionally, I do talk asking them to review the emails. I request they sue me for I would like my day in court.
This works the same way as robosigning. They don't have documentation so eventually they have to sue you using made-up affidavits. I would like to see a breakdown of their legal expense vs recoveries.
Unless they batch-process their claims in a court scheduled marathon, the legal bills would kill them for collecting through the courts. With even an inhouse attorney costing $125 an hour in court, how much can they make collecting $29 a month from somebody. Some court directed workouts are barely $10.00 a month. I've been in court when repayment hearings were discussed and was amazaed at the low payments that were being reviewed. So to thwart these guys, everyone who is being hounded should just go to court with their internet legal strategy.
No thanks for the tip Stone Heart Street Advisors. Funeral stocks are also a good vulture bet.
read "debt hope: down and dirty survival strategies" and then see if you still want to go to long these illegitimate children of keystone cops and gilligan.
As someone who's been on the receiveing end of this business, I wouldn't touch it. They suck. Like most JDB's they don't have the proper docs to sue successfully. They rely on intimidation and default judgements.
Stone - you couldn't be further from the truth. Your some kind of financial advisor? Laughable. I've personally talked to over 400 people in the last two years about thier CC debt. Only 3 actually had a "purchasing problem." If you have a $5000 limit and your 12 year old knocks out 4 teeth in a playground accident what are you going to do? (no insurance - no savings - living two weeks at a time) Everyone has their own story and rarely does it involve flat screen TV's in my experience. The banks collect insurance, get a tax write off and sell the bad paper to assholes like these. 20 to 30% of the debts they are trying to collect don't even belong to the folks being harassed.
Americans are waking up and responding to lawsuits instead of running (and in some cases filing lawsuits of their own - google Fair Debt Collection Practices Act or FDCPA you may find out what the average Joe really needs to be advised on) You don't need a lawyer either. I've beat three just by responding to the lawsuit. All three were dismissed without me even having to show up in court. Lack of prosecution. That is they couldn't respond to my interrogatories and were probably quite surprised by someone actually responding to their suit. While unilaterally changing interest rates, reducing credit lines and fucking with people's credit scores is technically legal it sure ain't right.
Sounds like you need to do some fact checking. If you are living paycheck to paycheck, you shouldn't be overextending yourself. PRAA does not buy hospital receivables. I understand there are instances where medical emergencies can cause a person financial hardship. It very easy to make the claim - but until someone can produce some real evidence that the majority of the defaults are caused by them, your comment is falling on deaf ears.
As for the banks collecting insurance - what are you talking about? They put up reserves for bad debt, that comes from their own pockets. While that does create a tax shield, it's not free money. In fact, selling the debt creates income if it has already been completely written off - which means more taxes.
sons of Benocide...I Hide!
Actually, this would work only if you are a moron. Before a credit card company sells this "receivable" it has been an UNreceivable for 12 months or more. The interest rate has been jacked up to 29.99% and overlimit & late fees of an additional $88/mo have been added. I know. My Citibank card (Limit $11,500) is now being persued by Asset Acceptance and they think I owe them $23,444.83 yeah right. Oh, but they are willing to settle for $14,000 or $75/mo. for the rest of my life! I settled once w/ Bank of America for 10¢ on the dollar, and got a nice suprise the next year: 1099-C to claim as income on my taxes for the amount written off. Don't these bastids know that it was our money TARP that saved them from extinction? Anyway, I filed Chap 7 Bankruptcy and I didn't need a lawyer to do it. I'm so broke the court waived the filing fees.
I'd like to know why banks are foreclosing on the underlying properties from Toxic Waste securities The FED took in, The FED made the banks whole, why doesn't that flow down to the mortgage debt?
Further details of the covert TARP program, “Where the Bailout Went Wrong”, by Neil Barofsky:
http://www.nytimes.com/2011/03/30/opinion/30barofsky.html?_r=1&scp=1&sq=...
If you settled for $0.10 on the dollar, then these guys are making $0.07 or 2.5x their money...they buy this stuff at $0.03 on the dollar (before expenses).
No, he is saying that BofA settled for 10c. PRA never got a shot at it. They made the same offer to me on a business credit card, but I filed BK instead.
Here's an old article about the debt collection industry. Some of the biggies are owned by hedge funds and big banks:
http://www.businessweek.com/magazine/content/07_46/b4058001.htm
"Waddell & Reed (7%)"
DAMN YOUUUUUUU!
:)
i dont invest in scumbags and i definately hang up on them in mid sentence
They are collecting on debts that other people are owed. If people were more responsible with their money - debt collectors wouldn't be needed. Do you really need the extra flatscreen for the kitchen (wants vs needs)? Seems your anger is misplaced - don't shoot the messenger!
No shooting would be required if the message wasn't an outright lie. See below.
They are collecting on debts which were sold to a consumer. Let's see... do you advocate true "caveat emptor"? Do you think I should be able to hawk "Dr Bill's Magic Sex Tonic", even though I know it will do nothing but cost you a pile of money, make me a pile, and keep your weiner limp as a wet noodle? If your answer is "yes", then, no problem. If it is "no", then you are an apologist for the bottom-dwelling scum-suckers.
These are the bottom-dwelling, scum-sucking cousins of their bankster/lawyer friends who pushed the debt in the first place.
They are collecting debts that were created by the consumer when he purchased a good or service (not hospital bills). I would agree that some people do encounter hardships (as noted below) that cause their financial profile to change. However, many people just have to have that brand new pair of shoes or that nice new purse - unacceptable. I am not an apologist in the least. How would you like it if your boss said he couldn't pay you because the guy that was purchasing (insert product that you sell here) wasn't paying his bills? At the end of the day, we are all selling something unless you work for the (directly) government.
Bottom dwellers....