Asset Acceptance Capital Corporation AACC
August 02, 2011 - 6:38pm EST by
mjw248
2011 2012
Price: 4.64 EPS $0.56 $0.00
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 $M): 164 EBIT 0 0
TEV ($): 306 TEV/EBIT 0.0x 0.0x

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Description

(Full disclosure: This security trades by appointment only)

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)















2006 2007 2008 2009 2010









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)











Low
High







Shareholders Equity $125,596 $125,596

Potential ROE 17.5% 20.0%

Earnings Power 21,979 25,119







Per Share Earnings Power $0.72 $0.82







Capitalization Multiple 10.0x 12.0x

Implied Value per Share $7.17 $9.83

Upside Potential 54.5% 111.9%







 

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 Earnings

Although 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

Monthly Yield3
5.45%

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






Other Revenues
1,500

Gross Revenues
437,782






Base Adjusted EBITDA
200,291






Cost Savings7:



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

Less: Other
0

Pre-Tax Income
27,917






Provision for Income Taxes
(10,608)

Net Income
$17,308






Diluted EPS   $0.56

Diluted Shares
30,838











   


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 Flow

At 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)













As of




30-Jun-11







Inflows:




Cash & Equivalents

$7,302

Income Taxes Receivable

351

Other Assets

5,899







Purchased Receivables:




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













Outflows:




Accounts Payable

($3,718)

Accrued Liabilities

(17,439)

Income Taxes Payable

(1,114)

Capital Lease Obligations

(160)







Revolving Credit Facility:




Principal

(38,500)

Interest10

0

Total Revolving Credit Facility

(38,500)







Term Loan:




Principal 5-Jun-13
(132,610)

Interest 5.75%
(14,749)

Total Notes Payable

(147,359)







Total Outflows

($208,289)













Net Pre-Tax Cash Flow

$273,675













Taxes:




Estimated Net Tax Basis11

($18,971)

Taxable Income

292,646

Estimated Taxes 38.0%
$111,206













Net After-Tax Cash Flow

$162,469







Common Stock Outstanding

30,663

Options

0

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)









Shares % Own.






Quad-C 10,932 35.7%

Brad Bradley 3,740 12.2%

D3 Family Funds 4,931 16.1%

Heartland Advisors 4,421 14.4%

Total Major Shareholders 24,023 78.3%






 

2) Key Components are Controllable

The key components required for Asset Acceptance to close the financial performance gap with its peers seem largely-controllable.  This turn-around is about lowering the Company's cost to collect through cost reductions and efficiency improvements, not about developing a superior product or repositioning a brand, which I would view with a much higher degree of skepticism.

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?

This opportunity exists for two simple reasons.  First, Asset Acceptance has a small market capitalization and an even smaller float.  More than 80% of the Company's equity is held by insiders and two large institutional investors, so there is only about $20 million of actual float.  As a result, Asset Acceptance is clearly below the radar of most investors.  Second, Asset Acceptance's accounting is "bizarre," in the words of the CFO, and takes a fair amount of effort to fully understand.  It is far from plainly evident that the Company's current annualized EPS run rate is likely greater than $0.56 per share or that the Company's turn-around initiatives are clearly gaining traction.  Asset Acceptance's EPS in 2010 was ($0.05) on a reported basis and only $0.10 excluding impairment charges and other non-recurring items.  Unless one really digs into the Company's accounting and financial statements, one would have no way of appreciating the earnings recovery that is underway.
 
 
 
Risks
 
Regulation - Accounts receivable management companies, such as Asset Acceptance, are regulated under various federal and state laws and regulations.  These companies will also be regulated by the new Consumer Financial Protection Bureau ("CFPB").  It is likely that at some point the CFPB will issue new regulations for the industry.  Exactly what these regulations will be and what impact they will have are unknowable at this point. 

