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