|Shares Out. (in M):||31||P/E||8.3x||0.0x|
|Market Cap (in M):||142||P/FCF||0.0x||0.0x|
|Net Debt (in M):||164||EBIT||0||0|
At its current price, $4.64, Asset Acceptance Capital Corporation's publicly-traded equity (NASDAQ: AACC) offers the potential for significant appreciation with a low probability of permanent loss of capital.
Asset Acceptance Capital Corporation ("Asset Acceptance" or the "Company") was one of the pioneers of the accounts receivable management industry, and it remains one of the largest buyers of distressed consumer credit portfolios today. Yet the Company's current financial performance substantially lags that of peers. The accounts receivable management industry has become much more competitive over the past decade. As more capital flowed into the industry and the pricing of distressed consumer credit portfolios firmed, Asset Acceptance's competitors lowered their cost structures and substantially enhanced their analytical capabilities to improve productivity and efficiency. Asset Acceptance did not keep pace.
The opportunity for Asset Acceptance is to regain its competitiveness and achieve financial returns comparable to peers under its new management team. Comparable companies in the accounts receivable management industry earn returns on equity of around 20% (excluding impairment charges)
|(Figures in thousands)|
|Encore Capital Group:|
|Shareholders' Equity, Average||$157,655||$179,653||$195,431||$223,259||$272,894|
|GAAP Net Income||$21,474||$12,231||$13,846||$33,047||$49,052|
|Return on Equity||13.6%||6.8%||7.1%||14.8%||18.0%|
|Portfolio Recovery Associates:|
|Shareholders' Equity, Average||$221,300||$241,279||$259,572||$309,672||$412,998|
|GAAP Net Income||$44,490||$48,241||$45,362||$44,306||$73,871|
|Return on Equity||20.1%||20.0%||17.5%||14.3%||17.9%|
If Asset Acceptance were to achieve similar performance, the Company would earn $0.70 to $0.80 per share and the stock would likely be worth $7.00 to $10.00, substantially higher than its current stock price.
|(Figures in thousands)|
|Per Share Earnings Power||$0.72||-||$0.82|
|Implied Value per Share||$7.17||-||$9.83|
I am generally skeptical of any turn-around, but three aspects of Asset Acceptance's situation make me find it compelling.
1) Limited Downside Risk
The risk of permanent loss of capital to an investment in AACC at its current price appears remote for three reasons.
Low Multiple of Current Run-Rate EarningsAlthough masked by byzantine and decidedly backward-looking accounting, Asset Acceptance's current normalized GAAP EPS run rate appears to be at least $0.56 per share. AACC is effectively trading at only a 8.3x price-to-earnings multiple. In contrast, Asset Acceptance's most comparable publicly-traded peers, Encore Capital Group and Portfolio Recovery Associates, trade at low-to-mid teens price-to-earnings multiples on their respective consensus EPS estimates for 2011. I believe Asset Acceptance's low valuation relative to current earnings power is simply due to the fact that its earnings power has not yet been made plainly evident in report results, something I expect to change over the coming quarters.
|(Figures in thousands)|
|Purchased Receivables, Beginning2||$340,935|
|Purchased Receivables Amortization Rate4||42.6%|
|Base Adjusted EBITDA Margin5||45.8%|
|Effective Tax Rate||38.0%|
|Collections - Amortizing Pools||$388,282|
|Collections - Zero Basis Pools6||48,000|
|Total Cash Collections||436,282|
|Base Adjusted EBITDA||200,291|
|Exit of Healthcare Receivables Business||2,500|
|Closure of Chicago Collection Office||2,000|
|Closure of Cleveland Collection Office||3,000|
|Termination of 3rd Party Service Provider||2,500|
|Total Cost Savings||10,000|
|Pro Forma Adjusted EBITDA||210,291|
|Less: Depreciation & Amortization||(4,666)|
|Less: Share-Based Compensation||(1,195)|
|Less: Purchased Receivables Amortization||(165,310)|
|Pro Forma Operating Income||39,121|
|Less: Interest Expense||(11,204)|
|Less: Interest Income||0|
|Provision for Income Taxes||(10,608)|
|2) As of March 31, 2011|
|3) Monthly Revenue Recognized = Beginning Purchased Receivables Carrying Value x Assumed Monthly Yield; this figure is the actual monthly yield assumption used for 1Q11|
|4) Purchased Receivables Carrying Value / Estimated Remaining Collections = Average Future Amortization Rate; in any given quarter, the actual amortization rate will vary based on cash collections|
|5) Reflects pro forma adjusted EBITDA margin for 2010. Adjusted EBITDA excludes purchased receivables amortization, depreciation and stock-based compensation.|
|6) Reflects LTM zero basis pool collections|
|7) Annualized cost savings expected from cost reduction actions taken in 2010|
Two things are important to note about this estimate.
First, the earnings Asset Acceptance actually reports will be affected by cash collections. Perversely, if Asset Acceptance collects more cash than it expects, it would likely report lower earnings in the near-term. It would still recognize the same amount of revenue - by attributing more of the cash collected to amortization - but would incur higher collection costs, which are driven by the amount of cash collected, not the amount of revenue recognized. This earnings shortfall would more than reverse over time though. The opposite would be true if cash collections were to come in below expectations - near-term earnings could benefit, but long-term and cumulative earnings would suffer.
