PRA Group Stock Q2: A Turnaround And A Hedge For An Economic Slowdown (NASDAQ:PRAA)

Richard Drury In recent weeks the market has become more concerned about an economic slowdown and possible recession. Many are probably asking if there is a way to hedge their portfolio or even make money in that scenario. There are very few pure countercyclical companies out there. By countercyclical I mean companies that perform better in a declining economy and perform well in a recession. One of the most countercyclical companies is PRA Group (NASDAQ:PRAA) along with its peer Encore Capital (ECPG). This report will focus on PRAA but include a direct comparison to ECPG. But there’s more here than just countercyclicality. This is also a turnaround story and a disconnect. After losing money in 2023, I believe PRAA is at an inflection point returning to much better operating results. After the earnings report on August 5, 2024, the stock analysts average EPS estimate for 2024 increased from $0.87 to $1.32. That’s a jump of 52%! Yet the stock actually dropped from $23.24 on that date to a $22.37 closing on August 9jth. That is one of the larger disconnects I have seen. Background PRAA is a collection agency of consumer debts. It acquires charged-off loans from banks, finance companies and other lenders for pennies on the dollar. It then works those accounts for recoveries. About 85% of its loans are credit cards. Most of the rest is labeled consumer finance, which is mostly unsecured consumer credit. The remaining 2-3% are auto loans. It has 2 geographies; Americas and Australia which is about 60% of revenues and Europe, the other 40%. The vast majority of the Americas is the U.S. Industry Buying charged-off credit cards and other unsecured loans is a lot like buying upscale wine. Both have good and bad vintages by year. The years 2020 through 2022 were poor vintages for PRAA. Like wine, poor vintages are usually followed by weak sales and profits the next 1-3 years. The price at which PRAA acquires the charged-off loan portfolios can be as important as how well they collect on them. When the economy is strong, loan charge-off rates are low. That results in less supply of charged-off loans forcing PRAA and its peers to pay more. This usually ends in a lower profit margin. From 2020 through 2022, due to massive stimulus in the U.S. the economy was very strong and people used their credit cards less. That was a double negative for PRAA. Less credit card usage meant less supply of loans, thus higher prices. But also, since there was so much stimulus, there were less charge-offs. In fact, delinquencies for all types of loans fell to historically low levels in that period. Great for most of us, but bad for PRAA. In Europe, there was also a lot of stimulus so the situation was similar to a lesser degree. The first chart below shows credit card balances in the U.S. since 2016. Balances dropped significantly in 2020 and 2021 due to massive government stimulus and less spending due to the pandemic. Credit card balances have since spiked and continue to rise at a rapid pace. Balances are now well above pre-pandemic levels whether inflation adjusted or not. This bodes well for PRAA going forward. The Daily Shot The second chart shows credit card delinquencies since 2005. Like balances, delinquencies dropped sharply in 2020 and 2021, to historically low levels. They are now increasing rapidly and are now well above pre-pandemic levels. Reasons for the increase include the government stimulus wearing off, student loans going back into repayment and inflation which has made consumer staples and housing much more expensive than before the pandemic. This trend show no sign of stopping. The Daily Shot, Equifax, NY Fed Financials Financial results starting with the last full year prior to the pandemic through last quarter are shown below. SEC filings Let’s start with the top line, revenues. Revenues were increasing at a steady rate prior to the pandemic. In fact, in 2019, they were up 11%. As mentioned earlier in the article, the landscape changed in 2020 with the massive government stimulus and less consumer spending. These resulted in lower credit card balances and way less credit card charge-offs. Less supply of charge-offs led to lower finance receivable balances as shown in the fourth line from the bottom from 2019 to 2022. It also led to much higher pricing when buying charged-off loans resulting in a lower profit margin. The level of finance receivables recovered in 2023 and is showing strong growth in 2024. There is a delay to when higher charged-off loan prices impact earnings. That is because in 2021, PRAA still had plenty of runway to collect on loans purchased in 2018 and 2019 and earlier. So, earnings actually increased in 2020 and 2021. The full impact of less loans at higher prices started to hit in 2022 and really became problematic in 2023. As shown earlier, credit card balances and charge-offs started increasing in 2022 and continue to increase. This resulted in better profit margins on loans purchased in 2022 and later. Again, there was a lag, but in 2024 we are now starting to see the benefits from buying charged-off loans at better margins. The most