Every Friday, sum zero sends out their top weekly idea. I really look forward to this mailing, and in the past few months they’ve had a strange habit of mailing out ideas right after I had written them up or researched them (ITIC being just one example. The sum zero write up, when published, drove the stock up approximately 25% in the span of a day or two and away from my limit buy order). So imagine my surprise and delight when I saw today’s idea was Asta Funding (ASFI), a stock I had previously written up and which I feel is dramatically undervalued because of some complex accounting. Maybe this article would delve into the accounting and serve as a catalyst to unlock value?!
Then I saw that the idea was a “short” idea with a price target about 60% of today’s level. I was immediately a bit worried — past short ideas have been very good, and I started to wonder if my due diligence had missed something significant and I was about to look a quick down 40% in the face.
Fortunately, I don’t think that I’ll be looking at a down 40% on this stock any time soon. As a matter of fact, if the stock dropped 40% or even 30%, I’d quickly make the stock the largest position in my portfolio by far.
I’ll do a quick summary of the long case, but you can find my full write up here. Basically, the company is trading for less than book value, and their book value likely understates their true worth due to too conservative accounting and off balance sheet assets.
So let’s start with the first error in the short case: valuation metrics.
The company has tangible book value of ~$162 million, of which ~$101 million comes from zero-cost basis portfolios. The author argues that these portfolios should be completely written off, which would result in tangible book value of ~$61 million, or $4.19 per share. He then applies a 1.83x multiple to the company (the average of their competitors) to come up with a value of $6.69.
Let’s start by adjusting the short cases numbers. He’s using figures from the 10-K, more than nine months stale; so let’s update it for the most recent 10-Q. Currently, their zero-cost basis portfolio sits at $88 million, not $101 million, and book value stands at $172 million, not $162 million.
Now, let’s talk about what the short case is missing. There are two problems here, and both of them are quite large. First, and probably most importantly from a margin of safety standpoint, $81 million of the zero cost portfolio that he argues should be written off are from the “portfolio purchase.” This $81 million is supported by $74 million of non-recourse debt. To put it simply, if this portfolio proved completely worthless, then the $74 million of debt would be wiped off the books (note: management confirmed on their most recent conference call they could and would walk away from this portfolio if it turns out to be worth less than the debt).
So now let’s assume that all of the $87 million of zero-cost basis portfolio is actually completely worthless (completely ridiculous, but stick with me for a second). Even if that’s the case, then $74m of debt will be written off along with that $87 million of assets. Book value would then drop by “just” $13 million, not $87 million, and book value per share would end up at ~$10.89. That alone is higher than today’s market price, but if you wanted to get really crazy (and hey, why not get crazy? We just completely wrote off $87 million of cash generating assets. That seems crazy to me) and use the 1.83x P/B multiple used in the sum zero write up, we come up with a target price of $15.65. That’s pretty aggressive for my taste, but hey, it’s their metrics, not mine!
Second problem: these assets aren’t worthless. In my first article, I even mentioned that I think the “portfolio” purchase could end up worthless, which would result in a $7 million write off. But the rest of the zero basis portfolio is most certainly not worthless. You can argue that is worth less than today’s price, but you can’t completely ignore it.
Zero basis portfolios are portfolios that management can no longer estimate the timing of the cash flows. Instead of recognizing a portion of the cash flow as interest income and a portion as principal pay down like they would from normal portfolios, all cash flow goes immediately towards principal payments on the balance sheets.
These portfolios are generating massive cash flows. In nine months this year, the $101 million of zero basis portfolio has generated $15.6 million of cash flow. Btw, this cash generation is what has reduced the value from $101 million at the start of the year to $87 million currently. To claim that a portfolio that is on pace to generate over $20 million in cash is completely worthless is absolutely asinine. Now, the cash flows from the portfolio will certainly decline over time as the portfolio winds down, so don’t value that $20 million like an annuity or anything. But to claim that this portfolio is worthless is insane!
The second valuation metric the short case uses is a price to cash flow basis. He notes the business will have declining cash flow in the future as their portfolio winds down and uses the declining cash flow to justify a low valuation.
Now, it’s a basic rule of finance — if an asset’s cash flow is declining, that asset is going to be worth less than an asset whose cash flow is increasing. But the short case misses something here — all portfolio recovery companies inherently are cash flow declining companies. Portfolio companies basically make an investment in receivables, which then generate a slowly declining amount of cash over the next five to eight years. They then have a choice: They can let the cash build on their balance sheet, or they can reinvest it in more receivables. The reason ASFI has declining cash flow is because they think receivables are currently overvalued! They aren’t reinvesting their cash flow and are instead letting their cash build. Their competitors, on the other hand, are buying receivables.
Now, maybe ASFI is wrong and receivables are actually cheap right now. In that case, you’d probably want to trade them at a discount to peers. But to value them on a cash flow basis seems really, really strange to me. It would imply they could increase their value per share from the $4.90 per share the short author suggests to at least $13 per share simply by immediately going out and reinvesting all of their cash flow.
Those are my two biggest criticisms of the short piece published on sum zero. There are other, smaller quibbles, but these points are so large that until they are overcome, there’s really no bother addressing any of the others.
Just to finish the article, let’s look at my bear case for what Asta Funding is worth, so shorts can understand what they’re getting into. First, let’s assume that the “portfolio” purchase is worthless. Remember, this means Asta walks away from their debt, so they’ll take a $7 million hit to their book value. They have ~$40vmillion in receivables outside of the “portfolio.” Of it, $6 million is in the dreaded zero income portfolio and $34 million is in the interest method.
Let’s assume that the receivables are worth 75% of what they’re on the books for, or $30 million. There’s another $10 million in write offs. Almost all of the rest of their assets are in hard cash; they have $252 million in total assets on their books — $122 million is in receivables, $104 million is in cash (note: with no recourse cash, that means net cash per share currently sits at $7.12 per share). The other $26 million or so is mainly deferred taxes and some receivables. You can make whatever adjustments you want, I’m going to assume the rest of their assets are worth what they’re stated on the books given how conservative we’ve already been. So, with these adjustments, book value is taking a $17 million hit in total and goes from $172 million to $155 million. With 14.6 million shares out, that puts book value per share at $10.62.
I think that’s your downside. Maybe take a 10% to 15% discount because they’re not reinvesting cash flows like all their competitors are, which means the cash is somewhat locked up and at risk of being used for a weird acquisition, so your ultimate downside is $9.00-$9.50 or so. It’s tough to imagine downside too much lower than that, given how conservative we’ve already been and that we’re quickly approaching the value of just their cash balance. Note I haven’t factored in any accretion from the share buybacks — a program that just began and which could greatly drive book value per share up as they execute it at today’s price.
***This piece may have come out a bit more critical than I intended. I'm reminded a bit of the saying, "Once management starts bashing the shorts, you know the shorts are correct." But I honestly believe that the company is so undervalued to anyone willing to dig through the accounting and the report by the short was so sloppy that it deserves a fair bit of criticism, especially when the case is published and mailed out en mass.***