In 2007, ASFI made a poorly timed purchase of $6.9billion worth of receivables for $300 million. This was expensive relative to other purchases that ASFI had made previously (4.3% vs closer to 3%) and the purchase was made just prior to the Great Recession which worked against the company, making recoveries much more difficult. The reasoning is that it is easier to recover from someone who has a job (their wages can be garnished) or from someone who has assets (which can be taken in legal proceedings). The Great Recession made people that fit these characteristics relatively more rare than before.
ASFI places receivables in different pools based on their shared characteristics. When a specific pool’s recovery rate is estimated (in management’s discretion) to be less than the purchase price of that pool, management changes the accounting for that pool to the Cost-Recovery Method. This means that the total value of the pool is written off immediately and the company’s earnings are reduced accordingly by the full amount. As cash is collected, it is added to the income statement as revenue and it flows down to earnings and then to retained earnings on the balance sheet (which a corresponding increase in cash). This means that actual profits are not recognized until the amount of the writeoff has been recovered (hence, Cost-Recovery). This differs from the accounting for the other pools, where a portion of estimated profit is recognized for each dollar collected. The accounting treatment is important in this case.
In analyzing ASFI, I noticed that the company’s earnings were poor over the last few years, but that the company is trading at a roughly 26% discount to NCAV. First, I looked at the company’s assets, which are predominantly comprised of consumer receivables. When the company impairs these receivables and uses the Cost-Recovery Method, they are no longer included on the balance sheet. It turns out that a good deal of cash is recovered from assets that have been impaired – $45.3m in 2008, $40.7m in 2009 and $34.3m in 2010. These figures translate to 39%, 58% and 75% of revenues in these years, respectively – not trivial figures!
I wanted to see how much of these receivables have been written off to see precisely how many assets the company has which are not contained on the balance sheet (this is somewhat philosophical, since they aren’t assets if they aren’t on the balance sheet – remember, management is saying these are worthless). The results astounded me.
The “Portfolio Value” in this image is the value without any impairments. The “Carrying Value” is the amount the company is carrying on its books after impairments. This shows how aggressively management has been writing off its portfolio of receivables over the last three years, declining from nearly 100% in 2006 to less than 40% today. At the same time, the company is still earning strong returns from its zero-basis portfolios which are becoming an ever-increasing portion of its revenues. Why is this? A review of the company’s 10-Qs and 10-Ks shows that the company has been purchasing fewer receivables over the last few years. $49.9m in 2008, $19m in 2009 and just $8m in 2010. The company simply is not replenishing its loan portfolio. Management explains this by stating that the environment for consumer receivables became more competitive over the last three years and that, in ASFI’s opinion, the prices these receivables were being sold at were too high (clearly above 4% of face value). This reminds me of Fairfax Financial, where Prem Watsa’s annual letters often discuss how the company will not write unprofitable insurance simply for the sake of maintaining revenue and asset levels. Likewise, ASFI will wait until the opportunities exist for good buys. When the company doesn’t buy more receivables, its easiest sources of revenue (the most recently purchased receivables that have been relatively less picked through) are less available. Combine that with massive write-downs in the existing pools, and you have a poor earnings environment.
It appears management is being extremely conservative in its writedowns, taking losses now but then ultimately recovering approximately the same amount later. By taking the impairments now, management is gaining tax savings that are largely going to reduce the company’s debt load (they repaid $91m in 2009 and $33m in 2010, equal to 57% of their total balance outstanding at the beginning of 2009).
Here’s a summary: The company buys $1 of receivables for about $0.03. Management, being as conservative as it is, has now turned around and written off 62% of that amount, bringing their carrying value to 1.86 cents for every $1 of receivables. The market is now pricing the company at a further 26% discount, or 1.38 cents per $1 of receivables. This is despite the fact that the company has historically earned between 6 and 7 cents for every receivable, and their recoveries from their zero-basis portfolios has stayed largely stable (there have been declines, as expected with aging receivables) and the company has not yet begun replenishing its receivables pipeline.
As if the above weren’t enough, I thought I’d also mention that management appears to me to be strongly considerate of shareholders in that, despite the fact that the founding family owns about 27% of the company, they have put in place safeguards to ensure that independent directors must approve of large transactions. This may not seem significant to you, but over the last several months I have seen founding families exerting far more control and otherwise taking advantage of other shareholders by running the company as if it were still private. Reading about ASFI’s corporate governance has been refreshing.
Author Disclosure: Long ASFI