Sleuthing on Covenants

Much has been written about the recent evolution of "covenant lite" corporate lending making the current LBO/Private Equity craze possible.

Here we will examine how opportunity can present itself when an investor takes the time to sift through all the dry SEC filings and loan documents of a potential investment. This is definitely in the "eating your spinach before your desert" category. (Sherlock would be proud of you)

I was keeping tabs on one of my investee's recently(Asta Funding/ASFI) when I thought I saw a disturbing trend: a decelerating expectation on managements part of the future Net Cash Collections on a new and very significant portfolio purchase of charge offs and judgements.

Note: ASFI is in the business of buying charged off debt for a few pennies on the dollar, usually 2-4 cents and collecting 7-12 cents in gross collections. The knock on the company is that they outsource most of their collections. Having run a few companies for many years, I personally see that model as a significant asset in their industry. All the heavy lifting of HR;heavy turnover of collectors; etc is left to a very large and fragmented industry of collectors...yet management gets total elasticity when it comes to scaling up when they need to.

In this case, $6.9 Billion in face value was purchased for $300 mm.The company financed the purchase of this substantial portfolio by borrowing $225 mm at Libor + 170bp's. The price is at the high end of what they usually pay because a significant amount of judgements have already been obtained....Yet management was estimating a Net Cash Collection (after paying collectors) rate of only 137%.
They have averaged significantly more than that (roughly 160%) since pursuing a suit strategy a few years ago and they continue to write up the value of the existing portfolio's because they are over collecting their initial expectations. It should also not be lost on anyone who read the agreement to purchase the debt, that the sellers negotiated future payments of 20% of any amounts collected above 150% of NCC's.

Upon further inspection, it became clear to me that it was in shareholders and managements interest to be conservative in estimating future returns in this instance.Obviously, they had borrowed a significant portion of the purchase and being aggressive here would be less than prudent.You see, the loan covenants on the funds they borrowed to make this very large purchase require that all NCC's(net cash collections) go to paying down the LOC (line of credit). The way GAAP works in terms of accounting for the purchase is for management to apportion a percentage of every dollar of NCC's to revenue and a certain percentage to return of principal. A significant portion of ASTA's revenue becomes taxable income (historically 75%) because they have low overhead due to the outsourcing reviewed above. Classifying more cash flow as current net income by having more aggressive estimates would mean paying more TAXES NOW while also paying down the loan with all of the NCC's.The cash they would have to divert from other portfolio's to pay the taxes could be earning higher returns elsewhere being reinvested in other portfolio's......So what happens when the LOC's are paid down significantly?
One thing that certainly may happen is another $69 mm of NCC's could walk in the door. Based on 15mm shares O/S, that should conservatively translate in to another $1.55 per share in earnings that the market is not counting on over the next few years.
Normally, a management having such latitude in estimating cash flows would give me great cause for concern. In this case, I view it more like a family run business being very smart about the timing of cash flows and WHEN they are going to pay those taxes.
Conversely, a management incented only by more short term oriented earnings or goals might be tempted to focus on the immediate benefit of reporting substantially higher earnings
Not surprisingly for this family run company with large insider ownership, there seems to be a history of writing UP the values of the portfolio's as management is able to gain clearer visibility of future NCC's based upon actual portfolio experience.
ASFI currently sports a TTM P/E of 11. Even with these reduced expectations, I believe they could earn $4.15-4.50 this year, which would represent growth in earnings of 23-36% over last year.
They have been growing the book value at 25% per year for a very long time.
Return on Avg Equity was 24.8% last Q and similar in recent years.(EBIT/EV does not work on a finance company like this).
The internal rate of return for the recent portfolio purchase is in "the 20's". When you can borrow at roughly 7% and get all or most of the loan paid back in 18 months (all the while paying down the balance significantly every month), that is a very shrewd way to leverage a finance company that is essentially in the business of earning a spread.
Many sophisticated hedgefunds and Sub-prime originators take substantially more risk in my opinion trying to simulate such a money machine. Here at ASFI, no one is charging you 2/20 for the priveledge of coming along for the ride.
Unlike a sub-prime player that may get swamped with repurchase requests, ASFI can put debt back to the seller if it deficient in many different respects.
I believe all of these dynamics add significantly to an already extremely attractive valuation. Given the fact that job's are still strong, but underwriting guidelines are tightening all across the board in the mortgage world, the ASTA business model of buying charge offs and pursuing wage garnishments on borrowers capable of paying should really have the wind at it's back for quite some time