Second, this estimate does not reflect the benefits of various cost reduction and efficiency improvement initiatives that the Company is likely to realize in 2011. It simply takes the 2010 cost structure, reduces it for a limited number of specific cost reduction initiatives implemented in 2010, and applies it to implied normalized revenue and cash collections based on Asset Acceptance's June 30, 2011 balance sheet.
Discount to Run-Off Net Cash FlowAt its current price, Asset Acceptance's common stock appears to be trading at a slight discount to the net after-tax cash flow the Company would generate if it were to simply run-off its existing receivable portfolios. While such an unrealistically-pessimistic scenario likely would not deliver a terribly attractive return, it also would likely not result in a negative IRR.
|(Figures in thousands, except per share figures)|
|Cash & Equivalents||$7,302|
|Income Taxes Receivable||351|
|Est. Remaining Collections - Amortizing Pools||800,793|
|Est. Remaining Collections - Zero Basis Pools8||100,000|
|Est. Remaining Collections - Total||900,793|
|Less: Cash Collection Costs9||48.0%||(432,381)|
|Estimated Cash Collections, Net||468,412|
|Total Cash Inflows||$481,964|
|Income Taxes Payable||(1,114)|
|Capital Lease Obligations||(160)|
|Revolving Credit Facility:|
|Total Revolving Credit Facility||(38,500)|
|Total Notes Payable||(147,359)|
|Net Pre-Tax Cash Flow||$273,675|
|Estimated Net Tax Basis11||($18,971)|
|Net After-Tax Cash Flow||$162,469|
|Common Stock Outstanding||30,663|
|Effective Shares Outstanding||30,663|
|Net After-Tax Cash Flow per Share||$5.30|
8) Conservative estimate; this amount was $50 million in 2010
9) All cash operating costs, including administrative overhead
10) Assumes the Company would pay down its revolver immediately
11) Shareholders equity - deferrred tax liability /assume tax rate
Value to a Strategic Buyer
If Asset Acceptance's turnaround efforts were to stall, it would be more likely that the Company would look to sell itself than run-off its receivable portfolios and liquidate. Any strategic buyer would primarily value Asset Acceptance based on its existing receivable portfolio, but might also value the Company's particular expertise in liquidating certain types of portfolios, its historical data about the tens of billions of dollars in face value of receivable portfolios it has purchased and liquidated over the past several decades, and its in-house legal collection infrastructure, which some of Asset Acceptance's competitors are only now beginning to develop.
It is possible that certain strategic buyers - as a result of having lower costs to collect than Asset Acceptance and by eliminating duplicative overhead - could realize more net after-tax cash flow per share from running-off Asset Acceptance's receivable portfolios than Asset Acceptance could. For example, if I apply Encore Capital Group's consolidated cost to collect to my run-off analysis, I get over $6.00 of net after-tax cash flow per share without any overhead synergies and over $7.00 of net cash flow per share assuming full overhead synergies (i.e. no incremental overhead). Any strategic buyer would clearly require some positive return on such a transaction, so the theoretical purchase price would almost certainly reflect a discount to the expected net cash flows. Even reflecting such a discount though, it is possible that Asset Acceptance could be sold to a strategic buyer at a premium to the current stock price based on the value of its receivables alone, providing further downside support to this investment.Importantly, I'm confident that all of the Company's major holders, including Quad-C, Brad Bradley, D3 Family Funds and Heartland Advisors, who collectively own almost 80% of the Company's equity, would sell if that proved to be the most attractive option. Quad-C has been in this investment since 2002 and filed an S3 to register its shares for sale in 2008 when the stock was around $13. Nathaniel "Brad" Bradley, the co-founder, current Chairman, and former CEO, has been gradually reducing his stake in the company since the Quad-C transaction in 2002, and in 2009 relinquished his role as CEO. Finally, both D3 and Heartland have made comments on the Company's recent earnings conference calls that only thinly veiled their desire for the Company to sell itself if its turnaround efforts do not demonstrate meaningful traction in the near term.
|(Figures in thousands)|
|D3 Family Funds||4,931||16.1%|
|Total Major Shareholders||24,023||78.3%|
There are three primary components to lowering the Company's cost to collect.
Increased Use of Off-Shore Account Representatives
Asset Acceptance has a substantial opportunity to lower its cost structure by shifting its call center collections to low cost locations, specifically India. Encore Capital Group was the pioneer of off-shore call centers in the accounts receivable management industry, and its path and success provide a good framework for understanding the opportunity in front of Asset Acceptance.
Encore first opened a call center in India towards the end of 2005 to take advantage of the substantially lower labor costs in India relative to the U.S. The operation has since grown explosively. From 2007 to 2010, the number of account managers grew from 234 to 909, the volume of collections grew at a 93% CAGR, and the portion of Encore's overall collections processed through India increased from 10% to 44%.
The cost benefits of Encore's India operations are abundantly clear in Encore's financial results. Encore's cost to collect has declined from above 50% in 2007 to 40% in the first quarter of 2011, due in significant part to the lower cost of Encore's off-shore collections. While this decline in cost structure may not seem that dramatic at first glance, it effectively doubled the profitability of Encore's business, a game-changing impact.
Asset Acceptance is several years behind Encore in taking advantage of the opportunity presented by lower-cost, off-shore call centers. Asset Acceptance is arguably now roughly where Encore was in 2007. The Company has 250 account representatives in India through a third-party provider, and in the first quarter of 2011 processed about 5.5% of its total collections through India. Asset Acceptance expects the portion of its collections processed through India to continue to increase rapidly for the foreseeable future, and at some point, it may make sense for the Company to directly own and operate its call center in India. In any case, as Asset Acceptance processes a growing portion of its collections through India, it should realize material improvements in its cost to collect.
Enhanced Use of Analytics
A critical factor in keeping costs to collect low in the accounts receivable management industry is to allocate collection spending as efficiently as possible across acquired portfolios. Buyers of charged-off consumer credit portfolios are typically only able to collect from around 20% of the accounts in a given portfolio, so one of the most important aspects of allocating spending efficiently is to not spend on accounts that are unlikely to pay. With regard to the accounts that are likely to pay, determining the appropriate channel and methods for collection at the outset is another key to cost efficiency. A high degree of analytical sophistication can make a big difference in the efficiency of a given company's collection spending.
Historically, Asset Acceptance made these collection spending decisions based more on experience and intuition than on data and analytics. As the accounts receivable management industry became more competitive over the past decade, portfolio pricing increased and returns came under pressure, Asset Acceptance's relatively unsophisticated approach became increasingly inadequate to remain competitive and deliver attractive financial returns.
Under a new management led by CEO Rion Needs, Asset Acceptance has implemented a new collection platform, activity-based costing, predictive modeling, new business intelligence platforms and has expanded the number of analytical staff with advanced degrees and experience in statistics. Whereas the Company was a "three or four" out of ten in terms of analytical sophistication when Rion Needs joined the Company in 2007, it is now a "seven or eight." The benefits of this transformation are only now beginning to show up in the Company's financial results with more to come.
Increased Volume of Purchasing
While a large portion of the cost structure of an accounts receivable management company is variable, there are some fixed costs, such as corporate overhead, purchasing and analytical staff, infrastructure, and also in-house collection personnel in the intermediate-term, that can be leveraged with higher purchasing volume.
Asset Acceptance has been relatively capital constrained since it undertook an ill-timed recapitalization transaction in 2007. The Company's purchasing activity is still below its level in 2007, despite purchasing conditions being much more favorable today than they were back then. While the Company has sufficient financial capacity to execute its business plan for 2011, it plans to refinance this year its revolving credit facility, which is set to expire in June 2012. As part of this refinancing, Asset Acceptance expects to expand the capacity of its bank facility to provide it the financial flexibility to purchase at optimal levels. Increasing collection volume should enable Asset Acceptance to realize the scale efficiencies that have eluded it over the past few years.
3) Initiatives Are Clearly Demonstrating Traction
Asset Acceptance's progress in its turn-around is already evident in its financial results. Important metrics like total cash collections, total estimated cash collections, and costs to collect are all trending in the right direction, and the Company expects these metrics to continue to improve over the coming quarters.
Why does this opportunity exist?
Purchasing Conditions - Market conditions for purchasing distressed consumer credit portfolios have been attractive over the past few years due to the significant increase in the volume of charged-off receivables resulting from the recession and a concurrent decline in demand as capital market conditions deteriorated. Market conditions are likely to tighten going forward. According to data from the Federal Reserve, the total amount of consumer credit card debt outstanding has declined by about 20% since its peak in 2008 while delinquency and charge-off rates have been improving over the past several quarters.
Refinancing & Interest Rate Risk - Asset Acceptance's revolving credit facility matures in June 2012 and its term loan matures in June 2013. The Company will have to refinance these debts. It recently went to market to refinance its revolving credit facility, and was unsatisfied with the terms it received. If the Company's financial performance doesn't improve as expected, it may not be able to refinance its debts on acceptable terms.
Additionally, the Company's bank financing pays interest at a floating rate, which exposes it to interest rate risk.
Poor Track Record - The Company's track record of performance over the past decade is relatively poor, characterized by a consistent deterioration in its financial results and distinct underperformance relatively to peers. While substantial changes have been made to the management team, the Board of Directors is still largely the same group that oversaw the Company's extended period of poor performance.
Consumer Exposure - The extent to which Asset Acceptance can successfully liquidate its receivable portfolios is dependent on the financial health of the U.S. consumer. Any factors that would hurt the financial health of the U.S. consumer, such as rising gas prices and increasing unemployment, would almost certainly negatively impact the amount of cash the Company is able to collect on its portfolios.
Competitive Disadvantage - While Asset Acceptance's high cost to collect represents a substantial opportunity for the Company, it also represents a competitive disadvantage to some extent. Competitors with lower cost structures can afford bid more on portfolios than Asset Acceptance, all else being equal