Compucredit (CCRT) is a wonderful business that is trading at well under 1/3 of it’s 2009 intrinsic value. Holding the stock for 2-3 years is likely to yield a 30-70% annualized return with minimal downside.

 

Compucredit is a subprime lender that provides credit and related financial services and products to the underserved consumer credit market. While subprime is a four lettered word nowadays, there is real value here and minimal risk. This baby got thrown out with the bath water.

 

The company is expected to see substantial increases in earnings in the 2^nd half of 2007 which is expected to continue into 2008 and beyond. Average consensus estimates for 2008 earnings are $4.47. I believe this is understated. Also, earnings are expected to continue to grow at atleast a double digit rate in 2009 and beyond. A well-managed $5-6 earner ought not to trade at twenty something. And those earnings are being delivered with an under-leveraged balance sheet. The current subprime dislocations are likely presenting excellent opportunities to CCRT’s savvy management – helping pave the way for very robust earnings growth in the years ahead.

 

Let’s dig into CCRT’s various business units:

 

 

Compucredit is the largest marketer and servicer of credit cards solely dedicated to the subprime space in the US. The credit card business can be broadly divided into two parts – Origination and Portfolio Purchases. Compucredit markets credit cards to credit-impaired customers. They have two main types of credit card offerings:

 

·         Fee-based Credit Cards

·         Standard Credit Cards

 

Here are the typical nuances of the fee-based cards:

 

FICO Score:                     <600 (credit impaired)

Annual Fee:                      $150

Activation Fee:                 $29

Monthly Maint. Fee:          $6.50

Average Credit Limit:        $300

Average APR:                   20%

Net Charge Offs:               20%

And here are the typical nuances of the standard cards:

 

FICO Score:                     600 – 700 (sloppy players)

Annual Fee:                      $0-85

Activation Fee:                 $0

Monthly Maint. Fee:          $0

Average Credit Limit:        $2000

Average APR:                   19-29%

Net Charge Offs:               8%

 

As you can see, CCRT makes money on both products. Their core competency is that they have a very good handle on the defaults, chargeoffs etc. and have products that deliver real-value to these households while making business sense to the company. The universe of folks CCRT focuses on is 75 Million people in the US and about 20 Million people in the UK. That’s 25% of the US population that very much has pressing credit needs. The products offered lend themselves to recurring revenues and customer loyalty. By appropriately pricing the risk, CCRT is able to profitably manage itself through the credit card business.

 

 

Savvy insurers like Berkshire let their premium volumes ebb and flow based on the pricing offered. Since 1998, CCRT has purchased more than $6 Billion in credit card receivables portfolios through approximately ten transactions. CCRT has not had even one of these deals turn out to be unfavorable to the company. They know this space cold and are typically buying portfolios from companies whose core business is not subprime credit card lending. This business (of buying portfolios) is not at all smooth. It comes and goes based on market pricing. CCRT management are extremely savvy allocators of capital. They are only interested in growing their credit card business if it makes economic sense. In 2006 they did no deals as pricing was unfavorable. In 2006, they focused on growing organically.

 

Let’s look at their most recent deal to buy a $970 Million portfolio of credit card receivables from Barclays in the UK in April ’07. They purchased this portfolio for $770 Million – at about a 21% discount to its book value. This portfolio comprises about 500,000 subprime UK customers with interest rates in the 30-32% range – similar to CCRT’s existing business. In addition, the company was able to establish European operations (for free) and is sharing best practices across their US and UK businesses. They expect to use this platform to grow organically in the UK with originations etc.

 

CCRT immediately securitized this portfolio with Bank of America. Advance rate was likely 80-90% (tying up $75-150 Million of CCRT capital). CCRT has plenty of liquidity to do more such deals or invest in originations marketing, its other businesses or share buybacks. Prior to the Barclays deal they had about $700 Million of excess capital/liquidity.

 

Since the acquisition, on the Q2 call, the company mentioned that, while it was still early, it appears that the portfolio they acquired is performing meaningfully better than their expectations when they bought.

 

 

This business buys previously charged-off receivables and Chapter 13 bankruptcy collections. They have an innovative balance transfer program which enables someone with severely impaired credit to get a usable credit card without having to put up a security deposit. Jefferson represents about 5-10% of the CCRT earning’s pie today. The company is innovative and had demonstrated a repeated ability to enter and scale new lines of businesses. In the future Jefferson is likely to keep growing.

 

 

They entered this business through acquisition in 2004. They operate about 500 stores in 17 states. The average loan is $300 for 2 weeks with a $15 fee for every $100 borrowed (ouch!). While this appears high, it is lower than overdrafts or other late fee charges etc. They have 4 stores in the UK and plan to scale this business in the UK and certain US states with enabling legislation. This segment also makes up less than 5% of the pie.

 

 

This is a relatively new business which they acquired from Wells Fargo in 2005. They offer these loans through car dealers (buy here; pay here) and have recently acquired ACC (another auto lender). Management had expressed disappointment about the lack of growth in this business and hope to change that in the coming years (less than 3% of the earnings pie).

 

If you look at Compucredit over the years, one notices that they enter new businesses periodically in a small way, learn the business and then scale up. The common theme in all their businesses is the focus on the subprime borrower.

