This Stock Turns Bad Money into Good

Warren Buffett — and Benjamin Graham before him — made their fortunes off of one simple strategy: buying assets at cheap, undervalued prices and then helping those assets realize their value. It’s a tried and true strategy that’s spawned generations of value investors.

For an investor, it makes a lot of sense if you can find a company that takes a similar approach. I’ve found a company that does just that, but with one slight difference. Instead of buying companies or physical assets, it treats debt as an asset — and tries to buy it for as cheap as possible. If the company can collect just about anything off of the debt, it’s usually for a huge profit.

But instead of investing in Uncle Sam’s debt or Corporate America’s debt, this company relies on the individual. Let me explain.

Any business that allows its customers to pay after they receive goods or services is going to have some percentage of deadbeats. Credit card companies deal with this all the time. So do other types of lenders. And as the economy struggles, so does the average consumer. That means bad debt, which always exists, is all the more prevalent.

When the internal collections department of a company finally gives up on pursuing its late payers, or just don’t want to deal with the hassle of collections, that debt gets sold off for pennies on the dollar.

There are several players in this space that are effective at collecting on these debts, but my favorite is Portfolio Recovery Associates, Inc. (Nasdaq: PRAA).

The company has a very wide reach. It acquires receivables of the well-known credit card companies — Visa (NYSE: V), MasterCard (NYSE: MC) and Discover (NYSE: DFS), as well as private label credit cards, installment loans and lines of credit, bankrupt accounts and will pursue legal judgments and trade payables from various debt owners. The company also provides a range of fee-based services, including locating collateral for creditors, performing audits and debt recovery services for various government entities. There really isn’t a sector the company doesn’t service.

Portfolio Recovery Associates may have anywhere between $40 million and $75 million worth of receivables at any time, of which 60% are currently from the big three credit card issuers, 23% from consumer finance entities, 14% from private label credit cards and 2% from automobile contracts.

The key to all this, however, is how cheaply Portfolio Recovery acquires the debt. Since the company began in 1996, it has purchased debt for an average of three cents on the dollar. Three cents. This shouldn’t come as much of a surprise considering the delinquent accounts are usually no younger than four months old and can be as old as nine months. After that much time, the internal collections department of any debtor pretty much assumes the debt is uncollectible as far as their efforts are concerned. But for Portfolio Recovery, to get it for three cents is a gift.

Part of the company’s advantage is that it specializes in collections. Talk to a collections agent and you’ll learn a variety of legal tricks and methods of persuasion that the initial debtor simply lacks. They’ll try to get debtors into a payment plan, for example, in which the customer makes five payments of 20% of their balance each.

And here’s the beautiful part about it: all it takes is one payment, and in most cases Portfolio Recovery has already made a huge profit based on the purchase price. Beyond this, Portfolio Recovery has an army of lawyers who can initiate legal proceedings and commence with garnishment for debtors who “have the ability but not the willingness to resolve their account.”

Portfolio Recovery is quite astute at getting those accounts paid. Last year the company booked $281 million of revenue, with a cost of revenue of $14.7 million. That means the company has astonishing gross margins of 95%. After backing out all expenses, net margins are 16%, generating a $44 million profit. In other words, the company’s bottom line profit is triple that of what it paid for the debt.

Portfolio Recovery has generated some $80 million of free cash flow each of the past three years. This allows the company to buy that bad debt without incurring debt itself, which would shrink margins.

Action to Take –> Portfolio Recovery Associates has created a finely-tuned machine that buys debt for next to nothing, collects on it and generates huge profits. It’s a simple business to understand, and the company is executing it brilliantly. With +30% annual earnings growth ahead and the stock trading for 18 times this year’s estimates, investors have a chance to buy a great company at a cheap price.