recent quarter had both strong revenue growth and strong earnings growth. Both benefitted from an accounting adjustment. During that quarter there was a $19 million positive adjustment for changes in future recoveries. It represented $19 million of the $23 million profit. Naysayers of course will say most of their profits were an accounting adjustment. That is true. But it’s the trend that is more important here. They also collected $54 million in the quarter of above forecast, which drove the adjustment. Importantly, the overcollection was actually more in Europe than the U.S. That indicates the recovery is not just in the U.S. but also in their second largest market. Not shown in the chart above but inferred by it is the amount of loan purchases. PRAA paid $379 million for charged-off loans last quarter, up from $328 million a year earlier and $246 million in the prior quarter. It was their third largest ever quarterly purchase amount. More loans to work on, if purchased with good pricing, means more profits. Management is confident that pricing has now returned to more normal levels and continues to improve. The charts below were provided by PRAA in their last earnings presentation. They show the increased purchases (top 2) and improved pricing (bottom 2). PRA Group earnings presentation last quarter Please note that EBITDA is not a usable figure for PRAA, similar to most other financial companies. PRAA’s adjusted EBITDA was $1.065 billion for the last 4 quarters. But $809 million of that was something called “ Recoveries applied to negative allowance less changes in expected recoveries”. Essentially a principal paydown of their charged-off loan portfolio. It’s really there more for the loan covenants. Guidance Management provided the following guidance in their last quarter earnings announcement. Continued strong portfolio purchases Double digit cash collection growth A 6-8% return on average tangible equity for the full year of 2024 The following calculation backs into full year EPS guidance using management’s 6-8% ROE guidance. Tangible equity was $787 million as of June 30, 2024, which of course is midyear. Using the 7% midpoint ROE, that means earnings guidance is $55 million. With 39.4 million shares outstanding, that is an EPS of $1.40 for the year. Since EPS was $0.63 in the first half of the year, the guidance is $0.77 for the second half at the midpoint. While that is a drop off from the $0.54 earned last quarter (when annualized), remember most of that was an accounting adjustment. Earnings going forward should have much less of that. After the earnings report, the average stock analyst’s EPS estimate for 2024 increased from $0.87 to $1.32. The average analyst estimate for 2025 increased from $1.77 to $1.97. Debt PRAA has $3.1 billion of lines of credit, which had $1.4 billion available as of June 30, 2024. All of PRAA’s interest-bearing debt outstanding as of June 30, 2024 is shown below. PRAA most recent 10-Q and 10-K filings The most important thing to look at is the percentage of outstanding balances that are from adjustable rate loans. All three Central Banks (UK, European and American) have started to cut interest rates or are expected to. The UK started this month and the ECB in June. The Fed is expected to do so in September. Each 0.25% combined reduction improves PRAA’s EPS by about $0.08 annually after tax. Things will improve further if rates are down considerably when they need to refinance the loans maturing in 2028 and 2030. They have already raised the cash needed to pay off the 2025 notes. Catalysts PRAA has a number of catalysts going forward to increase EPS significantly. In fact, I believe it will be difficult for them not to increase EPS next year. As discussed earlier, profits in this industry are heavily impacted by the prices and volumes of charged-off loans purchased in the prior 1-3 years. The past year has seen big improvements in both. 1. Lower interest rates– As shown in the debt section of this article, 53% of their outstanding borrowings have adjustable rates. The Central Banks of the U.S., Europe and the U.K. are all starting to (or expected to) lower interest rates. That will reduce the interest cost for PRAA. 2. Rapidly increasing credit card charge-offs– The second chart in this article shows credit card delinquencies are rising rapidly and are now above historical norms in the U.S. PRAA does well in a rising charge-off environment. What they pay for their charged-off loans is half the battle. When supply increases, pricing gets more favorable. 3. Increasing credit card balances– The same as increasing charge-offs. More supply means better pricing. The first chart in this article showed rapidly increasing credit card balances in the U.S. 4. Cost cuts – PRAA has several cost-cut programs including outsourcing much more to offshore call centers. Their peer ECPG has been doing this successfully on a much larger scale for years. 5. PRAA does well in a recession – PRAA’s EPS in the last real recession took off to well above the level now despite being much smaller. EPS was $2.87 in 2009, $4.35 in 2010, $5.85 in 2011 and $7.39 in 2012. EPS then dropped back to a range of $3.45 to $3.50 in the next 3 years. 