Philipvan Doorn

Investing columnist

Portfolio Recovery Associates is a hot, but little-known, stock, up more than 3% today after an upgrade by Janney Capital Markets.

The company had disappointed investors by reporting first-quarter earnings of $40.8 million, or 81 cents a share, increasing from $38.6 million, or 75 cents, a year earlier. The consensus among analysts polled by FactSet was 84 cents.

But when breaking down the numbers and listening to what Chief Executive Officer Steve Fredrickson has to say, you can’t help but consider putting money in this small-cap company. After all, the stock has more than doubled the returns of its index in the past five years. And it’s not in an inherently risky business like some other small-caps.

Portfolio Recovery Associates Inc. PRAA, +1.09%  of Norfolk, Va. buys portfolios of nonperforming or charged-off loans, mainly in the United States and the United Kingdom. The company has a deal in place to expand its operations in Europe through the purchase of Aktiv Kapital of Oslo for $880 million in cash. Portfolio Recovery Associates will also take on Aktiv Kapital’s debt of $435 million, for a total value of $1.3 billion. The purchase is expected to be completed by the end of June and is being funded through a combination of cash on hand and borrowing.

When the deal was announced in February, CEO Steve Fredrickson said he expected the “transformative” deal to be “immediately accretive to earnings.”

The business of buying servicing rights for stressed mortgage-loan portfolios in the U.S. boomed after the credit crisis of 2008, with many players, including Ocwen Financial Inc. OCN, +0.93%  expanding exponentially by buying huge blocks of servicing rights from several of the nation’s largest lenders. The mortgage servicers are now under a great deal of scrutiny, with New York Superintendent of Financial Services Benjamin Lawsky saying in a speech Tuesday that he remained concerned over the expansion of mortgage servicers, and that his department would broaden its investigations.

Portfolio Recovery Associates is different from Ocwen because, in addition to providing collection and related services (including repossession and skip tracing) to banks, governments and retailers, it buys pools of problem loans (not just the servicing rights) at a discount, and then seeks to recover as much as possible through collection efforts. Because it owns these portfolios and doesn’t resell them, the company can be patient with recovery efforts.

At this point in the credit cycle, “the supply of available debt to acquire in the U.S. remains lower in years past,” Fredrickson said in the company’s first-quarter earnings press release, which helps explain the need for a massive expansion into Europe.

Janney Capital Markets analyst Sameer Gokhale upgraded Portfolio Recovery Associates to “buy” from “neutral,” with a fair value estimate of $60, implying 11% upside from Thursday’s closing price of $53.03. Of eight analysts who cover the company, six have “buy” ratings and two “hold” ratings.

The shares look cheap, trading for 11.4 times the consensus 2015 EPS estimate of $4.64. The consensus 2014 EPS estimate is $3.87. Still, the stock is flat year-to-date through Thursday, following a 48% return in 2013 and a 58% surge in 2012. The stock’s five-year total return is 385%, more than double that of the S&P 600 SmallCap Index.

Here’s a more interesting point for investors looking ahead — Portfolio Recovery Associates’ first-quarter return on common equity (ROCE) was 21.38%, increasing from 20.37% a year earlier, according to FactSet. The 2013 ROCE was higher, at 22.22%, but the first-quarter number is very impressive, and the consistent ROCEs above 20 mean there’s plenty of support for the stock price and plenty of earnings to support its expansion. Meanwhile, the company has grown its annual sales per share for 10 straight years, which takes us back to 2005, well before the U.S. credit crisis began.

Fredrickson in February said he expected the Aktiv deal to help Portfolio Recovery Associates “meet or exceed our twin goals of 20% ROE and 15% EPS growth, delivering long-term shareholder value through the years ahead.” If he is right in this prediction, investors have an opportunity to buy a long-term winner at a discount.

Portfolio Recovery Associates’ financing of the Aktiv deal through debt is good news for shareholders, who aren’t being diluted by a deal that is expected to add to earnings this year. According to Gokhale, Portfolio Recovery Associates’ leverage following the Aktiv deal and associated borrowings will be “approximately two times debt-to-adjusted EBITDA (including their deferred tax liability as debt).”

The analyst believes the company could decide to lever up further, to 3.1 times EBITDA, which would free up an additional $1 billion that could be deployed through more acquisitions, purchases of debt portfolios or share buybacks.

Gokhale also sees another possible growth opportunity for Portfolio Recovery Associates, since there is “the chance that three of the large debt sellers who exited the market could start selling charged-off receivables in 2014 or 2015.”

More must-reads from MarketWatch: