pcess609
The pandemic was weird.
A normal cycle would have seen a surge in bad debts that banks and other creditors would ultimately write off and sell to recovery companies like PRA Group (NASDAQ:PRAA) and Encore (ECPG). Unlike prior cycles, consumers got an unusual level of government assistance this time, propping up their solvency and the credit quality of lenders. With that, the expected surge in write-offs never really happened, and PRA Group and Encore have been watching their inventory of charged-off receivables dwindle, hitting cash collections, revenue, earnings and cash flow.
PRA Group shares are down about 25% since my last update, while Encore has done slightly worse. I have no expectations that a quick turnaround in reported financials is around the corner, but I do see rising consumer debt, declining credit quality, and a tougher economic environment in 2023. Should that all play out, charge-offs will start increasing more meaningfully (likely in late 2023 or in 2024), PRA Group will have more to collect, and earnings will rebound. Whether investors want to wait for that rebound is up to them to decide, but the shares do look undervalued below the $40’s.
Weak Core Trends, But The Company Is Controlling What It Can
The best I can say about third quarter results is that I believe management is running this company about as well as could be hoped given the circumstances. Core efficiency metrics haven’t fallen off that much, and management is being prudent about its purchases.
Reported revenue declined 7% and beat expectations, with the company benefitting from collections in excess of expected recoveries. Cash collections, though, were down 11% in constant currency, with a 15% drop in the Americas (and Australia) offsetting a 4% constant currency improvement in Europe (which was down due to foreign currency translation). Core Americas collections fell 18%, while bankruptcy fell 15%, and core European collections improved 2% (constant currency), while bankruptcy collections improved 18%.
Operating expenses declined 7%, limiting the operating income decline to 9% and driving a cash efficiency ratio of 58.4% (down from 61.9% a year ago and 61.3% in the prior quarter). Management is working down its collector headcount and shifting more legal collections to in-house teams, both of which help reduce costs, and the company also continues to grow its digital collection efforts, which are meaningfully more cost-effective for the company.
Estimated remaining collections (or ERCs) declined 13% in the quarter, and this is an ongoing worry as it represents the company’s store of future revenue, earnings, and cash flow. Looking at collections to ERCs, PRA recovered 7.2% of its average ERC in the third quarter, down from 7.8% last year and 7.6% in the prior quarter. Encore saw similar declines (down 70bp yoy and 40bp qoq to 6.0%).
Purchases declined 53% yoy, with Americas purchases down 36% and Europe purchases down 67%. Purchases were less than half of cash collections in the quarter, and management is seeing no near-term changes in the U.S. market, while the European market has improved some.
The Waiting Is The Hardest Part
This isn’t the first time that PRA has gone through this sort of challenge. The availability of charged-off debt ebbs and flows with the economic cycle, and competition plays a role – in the past, some recovery companies have gotten too aggressive with purchases and run themselves out of business by overestimating their recoveries and overpaying. There have also been changes to the market designed to push out bad actors; over the long term, this should help companies like PRA and Encore.
Consumer credit has continued to expand since the reopening of the economy, and revolving debt is now around 110% of pre-pandemic levels. Revolving credit grew about 13% in the third quarter, and card loans were one of the fastest-growing lending segments for banks. At the same time, though, inflation is reducing the purchasing power of wages and consumer savings are at low levels.
Card charge-offs have started slowing ticking back up, from a low of 1.6% in the fourth quarter of 2021 to 2% in the third quarter. With the economy likely to slow further next year, charge-offs could start getting back into the 3.5%-4% range, where there’d be more meaningful supply. In fact, in past cycles it wasn’t unusual for charge-offs to exceed 5% at some points in the cycle, so I do think supply is likely to improve from here even with banks getting a little more cautious on credit.
I should also note that credit cards are simply one kind of charge-off debt that PRA can acquire and recover. They represent about 80% of the business, but PRA has been running pilot programs with other types of debt.
The Outlook
It takes time for charge-offs to translate into purchases and then into collections. I expect that 2023 will be even worse at this point, but I would expect the business to start showing improvement 2024 or 2025. Whether the stock starts trading up on improved supply (and purchases) is hard for me to answer, but I think it’s credible to think that the Street will move in anticipation of earnings growth as PRA rebuilds its ERC inventory.
I’m looking for a 50% peak-to-trough move in core earnings, but over the long term I still expect low-to-mid single-digit core earnings growth and stronger free cash flow growth. I’d rather see the company hold on to more of its cash for future purchases (as opposed to buybacks), and I do have some concerns about running down the headcount too far (the company has previously had to scramble to add headcount in upturns), but those are more quibbles than core criticisms.
Based upon core earnings and discounted adjusted cash flow, I believe PRA should trade in the low-to-mid-$40’s. The biggest change to my model is a much steeper decline in 2022/23 on inadequate collections supply, with more earnings and cash flow pushed to the right (which hurts any NPV-type calculation).
The Bottom Line
I don’t expect the stock to recover quickly in the absence of evidence of increased consumer stress (namely higher charge-offs), and even when that happens, the Street may well argue that debtors don’t have the capacity to pay anyway, and PRA will have to wait for the recovery to reap the benefits. I agree with this, but the question is one of timing. Of course, there’s also the ongoing risk that credit doesn’t appreciably worsen and that PRA and Encore continue to struggle to find and purchase worthwhile receivables.
While the financials are going to look ugly for a little while longer, I think the core metrics are still solid and when charged-off debt supply improves, so will PRA’s near-term earnings outlook. For patient investors, this is a name to consider, but it will take a while longer for the debt market to move in the company’s favor.
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