H&R Bullet Proof and the Problems with Going Short

My two vicarious mentors, Warren Buffett and Charlie Munger have both strongly advised against shorting. ( betting that a stock will decline). Charlie has gone so far as to call it a miserable way to live, given the fact that an investor can be exactly correct that a particular company or management can be a complete fraud while being a very good fraud. All the while the investor that has shorted the fraud is paying dividends on the borrowed shares or suffering the eroding time premium associated with long dated put options



It is extremely rare that I ever short anything. The mortgage and real estate related space is the one area where I have made an exception due to my industry "insider" status and confidence I have in my insights.I have taken a few very small positions via some put options ( LEAPS) as a hedge to my mortgage income and to keep from sticking a fork in my forehead as things seem to unravel exactly as myself and my mortgage buddies have envisioned



Well, every once and a while the student has to learn by first hand experience, which is also a nice way of saying that the young wannabe needs to get his ass kicked to learn the lesson for himself. Although it has been a mild ass kicking, that is exactly what seems to be happening here with HRB and it's Option One Mortgage division.


I shorted Block for many sound reasons, which would all largely seem to have come to fruition....Yet, the stock has barely budged. At 12/31/06 it stood at $23. After a horrendous Q4 which has effectively wiped out the entire years worth of earnings...and after lowering guidance for 2008....it stands at 22.04 after today's close.


Here are a few highlights of this mornings pre-opening conference call which initially had me doing the happy feet thing:

• $960 mm Pre Tax Loss. $808mm after tax loss from all "discontinued operations". <$2.48> per diluted share


• Q4 Net gain on sale margin of -687 basis points (yes, that is a negative sign)


• Impairments charges and additional reserves galore due to loan repurchases and a highly unfavorable market for "scratch and dent" loans. They are experiencing higher loss severity on many foreclosure's


• The warehouse lines covenants have been breached, although they have obtained waivers due to the pending sale
• The $700 mm they had hoped to "redeploy" to share repurchases after the sale of OOMC has essentially evaporated
• H&R Bank has fallen below the minimum capital threshold guidelines of the OTS and will not be able to be in compliance until at least the end of Q4 2008
• Book value is very likely to be continuing to decline and the sale price is a moving target. The closing will not take place until Q2 2008 which ends 10/31/07.

The stock trades at 18x the low end of next years optimistic guidance after all of the above.

I have had more success with my other 'basket case' of real estate and mortgage shorts, but all in all it has not been worth the argeda or the time and effort. The satisfaction of my investment thesis being correct has been over shadowed by being on the wrong end of a manic depressive Mr. Market, who refuses to be pessimistic enough given the circumstances.

So there you have it boys and girls. Eat your spinach, don't race trains to the cross roads and pay attention to your elders wise advice.

Size Still Matters......

Especially if you used the Kelly Formula for your sub prime positions. I'm rooting for anyone who ventured into the shark pool .....but I am afraid it may end in tears for many.

Introduction to this blog

"Caution: This could happen to you too!"
That was the caption my son Matt and his college roommate's put under the copy of my old drivers license they had hung on their fridge. I thought it was pretty funny so I figured that it might be a good introduction. Of course, the "this" they are referring to is the 30 years of living, marriage, parenthood and entrepreneurship that have taken place since 1978....of which I am pretty darn happy about!( yuze yutes don't know nuthin)



“I’m a better investor because I am a businessman ………..and a better businessman because I am an investor” Warren Buffett

