Recommendation

Asta Funding has a substantial portfolio tail risk and regulatory headwind which is not fully priced by the investing community. It creates an unfavorable investment position in the common stock of the company (“ASFI” or the Company). As of August 12, 2011, the stock is trading at $8.3. The stock has an intrinsic value of $6.7, representing a downside of 20%.

Business Description

Asta Funding, Inc., together with its subsidiaries, engages in purchasing, managing, and servicing distressed consumer receivables in the United States. Its principal portfolio includes charged-off receivables consisting of accounts that have been written-off by the originators and might have been previously serviced by collection agencies; semi-performing receivables, including accounts where the debtor is currently making partial or irregular monthly payments, but the accounts might have been written-off by the originators; performing receivables comprising accounts where the debtor is making regular monthly payments that might or might not have been delinquent in the past; and distressed consumer receivables consisting of the unpaid debts of individuals to banks, finance companies, and other credit and service providers. The company’s distressed consumer receivables consist of MasterCard, Visa, and other credit card accounts, which were charged-off by the issuers or providers for non-payment. Asta Funding, Inc. was founded in 1994 and is based in Englewood Cliffs, New Jersey.

Key Recent Events:

On August 4, 2011 - Asta Funding, Inc. Announces Financial Results for Third Quarter and Nine Months of Fiscal 2011
The Company reported net income of $3,344,000 for the three month period ended June 30, 2011, or $0.23 per diluted share as compared to net income of $3,121,000 for the three months ended June 30, 2010, or $0.21 per diluted share. Total revenues for the three month period ended June 30, 2011 were $11,297,000 as compared to $12,097,000 for the three month period ended June 30, 2010.
• Net Income of $3.3 Million, or $0.23 Per Diluted Share for Third Quarter
• Strong Balance Sheet, Strong Liquidity Position Continues
• $103.8 Million Cash & Cash Equivalents as of June 30, 2011
• Approximately $107 Million Cash & Cash Equivalents as of August 3, 2011

On June 22, 2011 - Asta Funding, Inc. Announces Share Repurchase Program
Asta Funding, Inc. (Nasdaq:ASFI) (the "Company"), a consumer receivable asset management and liquidation company, today announced that its Board of Directors has authorized a share repurchase program for up to $20,000,000 of the Company's common stock.

Gary Stern, CEO of the Company, commented, "Our open market repurchases by the Company over the course of the next year reflects the Board of Director's continued confidence in our business strategy and growth prospects as we continue to seek portfolio investments and acquisitions in the financial services industry. Based on current market prices, we believe the repurchase program is prudent and in the best interests of our shareholders," further stated Mr. Stern.

As of June 16, 2011, Asta had approximately 14.6 million shares outstanding, and approximately $102 million in cash and cash equivalents.

On May 10, 2011 - Asta Funding, Inc. Announces Financial Results for Second Quarter and First Six Months of Fiscal 2011
The Company reported net income of $2,855,000 for the three month period ended March 31, 2011, or $0.19 per diluted share as compared to net income of $2,875,000 for the three months ended March 31, 2010, or $0.20 per diluted share. Total revenues for the three month period ended March 31, 2011 were $11,234,000 as compared to $11,200,000 for the three month period ended March 31, 2010.

• Net Income of $2.9 Million, or $0.19 Per Diluted Share for Second Quarter
• Strong Balance Sheet, Strong Liquidity Position Continues
• $91.8 Million Cash & Cash Equivalents as of March 31, 2011
• Approximately $97 Million Cash & Cash Equivalents as of May 10, 2011

On February 9, 2011 - Asta Funding, Inc. Announces Financial Results for First Quarter Fiscal 2011
For the three months ended December 31, 2010, the Company reported net income of $2,666,000, or $0.18 per diluted share, an increase over net income of $2,475,000, or $0.17 per diluted share for the comparable period of fiscal year 2010. Total revenue was $10,838,000 for the quarter ended December 31, 2010, as compared to $11,053,000 for the three-month period ended December 31, 2009. Finance income from fully amortized portfolios (zero basis revenue) was $8,793,000 for the three-month period ended December 31, 2010, an increase of $685,000 from the first quarter of fiscal year 2010 of $8,108,000.

