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On Jan 30 2014, we downgraded, Portfolio Recovery Associates Inc. (PRAA - Analyst Report), to Neutral from Outperform owing to lack of potential growth catalysts in the near term. This outsourced receivables management services provider currently carries a Zacks Rank #3 (Hold).

Why the Downgrade?

Estimates for Portfolio Recovery have been unvarying over the last 30 days due to lack of any significant growth catalyst.

Although Portfolio Recovery delivered a 20.5% positive earnings surprise in the last reported quarter, we remain concerned about the near-term prospect as higher operating expenses and borrowing costs are likely to weigh on the company’s positives.

Cause for Concern

Owing to a fragmented and competitive accounts receivable management industry, Portfolio Recovery faces several challenges in acquiring defaulted consumer receivables and placement of fee-for-service receivables. Going ahead, relatively low barriers to entry and high returns will likely create more – though less skilled – entrants over time, thereby adding pressure on pricing.

Moreover, global economic crisis has pressurized the operating leverage of Portfolio Recovery for quite some time. Operating expenses also witnessed a surge, pressurizing margins. Compensation and employee services, legal collection fees and costs, outside fees and communications drove much of the expense during the past few years. We expect further growth in expenses in the upcoming years, unless an effective cost management policy is adopted.

In several of the past quarters, rising borrowing costs and increasing leverage have resulted in higher interest expenses. Additionally, the stock split initiated in Aug 2013 may have an adverse effect on the company’s earnings, given the increase in share count.

Nevertheless, amid the negatives, growth in income from finance receivables, higher cash collections and portfolio acquisitions raise optimism on the stock. Also, the credit facility amendment made in Aug 2013 strengthens the company’s liquidity and is thus expected to help Portfolio Recovery enhance its operating efficiency.

Stocks That Warrant a Look

Some better-ranked stocks in the financial services space include Marsh & McLennan Companies, Inc. (MMC - Analyst Report), CNO Financial Group, Inc. (CNO - Analyst Report), FBL Financial Group Inc. (FFG - Snapshot Report). While CNO Financial and FBL Financial carry a Zacks Rank #1 (Strong Buy), Marsh & McLennan holds a Zacks Rank #2 (Buy).

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