I am an entrepreneur and businessman. I have spent the majority of my career as a mortgage banker and founder of Union Trust Mortgage Corporation of Peabody Massachusetts.
I started my first real business when I was 20 and became fascinated with learning how to deal with all of the issues and challenges I had encountered. I immediately switched my major to business that fall. One of my first professors had us picking stocks as a model for teaching finance. Borrowing a page from Peter Lynch, (actually he had not written his books yet) I invested in what I knew. At that time, I knew pretty well some of the products of a company called Warner Communications. The stock did fantastic and I was hooked.
In spite of being the world’s greatest value investor, Warren Buffett has stories of years spent reading charts and handicapping horse races when he was a kid. I spent my very early years following “Stocks in the News” on what was then called the Financial News Network (CNBC). Also as a kid, I would spend much of my free time trying to find profitable betting systems at the greyhound track. I quit the dog track when I was around 20 after playing only three races one evening, “hitting” all three and breaking even.
Warren says that for him, it all came together like Paul on the road to Damascus when he read Ben Grahams book ‘The Intelligent Investor’.
For my part, I was an immediate convert to value investing when I read Roger Lowenstein’s book on Buffett, ‘The Making of an American Capitalist’. I believe I was 33 at the time and although I had long before stopped following what is now called momentum investing, I did not have a framework that gave me much confidence in investing in public companies. Yet here was Buffett operating so successfully in a fashion very similar to the way I was raised….. (Six kids, parochial schools, college, dentists and a wonderful home life all on a machinist income and a woman who could find 20 dollars worth of value for every dollar that came in the house.)

I am now forty seven and transitioning to full time value investing. I have been doing the work for years now whenever I could make the time. I thoroughly enjoy the process of ‘buying dollar bills for fifty cents’ and ‘finding nuggets of gold as I walk along the river banks’. I hope you will find some of my posts useful. I have spent countless hours studying the writings and teachings of men I consider to be master craftsman; Warren Buffett, Charlie Munger, Seth Klarman, Peter Lynch and Joel Greenblatt. I am not any where near as smart as any of the above, but they tell me if I have average intelligence, the right temperament and discipline I will do OK. So far so good…..
Cheers

Merrill Seizes Sub Prime Assets of two Bear Stearns Hedge Funds

Even the whales are exploding as things are starting to really get smelly in sub prime!

So are these problems with Bear's funds the beginning of the end for the massive hedge fund yen/sub prime carry trade? ( borrower near zero in Yen and invest near ten in dollars)

Here is what the WSJ had to say:

"The funds, which once controlled more than $20 billion in a combination of investor and lender money, have swooned in recent weeks amid weakness in the market for subprime mortgages, or risky homes loans."....and ...."By unwinding those loans in an orderly manner, rather than through a series of fire-sale auctions, Bear's fund managers, led by veteran bond salesman Ralph Cioffi, could help stave off painful ripple effects in the broader market for mortgage-backed securities and related instruments. Because such securities can be thinly traded, it is often hard to find their true valuation, making players in those markets vulnerable to inventory gluts that could depress prices across the board." Read the whole story here:http://online.wsj.com/article/SB118230204193441422.html?mod=home_whats_news_us

I believe that this whole mess is still in the first few innings. Last weeks National Mortgage News was littered with Asset Back Securities being downgraded by an ever so queasy group of rating agencies. The senior/subordinate structure of the ABS is causing many of the over capitaization rates used in creating the credit grades to widen for many issuers. What this means in plain english is that the issuers (lenders) will have to continually raise interest rates to borrowers in order to try and protect any margin they will have left in future deals. Fannie Mae and Freddie Mac are being very aggressive buying sub-prime type debt at Alt-a prices through there automated underwriting engines. I do not believe this will bode well for the wounded sub-prime industry given the GSE's competitive advantage and the political climate for sub prime lenders.

I have contributed to several threads on sub prime over at The Motely Fool's Liquid Lounge message board, so rather than bore the innocent I will leave it at that.(most recently here:http://boards.fool.com/Message.asp?mid=25520099&sort=whole&vstest=search_042607_linkdefault)

In closing, I guess I will stick with the whole ocean theme. Soon I believe many a sub prime investor will wish they had a bigger moat...I mean boat.

See this post for a what may be a sharper visualization of what could be waiting for the average sub prime investor. http://peterbrotchie.blogspot.com/2007/06/size-may-matter.html ( I have EBD: early blogger dysfunction. I cant figure out how to put in a picture down at this end of the page)

The photo above is an actual whale that exploded while being hauled through a city street in Taiwan. Thanks to valueguy88 for originally posting the link to the article and photo over at the Liquid Lounge board of The Motely Fool

Coming Soon....

In this space I will hopefully be able to share my adventures in value investing with my friends and family. I will also look to share idea's with my fellow 'members of the academy' headed by Warren and Charlie. Until then , please enjoy the summer