• Net Income of $2.7 Million, or $0.18 Per Diluted Share
• Strong Balance Sheet, No Impairments, Strong Liquidity Position Continues
• $84 Million Cash & Cash Equivalents

On January 14, 2011 - Asta Funding, Inc. Reports Additional Information Regarding Director Attendance at Board Meetings During the Fiscal Year Ended September 30, 2010
Asta Funding, Inc. (Nasdaq:ASFI) (the "Company"), a consumer receivable asset management and liquidation company, today reported that during the fiscal year ended September 30, 2010, six of the seven members of its Board of Directors attended at least 75% of the meetings of the Board of Directors that such directors were eligible to attend and 75% of the meetings of committees of the Board of Directors of which such director was a member. Arthur Stern, Chairman Emeritus of the Board, attended 8 of the 12 meetings of the Board of Directors convened during the fiscal year ended September 30, 2010. Mr. Stern was unable to attend certain of the meetings due to personal and family medical issues.

Why is the stock expensive?

Since 2008, ASFI has been trimming down the portfolio and aggressively collecting the cash without buying back new loans, the free cash flow per share and the free cash flow yield have been tremendous. In 2010, ASFI pocketed $8.23 FCF/share and 107.1% FCF yield while competitors like PRAA ($0.1 FCF/share and 0.1% FCF yield), AACC ($0.53 FCF/share and 8.9% FCF yield) and ECPG (-$2.28 FCF/share and -9.7% FCF yield) all recorded less than favorable results.

The relatively decent performance of ASFI had supported the stock price in the past 3 years. In addition, there is only one analyst following ASFI (Keefe, Bruyette & Woods), the under-covered arena creates a favorable environment for unrecognized potential, as well as unrecognized problems. So, the true earnings power of the company is widely mis-understood by the investing community, leading to a mis-priced opportunity.

Why is the high valuation not sustainable?

1. Shrinking receivables and declining market share in a growing pie

The distressed consumer receivables market has been increasing in the past 5 years. The total purchased portfolio under the four biggest operators (AACC, PRAA, ECPG and ASFI) increased from $1.1bn in 2006 to $2bn in 2011. However, the portfolio size of ASFI has been shrinking from the peak of $550mm in 2007 to $125mm in 2011. It is the only company with declining receivables.

The market share has declined substantially from 24% in 2006 to only 8% in 2010. Unlike the competitors which aggressively bought delinquent portfolio at cheap price during financial crisis, ASFI was relatively quiet after the credit crunch. The low market share painted a dull picture of ASFI to buy high quality non-conforming portfolio in a highly competitive market and raised question for ASFI to sustain the business with a lack of scale advantage.

In addition, the players have been taking more risk to take on portfolios with longer time since delinquency. According to Federal Reserve, the consumer lending 30+ delinquency has been dropping since the financial crisis, especially the credit card portfolios which are most sought after by the industry players. The delinquency rate dropped from 6.61% in Q1 2009 to 3.89% in Q1 2011. The question becomes if there are fewer and fewer delinquent loans in the market, how can the players sustain to purchase more “quality” non-performing portfolios? As indicated by the industry participants, the answer is they keep buying riskier portfolios which they don’t buy before (like older delinquent loans, portfolios collected by many collection agencies before and etc) to maintain the loan reinvestment level.

2. Abnormally high proportion of questionable account

The industry utilizes two methods for revenue recognition: Interest Method and Cost Recovery Method.

Interest Method
Typically the players in this industry utilize the interest method of revenue recognition for determining a portion of our finance income recognized, which is based on projected cash flows that may prove to be less than anticipated and could lead to reductions in revenue or additional impairment charges under Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 310, Receivables — Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310”). Static pools of accounts are established. These pools are aggregated based on certain common risk criteria. Each static pool is recorded at cost and is accounted for as a single unit for the recognition of income, principal payments, and loss provision. Once a static pool is established for a quarter, individual receivable accounts are not added to the pool (unless replaced by the seller) or removed from the pool (unless sold or returned to the seller). ASC 310 requires that the excess of the contractual cash flows over expected cash flows not be recognized as an adjustment of revenue or expense or on the balance sheet. ASC 310 initially freezes the internal rate of return (“IRR”), estimated when the accounts receivable are purchased, as the basis for subsequent impairment testing. Significant increases in actual, or expected future cash flows may be recognized prospectively through an upward adjustment of the IRR over a portfolio’s remaining life. Any increase to the IRR then becomes the new benchmark for impairment testing. Rather than lowering the estimated IRR, if the collection estimates are not received or projected to be received, the carrying value of a pool would be written down to maintain the then current IRR.

Cost Recovery Method
This is where ASFI different from the competitors. ASFI painted a slightly positive picture from the competitors when describing the use of cost recovery method:

“As we believe our extensive liquidating experience in certain asset classes such as distressed credit card receivables, consumer loan receivables and mixed consumer receivables has matured, we use the interest method when we believe we can reasonably estimate the timing of the cash flows. In those situations where we diversify our acquisitions into other asset classes in which we do not possess the same expertise or history, or we cannot reasonably estimate the timing of the cash flows, we utilize the cost recovery method of accounting for those portfolios of receivables.”