6. Rise of Fintechs – Upstart, Sofi, Lending Club and many similar companies mostly didn’t exist 10 years ago. Their rise means way more unsecured consumer loans outstanding at much higher interest rates. Higher interest rates almost always mean more risk of a charge-off. That means the charge-off rate is likely to be much higher than at banks and other lenders. All say they are tech leaders in a new Fintech field. But to this former Bank Examiner, they are just more subprime (high interest rate) lenders. I could talk a lot more on this point, but it would be a side track from PRAA. The gist here is there are a lot more unsecured consumer loans out there than ever before, and that loan type gets charged off at a much higher rate than any other loan type. That means much more supply for PRAA and its peers. Comparison to Peer PRAA has a very similar peer in ECPG which is a little larger. They both focus on buying charged-off credit cards and other unsecured consumer debts. They both have the U.S. as their largest market with a large operation in Europe. A comparison of the two is below. SEC Filings, Yahoo Finance As you can see there are advantages and disadvantages to each one. Both had declining revenues and earnings over the past 4 years due to the poor vintages of 2020 through 2022. This proves PRAA’s problems were industry related, not company specific. PRAA had a higher revenue and earnings decline, though ECPG’s EPS was down about 90% in 2023 from 2021. ECPG also trades at a lower PE ratio and price to book. I believe the reason for ECPG’s lower valuation is the last item shown in the chart above. It has much higher leverage. I would rate PRAA’s leverage as moderate and comfortable. ECPG’s leverage is high. Another item in PRAA’s favor is the much faster revenue recovery this year. ECPG over the last 8 years has traded at a PE ratio of about half of PRAA. Both are worth looking at and should do well going forward. It really comes down to your risk tolerance. I have gone with PRAA as I have enough risk in my stock portfolio already. I also like their recent superior growth. Further due to leverage, I don’t believe ECPG, has more upside from here than PRAA does. Valuation Management is effectively guiding for $1.40 EPS in 2024, with the back half stronger than the first half. However, earnings are still in recovery mode from the large air pocket in 2023. PRAA also has a much higher interest expense than in 2021. It’s looking likely that the Fed will start lowering short term rates this year. PRAA has shown it has the capacity for an annual EPS of at least $4.00 in a normal economy. It earned that much in 2021 and almost that much in 2018 and 2020. It gets better. PRAA is countercyclical. In a recession or slow economy, it should perform better than historically. I believe it can earn $5 or $6 EPS in a recession, or more. It actually did better than that following the 2007-2009 recession. In fact, it earned $5.85 in 2011 and $7.39 in 2012, following the 2007-2009 recession. There was a two year lag back then between the start of the recession and better earnings. I believe the lag will be much less this time. Take another look at the second graph in this article. The current level of charged-off loans has already been rising for two years, whereas back in 2007 they were rising but at a much lower pace, and similar to 2005. They were also at a much lower level back then. This is very important because it indicates PRAA’s big jump in earnings is likely to occur during a recession if it starts next year. Even without a recession, earnings should exceed $4 by 2026, due to the current vintages of higher than normal charge-offs. That level of earnings is similar to what they did during the more normal years of 2018 and 2021. Value Line’s page on PRAA (behind a paywall so I can’t link it) shows it traded at a PE ratio averaging about 15 since 2016. Discounting a little for top of the cycle, I am using a PE ratio of 12.5. Keep in mind, in this business, top of the cycle can last 3-5 years. Multiplying that by $4.00 EPS brings my 2 year price target to $50. My 1 year price target is $40. A target of $40 is not a stretch at all. The stock traded for an average of about $40 most of the last 5 years until it fell off a cliff in April, 2023 after a really bad quarter. The issues that caused that drop are quickly fading. In a recession scenario in 2025, PRAA could be earning at least $6 EPS in 2026. In that case, it should trade over $60 in two years. Takeaway PRAA is a countercyclical stock that should benefit from a recession but also do well if things remain the same. That’s because half the battle for them is the price and volume they buy charged-off loans. The last 4 quarters have shown much improved pricing and volume. These trends are likely to continue based on a sharp rise in the delinquency rate and balances of credit cards in the U.S. If you expect a recession, I strongly recommend adding PRAA to your stock portfolio as both a hedge. Even if the economy stays relatively strong, the stock should increase significantly simply by returning to the $40 it averaged 1.5 to 5 years ago.

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