Special Situation Investing

Monday, February 12, 2007

Asset Acceptance Capital Corp (AACC)

A reader of this blog wrote in with a fairly detailed description of a company he is tracking. While it isn't really a special situation there is no point in letting his analysis go to waste.

I'm not sure if it qualifies as a special situation though, Asset Acceptance Capital Corp (AACC). It buys unpaid consumer debt, mostly credit cards, and collects on them using call centers and legal filings. It has a number of publicly traded competitors (PRAA, ASFI, FCFC, ECPG). People generally seem to think that PRAA is the class of the industry, but it trades at a higher valuation. AACC has a 52 week range of 14-21.4 and is currently trading at 15.73.

The sector in general has been battered because the price paid for debt has been going up as more players have gotten involved in the industry. AACC in the latest quarter said their cost to acquire debt has gone to 3.54 from 2.49 cents on the dollar in the previous year. AACC earned 10.7 million or .29 cents a share as opposed to 13.7 million (37 cents a share) the year before. Cash collections increased 3.5% from the previous quarter, but revenues decreased due to lower expected returns on their portfolio and a 6.3 million dollar impairment charge.

AACC like most of the industry uses the IRR method of accounting where they assign an estimated internal rate of return to each purchased collections portfolio and any amount collected above the IRR is applied towards the principal of the portfolios. If revised cash flow estimates don't meet the IRR an impairment is taken, but the IRR remains unchanged. This adds lumpiness to earnings as portfolios are marked down instead of just earning a lower rate of return over time (for accounting purposes).

Asset Acceptance have 320 million in tangible assets and 76 million in tangible liabilities (58 million of which is a deferred tax liability) with no debt. This gives them a tangible book of 244 million or 2.4 times their market cap of 588 million. They have earned roughly 0.30 the last three quarters and would have earned $0.40 cents in the 4th quarter of 2005 if it wasn't for a very large write down they took on a newly acquired portfolio of wireless bills (an asset class they had just ventured into). Their earnings have been declining in 2006, and their returns on capital have been declining for a long time due to increased competition.

I think the real question about this industry is should they be trading at a premium to their tangible book value and if so how much? The answer to the first question is clearly yes, because it takes knowledge, organization and experience to collect a portfolio of receivables. AACC has a table in their 10-K that shows account executives who have a year or more experience are 50% more effective than their less experienced co-workers. The second question is much trickier. The lack of debt on AACC's books give it some leeway when in comes to maintaining earnings in the face of declining returns on assets. They could borrow money, buy back stock and maintain their current level of earnings if industry ROA's where to decline somewhat. Also, at some point the industry becomes unattractive for new competitors to enter it.

At this point my thinking on the situation becomes more nebulous. On the one I don't think there are particularly steep barriers to entry to get into the industry. On the other hand I don't think it's an industry that the best and brightest of America's business schools are clamoring to get into. I don't think there is a lot of glory of it. I think this probably keeps the level of competition down and smart talented people in the industry can do reasonably well. This brings me to the question of why AACC as opposed to the other companies in the industry. The answer to this is that I found their financials to be well organized and straight forward with lots of useful information that an owner (stockholder) of the business might want to know. Their competitors financials I found less well organized and presented (I didn't look closely at PRAA because of its status of industry darling). One of their competitors had much higher ROE's but buried in its financials was the disclosure that it sold most of the receivables for big gains without actually collecting them (this strategy won't work if receivable prices don't keep increasing).

MY REVISED THINKING:

Most of AACC reported earnings come from receivable portfolios that were acquired at much lower prices 1-2 years ago. In their latest quarter they reported that they invested 27 million in new receivables the same as last year. However they only expect to have 53 million in revenue from this portfolio as opposed to 70 million from the one purchased in 2005. A significant decline in revenue with collection expenses staying constant/rising is going to cause a dramatic drop in earnings. Yes they can use leverage to make up for some of this, but I don't think their going to be able to borrow at rates that are all that great. I think I will look at this company again 1-2 years from now. It might be interesting then. At some point they will be reporting really ugly earnings, but probably have a lot of earnings power going forward due to a drop in the purchase price of unpaid debt. Then will be the time to strike. I'm glad I composed this e-mail so I can get out. Hmm..it might be a short opportunity.

...