Source: Asta Funding 2010 10-K P.28

Actually cost recovery method should be used in compliance with the authoritative guidance instead of being cherry picked by the company, accordingly to the competitor’s filings:

“If the amount and timing of future cash collections on a pool of receivables are not reasonably estimable, we account for such portfolios on the cost recovery method as cost recovery portfolios. The accounts in these portfolios have different risk characteristics than those included in other portfolios acquired during the same quarter, or the necessary information was not available to estimate future cash flows and, accordingly, they were not aggregated with other portfolios. Under the cost recovery method of accounting, no income is recognized until the purchase price of a cost recovery portfolio has been fully recovered.”

Source: Encore Capital Group 2010 10-K P.48

So if the future cash flow of the pool of receivables is not reasonably estimable, the company has to use the cost recovery method. The re-classification of the portfolio means it is a group of extremely doubtful non-performing loan account. Since the inception of the Portfolio Purchase financed by the Receivables Financing Agreement, the Receivables Financing Agreement has been modified four times due to collections not meeting the company’s expectations. The Portfolio Purchase has not met the expectations, and the shortfall has been exacerbated by the general economic down turn. ASFI has recorded impairments on the Portfolio Purchase totaling $97.2 million ($30.3 million in fiscal year 2008, $53.9 million in fiscal year 2009, and $13.0 million in fiscal year 2010). The Portfolio Purchase was transferred to the cost recovery method effective with the third quarter of fiscal year 2008, as collections became increasingly more difficult to predict. The total transfer amount was $10.1 million in the fiscal year of 2009. In Jun 2011, ASFI has $87.9 million receivables under the cost recovery method, accounting for 72% of total receivables. For the competitors (Asset Acceptance, Portfolio Recovery Associate and Encore Capital Group), none of them has over 0.2% of total receivables treated under cost recovery method.

It is very important to categorize the portfolios into interest method and cost recovery method clearly as the differential of finance income as a percentage of the receivables is huge. In 2010, ASFI only charged 1.27% finance income in the questionable $138 million receivables while the company charged 62.1% finance income from a normal loan book. A huge proportion of the risky receivables would inflate the true earning power of the receivables and mask the true impairment cost in the future.

3. Uncertainty from the Dodd-Frank Bill and other litigations

On July 21, 2010, the Dodd-Frank Wall Street Reform and Protection Act, or the Dodd-Frank Act, was enacted.
There are significant corporate governance and executive compensation-related provisions in the Dodd-Frank Act that require the SEC to adopt additional rules and regulations in these areas such as “say on pay” and proxy access. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be
implemented by various regulatory agencies, the full extent of the impact such as the requirement on the company’s operations is unclear. However, it will likely:

• increase cost of operations due to greater regulatory oversight, supervision and compliance with consumer debt issuance and collection practices;
• limit the ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations.

The Act establishes the Consumer Financial Protection Bureau (CFPB) that will assume broad regulatory powers over debt collectors and virtually all other “covered persons” who have any connection to consumer financial products or services. The Bureau will have exclusive rule-making authority with respect to all
significant federal statutes that impact the collection industry, including the FDCPA, the Fair Credit Reporting Act
(“FCRA”), and others. There is still uncertainty about the extent of the Bureau, but it is likely to act in favor of the desperate consumers and impact negatively the cash flow of Asta Funding.

ASFI’s tax filings are subject to review or audit by the IRS and state and local taxing authorities. In April 2010, they received notification from the IRS that their 2008 and 2009 federal income tax returns will be audited. This audit is currently in progress as of Q3 2011. The IRS examinations of their federal tax returns could result in significant proposed adjustments. The company can provide no assurance that any final determination in an audit will not be materially different than the treatment reflected in their historical income tax provisions and accruals. An assessment of additional taxes as a result of an audit could adversely affect their income tax provision and net income in the period or periods for which that determination is made.

4. Questionable management strategy and return on invested capital

The management has been aggressively collecting cash without reinvesting the money back from buying new loans. They have curtailed the purchases of new portfolios of consumer receivables in the last three fiscal years, finance income was negatively impacted and they expect it will continue to be negatively impacted going forward since they have not been replacing the receivables acquired for liquidation. However, it didn’t help the company to boost the return on invested capital. In the past three years, ASFI had been trailing the peers in terms of the return. Even though the management claimed they focused on reducing the debt with highly disciplined portfolio purchase, the debt to receivables level had been the highest compared to the key competitors. It means the goal of de-leveraging had not been achieved.

