Same for me, but apparently I'm told that the aim (BIS's) is to use TGA's and let O2 convert them after you apply them to your model ..... which it does (little DOS window appears).
Seems silly to me, if I have a .paa file, why the %$#@%$# won't it just let me apply it ! Really!
Instead I have to provide TGAs, and then clean out the directory of TGA files before I PBO it .... again, silly I think.