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

Catalyst

- Continued improvement in cost to collect
- Continued improvement in reported EPS
- Sale?
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    Description

    (Full disclosure: This security trades by appointment only)

    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)















    2006 2007 2008 2009 2010









    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)











    Low
    High







    Shareholders Equity $125,596 $125,596

    Potential ROE 17.5% 20.0%

    Earnings Power 21,979 25,119







    Per Share Earnings Power $0.72 $0.82







    Capitalization Multiple 10.0x 12.0x

    Implied Value per Share $7.17 $9.83

    Upside Potential 54.5% 111.9%







     

    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 Earnings

    Although 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

    Monthly Yield3
    5.45%

    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






    Other Revenues
    1,500

    Gross Revenues
    437,782






    Base Adjusted EBITDA
    200,291






    Cost Savings7:



    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

    Less: Other
    0

    Pre-Tax Income
    27,917






    Provision for Income Taxes
    (10,608)

    Net Income
    $17,308






    Diluted EPS   $0.56

    Diluted Shares
    30,838











       


    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 Flow

    At 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)













    As of




    30-Jun-11







    Inflows:




    Cash & Equivalents

    $7,302

    Income Taxes Receivable

    351

    Other Assets

    5,899







    Purchased Receivables:




    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













    Outflows:




    Accounts Payable

    ($3,718)

    Accrued Liabilities

    (17,439)

    Income Taxes Payable

    (1,114)

    Capital Lease Obligations

    (160)







    Revolving Credit Facility:




    Principal

    (38,500)

    Interest10

    0

    Total Revolving Credit Facility

    (38,500)







    Term Loan:




    Principal 5-Jun-13
    (132,610)

    Interest 5.75%
    (14,749)

    Total Notes Payable

    (147,359)







    Total Outflows

    ($208,289)













    Net Pre-Tax Cash Flow

    $273,675













    Taxes:




    Estimated Net Tax Basis11

    ($18,971)

    Taxable Income

    292,646

    Estimated Taxes 38.0%
    $111,206













    Net After-Tax Cash Flow

    $162,469







    Common Stock Outstanding

    30,663

    Options

    0

    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)









    Shares % Own.






    Quad-C 10,932 35.7%

    Brad Bradley 3,740 12.2%

    D3 Family Funds 4,931 16.1%

    Heartland Advisors 4,421 14.4%

    Total Major Shareholders 24,023 78.3%






     

    2) Key Components are Controllable

    The key components required for Asset Acceptance to close the financial performance gap with its peers seem largely-controllable.  This turn-around is about lowering the Company's cost to collect through cost reductions and efficiency improvements, not about developing a superior product or repositioning a brand, which I would view with a much higher degree of skepticism.

    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?

    This opportunity exists for two simple reasons.  First, Asset Acceptance has a small market capitalization and an even smaller float.  More than 80% of the Company's equity is held by insiders and two large institutional investors, so there is only about $20 million of actual float.  As a result, Asset Acceptance is clearly below the radar of most investors.  Second, Asset Acceptance's accounting is "bizarre," in the words of the CFO, and takes a fair amount of effort to fully understand.  It is far from plainly evident that the Company's current annualized EPS run rate is likely greater than $0.56 per share or that the Company's turn-around initiatives are clearly gaining traction.  Asset Acceptance's EPS in 2010 was ($0.05) on a reported basis and only $0.10 excluding impairment charges and other non-recurring items.  Unless one really digs into the Company's accounting and financial statements, one would have no way of appreciating the earnings recovery that is underway.
     
     
     
    Risks
     
    Regulation - Accounts receivable management companies, such as Asset Acceptance, are regulated under various federal and state laws and regulations.  These companies will also be regulated by the new Consumer Financial Protection Bureau ("CFPB").  It is likely that at some point the CFPB will issue new regulations for the industry.  Exactly what these regulations will be and what impact they will have are unknowable at this point. 

    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

    Catalyst

    - Continued improvement in cost to collect
    - Continued improvement in reported EPS
    - Sale?

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