The management’s strategy to purchase aggressively before the financial crisis had fired back. According to the management, besides the $183 million impairment in 2009, as a result of the a challenging economic environment and the impact it has had on collections, for portfolio purchases acquired in fiscal year 2009 they extended the time frame of the expectation of recovering 100% of the invested capital to a 24 -39 month period from an 18-28 month period, and the expectation of recovering 130-140% over 7 years from the previous 5 year expectation. The 2009 time frame of expectations has remained in force for fiscal year 2010.

Valuation

The following valuation techniques have been used to estimate the range of intrinsic value of ASFI:

1) Adjusted Tangible Book Value Per Share

Because ASFI has substantially high proportion of loan portfolios under cost recovery method where the cash flow estimation is highly uncertain even for sophisticated industry players. To make a better apple to apple comparison, the tangible book value is subtracted from the doubtful loan portfolio under cost recovery method, for example, ASFI had $100.68 million of doubtful loan with tangible book value of $161.898 million in 2010. The adjusted tangible book value per share becomes ($161.898 - $100.68) million / 14.6 million share = $4.19 / share. The price to adjusted bk value becomes 1.83x. The adjustment has been done for AACC, PRAA, ECPG and ASFI.

Since ASFI should be traded as similar multiple to AACC, when adjusted back the price of ASFI, the intrinsic value of ASFI should be 1.2 (AACC P/BV multiple) x $5.72 (adjusted tangible book value) = $6.69.

2) Normalized Cash Flow

The normalized cash flow should start from the CFO of ASFI in 2010. In order to maintain the business, ASFI should maintain a neutral loan investment, meaning the net increase/decrease in loans originated / sold should be zero instead of providing positive cash flow to the business. The business can’t sustain without continuous investment in non-performing loan portfolios to obtain finance revenue.

For the normalized cash flow: Cash Flow per share = CFO - (1 - t) Interest Paid + CAPEX + Net Loans Originated/Sold where the Net Loans Originated/Sold equals to zero at the 2010 cash flow level, so the unlevered free cash flow per share becomes $4.9. To maintain the stock price, the cash flow yield has to sustain at 100% level, so the intrinsic value of the stock is $4.9 x 100% = $4.9.

Investment Risks

High Delinquency Rate Risk: Ironically the higher the credit card or other consumer loan delinquency rate, the higher the supply of non-performing loans to the industry players. Provided that the demand (i.e. the number of buyers) stays the same, the higher supply would push the price down. Instead of paying 5 cents for a dollar, the buyers can purchase the portfolios for 3 cents for a dollar. It will dramatically reduce the risk of the industry and increase the attractiveness of ASFI. In addition, the higher volume would mean the higher probability ASFI can purchase more non-performing loans to expand the receivables.

De-regulation Risk: There are many industry push-back of the Dodd-Frank bills, since the scope of the Consumer Financial Protection Bureau (CFPB) is not well defined, the effort and lobbying from the industry players would be able to lessen the impact of the regulation. In fact, it usually takes longer than necessary for the industry to implement the new regulation, it buys some time for the company to get around the regulation and find out new source of revenue to offset the impact, which has been done successfully by major banks (e.g. increase the ATM transaction fees).

Portfolio Expansion Risk: Even though ASFI has been losing the market share to the competitors, if the management changes the strategy and starts aggressively purchasing the non-performing books or expand to other products (e.g. healthcare, private label and etc), the earning power of ASFI would increase. In addition, the zero basis portfolios poise risk as well as opportunity to the company. In 2010, the zero basis portfolios provided $34.3 million revenue to ASFI. Since the cash flow is not reasonably predicted and the impairment charges has already been incurred in the previous income statement, when the economy improves, the upside of the cash flow could remove the uncertainty and push up the stock price.

Why is the stock expensive?

Since 2008, ASFI has been trimming down the portfolio and aggressively collecting the cash without buying back new loans, the free cash flow per share and the free cash flow yield have been tremendous. In 2010, ASFI pocketed $8.23 FCF/share and 107.1% FCF yield while competitors like PRAA ($0.1 FCF/share and 0.1% FCF yield), AACC ($0.53 FCF/share and 8.9% FCF yield) and ECPG (-$2.28 FCF/share and -9.7% FCF yield) all recorded less than favorable results.

The relatively decent performance of ASFI had supported the stock price in the past 3 years. In addition, there is only one analyst following ASFI (Keefe, Bruyette & Woods), the under-covered arena creates a favorable environment for unrecognized potential, as well as unrecognized problems. So, the true earnings power of the company is widely mis-understood by the investing community, leading to a mis-priced opportunity.