You should probably note though that on Monday I am selling my long position in AACC and possibly getting short.

Bayard

I will keep watching this one. I have to agree that it's lack of coverage may be keeping it's pricing down. That in addition to it's un-glamorous industry are characteristics that tend to make for good investments.

Thanks for the post Bayard!

7 Comments:

  • Good summary analysis of this difficult company. I think the final paragraph or two are spot on. AACC looks inticing at first but should be avoided currently. They have made some stinker buys in the last few years that have left them struggling to make any real cash(as opposed to "earnings") profit. Good luck.

    By Anonymous Anonymous, at 6:00 AM  

  • Trying to assess how rising subprime mortgage delinquincies are likely to interplay with the consumer receivables market that AACC plays in.

    On the one hand it seems inevitable that it would bring higher volumes of bundled debt opportunities through greater overall credit pressure - i.e. ARMs resets and higher interest mortgages will cause both mortgage AND credit card, wireless and auto loan delinquency.

    Even more importantly, perhaps, the greater volumes of bad debt might also help tame their rising costs sooner than in 1-2 years as you suggested.

    On the other hand, the profitability of these new volumes of bad debt may be much worse - i.e. home equity lines of credit can no longer come to the rescue and consumers will see keeping a roof over their heads as a higher priority than unpaid credit cards.

    That said, if bad debt is fast growing a reality, isn't your analysis that these companies that know best how to tackle it are in the strongest position to win against new entrants increasingly important?

    Also, why don't any of these players try to move upstream to tackle mortgage delinquency collections within the foreclosure industry? Have I overlooked any major players in that area? Sounded like it was mentioned as distantly aspirational on PRAA's call this week.

    I am most curious about and would be thankful for any thoughts. I have small investments in AACC, ECPG and ASFI.

    By Anonymous Anonymous, at 7:50 AM  

  • Well that wasn't really my post but a few thoughts on the prospects of these companies.

    IF there is a downturn in credit quality, and there could be a major downturn, it is my belief that these firms will get hammered. The fact is, there collections on debt will decrease. The market tends to take short-term results and extrapolate outwards. So you may end up with a much lower stock price even though, in the long-run, it is the best of times. So yes, ultimately it could be a good opportunity for those still holding cash to pick up business but in the short-term that would be a better time for outside investors than now.

    The problem with entering new markets is collecting and analyzing the data. That is one characteristic that separates companies, the quality of their analysis of debt value. It's got to be hard to just walk into a market and out-calculate your competitors.

    By Blogger spinoff, at 6:57 PM  

  • I am a newcomer to looking at the sector so I could be off here, but I think the ability to collect of the debt collectors is the interaction of a number of factors the most important of which is the volatility of the finances of individual households. The debt collectors collect most of the money from the receivables they buy in the 2nd and 3rd years after they buy them. Households get into difficulty, default on some debts, and then recover and settle some of the defaulted debt. The availability of easy credit and the state of the economy both have an impact on how many households recover and how much they pay. I don't know how significant that impact is.

    It is the case however that the negative impact of lower recoveries from any distress will impact their income statement long before the positive effects of being able to acquire more receivables at cheaper levels. Whether the stock goes down or up depends on how forward looking the investor base is. My guess would be that if marginal recoveries were to go down because of factors in the greater economy the stocks would go down, at least in the short term.

    By Anonymous Bayard, at 7:51 AM  

  • Good summary. But take into account the reputation of the company. It's not a good one. I took a look at the US District court filings. Seems they are spending alot of revenue defending questionable tactics. FTC complaints are also numerous. If they play by the rules maybe returns will improve.

    By Anonymous Anonymous, at 8:40 PM  

  • AACC's earnings went down as I predicted, but more importantly (and less fortunately for my small short position) their stock price went up as they decided to leverage up their balance sheet by issuing debt to buy back stock and pay a special dividend. I think this was a good decision on their part, and the Street, obviously, agrees.

    By Anonymous Bayard, at 11:50 PM  

  • i get calls from this AACC from different numbers, the latest 2 being 757-209-2072 and 571-261-0113, every couple of days looking for some bogus person. every time i tell them wrong number and quit calling. every time i get an attitude and hung up on. i wish i knew what to do

    By Anonymous Anonymous, at 3:34 PM  

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