Every Friday, sum zero sends out its top weekly idea. I really look forward to this mailing, and in the past few months it has 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 ~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 the latest idea was Asta Funding (ASFI), a stock I had previously written about 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 (you can find the write up here). I was 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 at a quick 40% fall in the face.
Fortunately, I don’t think that I will be looking at a 40% decline in this stock any time soon. As a matter of fact, if the stock dropped 40% or even 30%, I would quickly make the stock the largest position in my portfolio.
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 its book value likely understates its 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 ~$162m, of which ~$101m 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 ~$61m, or $4.19 per share. He then applies a 1.83x multiple to the company (the average of its competitors) to come up with a value of $6.69.
Let’s start by adjusting the short case's 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, its zero cost basis portfolio sits at $88m, not $101m, and book value stands at $172m, not $162m.
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, $81m of the zero cost portfolio that he argues should be written off are from the “portfolio purchase." This $81m is supported by $74m of non-recourse debt. To put it simply, if this portfolio proved completely worthless, then the $74m of debt would be wiped off the books (note: management confirmed on the 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 $87m of the 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 $87m of assets. Book value would then drop by “just” $13m, not $87m, 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 $87m 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 $7m 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 toward principal payments on the balance sheets.
These portfolios are generating massive cash flows. In nine months this year, the $101m of zero basis portfolio has generated $15.6m of cash flow. Also, this cash generation is what has reduced the value from $101m at the start of the year to $87m currently. To claim that a portfolio that is on pace to generate over $20m 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 $20m 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 the 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 5-8 years. They then have a choice: They can let the cash build on the balance sheet, or they can reinvest it in more receivables. The reason ASFI has declining cash flow is because it thinks receivables are currently overvalued. It isn't reinvesting cash flow and is instead letting cash build. Competitors, on the other hand, are buying receivables.
Now, maybe ASFI is wrong and receivables are actually cheap right now. In that case, you would 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 the 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 the debt, so they’ll take a $7m hit to their book value. They have ~$40m in receivables outside of the “portfolio." Of it, $6m is in the dreaded zero income portfolio and $34m is in the interest method. Let’s assume that the receivables are worth 75% of what they’re on the books for, or $30m. There’s another $10m in write offs. Almost all of the rest of the assets is in hard cash. They have $252m in total assets on their books - $122m is in receivables, $104m is in cash (with no recourse cash, that means net cash per share currently sits at $7.12 per share). The other $26m or so is mainly deferred taxes and some receivables. You can make whatever adjustments you want, I’m going to assume the rest of the 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 $17m hit in total and goes from $172m to $155m. With 14.6m 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 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.