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We are upgrading our recommendation on Portfolio Recovery Associates Inc. (PRAA - Analyst Report) to ‘Outperform’ from ‘Neutral’ based on its strong cash collections and strategic acquisitions. Further, long-term investments are benefiting the core portfolio, while strategic acquisitions are accelerating the company’s earnings growth.

Portfolio Recovery reported second-quarter 2012 income from continuing operations of $1.87 per share, surpassing the Zacks Consensus Estimate of $1.64. The results also exceeded the prior-year earnings of $1.48.

Portfolio Recovery’s bottom-line results have shown great improvement over the past few years. Net income increased to $57.5 million in the first half of 2012 from $48.7 million in the year-ago period. The escalation is attributable to strong improvement in income from finance receivables, which managed to offset the disappointing fee income revenues as well as rising expenses.

Even the performance of the fee-for-service business improved in the second quarter of 2012, after posting weak results in the past few quarters. The increase was mainly due to the additional revenues from the new UK business, which were partially offset by a decline in the fee-for-service revenues from the U.S.

Acquisitions have also played a major role in Portfolio Recovery’s development. The acquisition of Mackenzie Hall Holdings Ltd., in January 2012, marked the company’s foray into the UK. The acquisition has boosted the company’s fee income and enhanced its competitive strength against peers, such as Asta Funding Inc. and Encore Capital Group Inc. (ECPG - Snapshot Report).

However, operating expenses of Portfolio Recovery have been escalating since 2007, leading to a decline in operating margins as well. Even in the first half of 2012, operating expenses soared 35.5% over the year-ago period to $189 million. We expect further growth in expenses in the upcoming years, unless an effective cost management policy is adopted.

Portfolio Recovery currently carries a Zacks #1 Rank, implying a short-term Strong Buy rating.

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