Monday, January 4, 2010

Protection From High Debt

Before delving into a full analysis, investors will often take a quick look at a company's balance sheet to get an idea of its financial position. Armed with information about the nature of the company's business, the investor can get a good idea of whether the company is "safe" from a solvency point of view. Since value investors value the protection of capital above all else, a company with a high debt level will often be immediately discarded from further analysis. Sometimes, however, a high debt load is not a threat to solvency at all!

Consider Asta Funding (ASFI), a firm that purchases consumer receivables from companies that offer credit to their customers (e.g. credit card companies, telephone companies). For the quarter ended September 30th, the company shows consumer receivables of $208 million against senior debt of $123 million, for a difference of $85 million.

Note that this is not the same thing as an asset of $85 million against no debt, because of the uncertainty of the value of the asset and the magnification of this uncertainty that results from leverage. To illustrate with an example, if the value of the asset is overestimated by 20%, the levered book value drops by almost 50% from $85 million to $43 million (208 * 0.8 - 123) whereas the value of the unlevered asset would only drop to $68 million ($85 million * 0.8).

In the case of Asta, the value of the assets is rather uncertain. The company purchases its receivables for pennies on the dollar, as the companies selling the accounts have already tried and failed to collect from these customers. Adding to the uncertainty is the fact that high unemployment levels have made it more difficult for Asta to collect on its receivables: the company has written down $184 million of its receivables in the last four quarters.

As such, an investor scanning only the balance sheet might take a look at these numbers and run. However, Asta is a lot safer than it looks. The reason for this comes down to the fact that most of its debt is secured by one particular asset, and only one particular asset. Should that asset (currently carried at $121 million) not perform, the loan of approximately $100 million does not have to be paid from the company's other assets! This is an interesting situation which increases the safety of Asta significantly.

The company trades at just 2/3 of its book value despite the fact that most of the debt is non-recourse. Aaron Stackhouse discusses the company's situation in further detail here, for those interested in further analyzing this company.

Looking at a company's balance sheet can give an investor a good idea of the company's debt level. However, only with a careful reading of the notes to the financial statements can an investor uncover items that significantly alter an investor's perception of how solvent a company may be.

Disclosure: None

10 comments:

heterocedastico said...

Interesting situation this one.

I was invested in ASFI during the downturn and accumulated losses of up to 80%. I sold in the worst of timmings to bet on safer net-net and at the time very very cheap companies, like TUES or SKX. Retrospectevely it was a bad move, comparing performances, but I also have to consider that I also divested from AIG at the same time (also a bad trade).

I come to realize that to bet on financials, and particularly small caps, you really have to know management. On ASFI, management have a poorly relation with investors and the stock is very much shorted.

But the analysis you present sure is compelling.

Best Regards
Heterocedastico

ValueInvestorToday said...
This comment has been removed by a blog administrator.
Saj Karsan said...

Hi VIT,

You're right, the wording in my article is not clear. Though the contract was originally non-recourse, it is now limited-recourse to $8 million. The point remains that the failure of the asset with the limited-recourse debt does not cause additional damage (beyond $8 million) to the rest of the assets.

ValueInvestorToday said...
This comment has been removed by a blog administrator.
Saj Karsan said...

Hi VIT,

When I read the portion you refer to, I draw a very different conclusion. Here are what I find to be the relevant items (copied from 10-K):

"The remaining $225 million was paid on March 5, 2007 by borrowing approximately $227 million...and consists of debt with full recourse only to Palisades XVI."

"As additional credit support for repayment by Palisades XVI of its obligations under the Receivables Financing Agreement and as an inducement for BMO to enter into the Fourth Amendment, the Company provided BMO a limited recourse, subordinated guaranty, secured by the assets of the Company, in an amount not to exceed $8 million plus reasonable costs of enforcement and collection. Under the terms of the guaranty, BMO cannot exercise any recourse against the Company until the earlier of (i) five years from the date of the Fourth Amendment and (ii) the termination of the Company’s existing senior lending facility or any successor senior facility."

From the above, my understanding is that after five years, BMO will only be able to collect $8 million outside the Palisade Portfolio.

Elsewhere in the 10-K is also the following:

"If we are unable to repay the loan due to BMO, or extend it (automatically for one year if the balance is $25 million or less, or through negotiation) the Company may be obligated to BMO on its $8.0 million limited guarantee" i.e. it's not open season on the company's assets, its limited recourse to $8 million.

What am I missing? Why is your reading of this different than mine?

ValueInvestorToday said...

SAJ,

Please remove ALL my posts concerning ASFI. I rather the information I have shared thus far be shared only between you and I. It shouldn't be public knowledge because it could severely impact the price per share. I entrust that you'll remove these posts because if you don't, any information from me in the future will be non existent. We should exchange email addresses, let me know how to get a hold of you and I'll share additional information concerning this holding.

Saj Karsan said...

Hi VIT,

Okay I have not published your latest comments, and have removed your previous ones, as per your request.

My e-mail is listed in the "contact us" page, that you can find by clicking the right frame, if you wish to discuss further.

bob said...

Saj;
I don't know what to make of the cryptic comments by Value Investor? Are you long this stock? If not, why not?

Saj Karsan said...

Hi Bob,

I am not; I wanted it a bit cheaper, so I missed out on a rise

jjv said...

It is currently trading as low as any other time in 2011. I'm not sure why there was a sell-off. I thought they had a pretty good 2nd quarter. They continue to show meaningful "Income from fully amortized portfolios" which is over and above any balance sheet value.

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