 

 

The company does not originate subprime mortgages. They were introduced to a John Devaney in 2002 who runs a hedge fund (United Capital Markets) that had significant exposure to Collateralized Debt Obligations (CDOs) and CMOs. Devaney’s fund owned about 10% of CCRT’s stock (5.4 Million shares) and CCRT had invested in his fund. Devaney took heavy losses in Q2 and due to margin calls needed to quickly unload positions. The company bought back some of this stock at about $28/share at the time. In addition CCRT reported a $25 Million loss related to UCM and carried the rest of the investment at $45 Million.

 

This loss caused some of the recent drop in CCRT’s stock price. News came out at the same time the rest of the subprime turmoil was underway. To put this in context, the company had less than 5% of its book value invested in UCM and the loss is roughly what the company generates in earnings in 4-6 weeks.

 

My take on this saga: These guys do deals and try to allocate capital intelligently. They’ve acquired 10 credit card portfolios, various charged off portfolios, auto lending businesses, pay day businesses etc. All of the deals are in the very toxic end of subprime lending. All except this one has worked. The ratio of great deals to lossy deals is highly favorable to CCRT stockholders.

 

 

A natural question with CCRT is how does the subprime mortgage mess effect CCRT and its default rates. Here is David Hanna’s (CEO) commentary from the 2006 CCRT annual report (published in April ’07):

 

David Hanna quotes Buffett in his shareholder letters. His annual salary is $50,000 – unchanged for a few years. He takes no bonus and has not awarded himself any stock options as far back as I checked. His only other comp from the company is about $1 Million a year of charter jets by the Hanna family paid by the company.

 

The Hanna Family owns 28.35 Million shares of stock. All officers and directors as a group own 31.5 Million shares. There were 49.2 Million shares outstanding as of June 30, 2007. It is highly likely the shares outstanding has gone down since then as the company buys back stock at its current ultra-cheap price.

 

Here’s the stock ownership summary:

 

Hanna and Insiders:                             31.5 Million Shares

Second Curve (Tom Brown):        4.7 Million shares

Corsair Capital:                          1.5 Million shares

Pabrai Investment Funds:            1.6 Million Shares

 

Total:                                        $39.3 Million shares

 

Some 80% of the float is “tied up.” The company has been an aggressive purchaser of its stock. In this environment, they have lots of opportunities outside of a buyback, but a buyback is extremely attractive right now. Buying back the remaining 10 Million shares would cost under $250 Million – they can easily do this.

 

The company’s board authorized a 10 Million share repurchase in May 2006. In Q107, the company bought 2.9 Million shares from Delaney in a private transaction. They have authorization to buy another 7.1 Million shares that does not expire till mid-2008.

 

Here is a sentence from their Q2 10-Q:

 

Compucredit’s GAAP earnings are mostly irrelevant to getting to real earnings and cash flows. As an example, when they bought the Barclays portfolio for $770 Million for $970 Million, GAAP requires them to book a gain. Then when the losses from delinquent cardholders come through, it gets recorded as a loss – even though the company fully expects those losses and subtracted them from the purchase price in the first place. Compound the Barclays transaction with all the other portfolios they’ve bought, acquisitions etc. and GAAP become meaningless.

 

The company uses Managed Earnings as a metric. They guided that Q307 earnings would be between $1.35 to $1.50 per share and Q4 would be $1.65 to $1.80. They further added the run-rate for 2008 would be “between Q3 and Q4 numbers.”

 

At the low-end Q3 is $1.35 and Q4 is $1.65. Mid-point is $1.50/quarter. At the high-end, average is $1.65. So 2008 earnings are likely between $6 and $6.60 per share. Beyond that earnings should rise at a decent clip as they put their $700 Million of liquidity to work. The annual cash flow generation is north of $300 Million from 2008 onwards – letting them invest aggressively in the right opportunities.

 

If they bought back 5 Million add’l shares, then the $6 - $6.60 per share earnings jump to $6.67 - $7.34/share. It gets even more ridiculous if they buy back more shares.

 

2009 earnings are likely well over $7/share. What should a $6-7 earner trade for? A 10x multiple gets you to triple the current stock price and a 15x multiple gets CCRT to over $100/share.

 

 

2007 has not been a good year thus far for Tom Brown’s Second Curve Capital. With 100% of assets in the financial sector and lots of exposure to subprime, Second Curve is deeply in the red in terms of performance YTD. But they have more than delivered great returns to their investors since inception. Tom Brown is a Tiger cub. He used to be with Julian Robertson and he and his team are extremely good at evaluating bank and financial services businesses and finding value. Brown’s picks can be quite volatile, but they’ve mostly done very well over time. Compucredit was presented by Tom at the Nov. ’06 Value Investing Congress in NYC. Here is that link:

 

 

And here’s an article by Tom on Compucredit

 

 

With some $150 Million invested in Compucredit, it is one of Tom’s largest positions. I estimate he bought at prices over 50% higher than present. Tom has about $700 Million under management - typically invested in under 15 stocks.

 

 

The risks with CCRT are well disclosed in their 10-K. They’ve had run-ins with regulators and been fined in the past (insignificant amounts). Pay-day lending will always have its detractors. The company believes that they have to charge fees and interest rate commensurate with the underlying risks. They have taken some actions to appease regulators. But any significant legal changes would affect CCRT. This sector of credit comprises 25% of the population. It is underserved and very few institutions are able to address the market opportunity profitably and scale. To the extent regulators and lawmakers are cognizant of the realities, risk of major law changes is unlikely.