Description

Asta Funding Inc.
Asta Funding (“ASFI”) is a leading consumer receivables asset management company specializing in the purchase, management, liquidation and servicing of charged-off consumer receivables and to a lesser extent semi-performing and performing receivables.

The charged-off receivable portfolios are acquired at a significant discount to face value (usually pennies on the dollar depending on the age and collectibility of the accounts) after doing both qualitative and quantitative due diligence and utilizing its extensive database and experience of historical portfolio collections. The price that Asta Funding is willing to pay is based on recovering roughly 2.5-3.0 times the price paid for the portfolio within five years, resulting in an IRR of 30%. The portfolios are purchased through a mix of brokered auctions and privately negotiated direct sales. After purchasing a portfolio, management actively monitors its performance and adjusts its collection and servicing strategies accordingly.

ASFI owns a small collection center that employs 33 people, but the majority of the servicing is outsourced to local collection agencies and attorneys. This outsourcing model enables ASFI to maintain a low fixed cost structure that affords it the option to remain on the sidelines when prices for portfolios do not meet the company’s return expectations. There is little need to accept reduced return portfolios just to help amortize or cover a high fixed cost infrastructure. Additionally, management makes it very clear that they run the business for the long-term growth of shareholder value, and will not make short-term purchases to grow their business at the expense of longer-term profitability.

As a result of the increased availability of receivables, some of the large competitors have raised equity financing in the public markets to fund their growth. Portfolio Recovery went public in November 2002, raising $42 million and Asset Acceptance went public in March 2003, raising $97 million. While Asta Funding has been public for some time (November 1995), it did a secondary offering in June 2003 to raise $43 million of capital and to increase the liquidity of its shares. Prior to the secondary offering, the Stern family owned more than half the shares.

Lack of Wall Street coverage, a less promotional management team and illiquidity of the stock have provided us with the opportunity to invest in a well-run franchise at an attractive valuation. The following points highlight why we believe ASFI is an excellent investment:

Attractive Valuation – While ASFI is currently trading at 2.2x book and 13.3x LTM earnings, it has an extraordinarily high return on equity. With marginal returns on invested capital in excess of 30% and a highly fragmented industry, we believe these returns are sustainable. On a relative basis, ASFI’s multiples compare quite favorably to those of PRAA at 3.3x book and 18.5x LTM earnings and of AACC at 3.9x book and 14.7x LTM earnings. ASFI’s average ROE from 2001-2003 was 34.0% compared with PRAA at 18.6% and AACC at 42.6%. It is also important to consider the fact that ASFI has a more conservative approach to accounting (discussed below), which serves to understate both earnings and book value as compared to its peers.

Conservative Accounting Relative to Peers – 85% of the portfolios are accounted for utilizing the effective interest method with the remaining 15% utilizing the cost recovery method. Under the effective interest method, a portion of the actual funds collected is accounted for as a reduction in the principal amount invested in the portfolio and the remainder is recognized as finance income and run through the income statement. An important metric to assess the conservative nature of the accounting when using the effective interest method is revenue recognized as a percentage of cash collections. ASFI’s ratio of revenue as a percentage of collections was 63.0% on an LTM basis vs. 72.8% at PRAA and 80.0% at AACC. In other words, for every dollar that ASFI collects, they recognize 63.0 cents of revenue while PRAA recognizes 72.8 cents and AACC recognizes 80.0 cents, and since there are no incremental costs, that difference flows directly to the bottom line.

To put this in perspective, if ASFI amortized its collections using PRAA’s and AACC’s amortization rate for the last twelve months, it would have shown an 81.3% and 120.9% increase in earnings respectively, which then translates into a PE of 7.3x and 6.2x respectively and a price to book of 1.9x and 1.8x respectively.

Additionally, ASFI has taken two small impairment charges over its entire history. PRAA and AACC have never taken any impairment charges. While this could be due to better underwriting, we believe the longer amortization schedules of PRAA and AACC have allowed them to avoid adjusting their receivable balance to accurately reflect their liquidations. It is hard to believe that the economic downturn of the last three years were accurately predicted to allow them to avoid any impairments.

Attractive Return Parameters – ASFI has generated returns on equity of 52.8%, 46.9%, 36.9% in 2000, 2001 and 2002 respectively. While they only generated a return on equity of 18.1% in 2003, that was due primarily to the fact that they had a significant capital raise and were not able to immediately deploy all of the capital during the year.

Strong Industry Position – ASFI is one the leading five companies in its industry. One sell side research firm has stated that ASFI was the largest debt buyer during the twelve months ended March 31, 2003. The industry is large and highly fragmented with more than 6,000 industry participants. ASFI is a well-respected participant with many years of experience, a solid network of third party collection agencies, and strong relationships with sources for debt purchases.

Knowledgeable and Stable Management Team — ASFI’s principals, Chairman Arthur Stern and CEO Gary Stern, are a father-and-son team with approximately 70 years of combined experience in the credit and receivables collection business.

Attractive and Growing Industry – According to the United States Federal Reserve, American consumers had aggregate indebtedness of more than $2 trillion as of January 2004, and the size of the revolving credit market in the United States was in excess of $750 billion as of January 2004. According to the Nilson Report, net charge offs of credit card debt have increased from $8 billion in 1990 to $51 billion in 2002 and the market for purchased debt has increased from $6 billion in 1993 to $72 billion in 2002. Further, there has been a trend towards outsourcing and selling nonperforming consumer debt as opposed to servicing it internally, making more portfolios available.

While these points appear compelling, we do have some concerns the investment will not perform. They are as follows:

Volatile Industry History – Two large debt buyers, Credit Trust and CFS, went bankrupt in the late 1990s after using gain on sale accounting to bolster earnings. This provided them with higher availability of debt financing, which they used to help overpay for portfolios. The current management within the industry claim that they have learned from the mistakes of the past and are therefore much more conservative buyers and will forgo growth in exchange for generous returns on capital. However, as the competition is trading at 3-4x book value, there is a need to sustain growth to support the valuations.

Lack of Transparency and Significant Discretionary Accounting Standards – As the accounting is based primarily on estimates of collection curves, it is difficult to be completely comfortable with the earnings and the value that will be generated by the assets on the balance sheet. Specific to ASFI however, is that their disclosure is less transparent than their peers. For example, PRAA discloses by year of purchase, the collections to date as well as expected future collections. For the portfolio overall, PRAA also discloses geographic data, the asset type, and the delinquency cycle. ASFI management states that they do not wish to disclose portfolio data for competitive reasons. This is only offset by the aggregate metrics which show ASFI does appear to be conservative in their revenue recognition.

Catalyst

· ASFI continues to generate +30% returns on equity and the value visibly accrues to the shareholders through the appreciation of the book value per share.
· Wall Street realizes the disparity in valuations between ASFI and its peers and the spread narrows. While we have shorted some of the peers, we believe that the strong industry dynamics will provide a constructive environment for the whole group.