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We are downgrading our recommendation on Portfolio Recovery Associates Inc. (PRAA - Analyst Report) to ‘Neutral’ from ‘Outperform’ based on its rising operating expenses and debt. Moreover, despite rising cash collections, the total estimated collections to purchase price ratio is declining steadily over the years.

Operating expenses has been escalating since 2007, thereby leading to a decline in operating margins. Compensation, legal collection fees and costs, outside fees, employee services and communications drove much of the expense during the past few years.

Moreover, in the past several quarters, rising borrowing costs and increasing leverage have been resulting in higher interest expenses.

Additionally, Portfolio Recovery faces ample challenges in acquiring defaulted consumer receivables and obtaining placement of fee-for-service receivables. The intense competition continues to apply downward pressure on its total estimated collections to purchase price ratio, which is a significant productivity metric. The purchase price ratio declined to 189% in the first nine months of 2012 from 332% in 1996.

Counting on the positives, Portfolio Recovery’s bottom-line results have shown great improvement over the past few years. The escalation is attributable to strong improvement in income from finance receivables and fee income, which managed to offset the rising expenses.

The performance of the fee-for-service business showed improvement in the second and third quarters of 2012, after posting weak results in the previous few quarters. The increase was mainly due to the fee income from the UK business, acquisition of Mackenzie Hall and higher revenues from PRA Government Services.

Moreover, both cash collections and collector productivity (cash collections per hour paid) continue to be at record highs as efficiency improves at the company’s operating call centers and the company continues to hire new collectors. Cash collections jumped 29% year over year to $679.5 million during the first nine months of 2012.

Overall, we expect modest growth in the long term. Portfolio Recovery carries a Zacks #3 Rank (short-term Hold). Peer Encore Capital Group, Inc. (ECPG - Snapshot Report) also carries a Zacks #3 rank.

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