Kerrisdale Capital Calls JGWPT Holdings Undervalued After 6% Stake

NEW YORK (TheStreet) -- Hedge fund Kerrisdale Capital said on Monday it believes JGWPT Holdings (JGW) shares are "highly attractive" given the structured settlement provider's current valuation. On Friday, Kerrisdale disclosed an over 6% stake in JGWPT Holdings, which operates the J.G. Wentworth and Peachtree brands, pushing shares in the company up 10%.

On Monday, Kerrisdale, a fast growing hedge fund with a value investing bent, published a research note on JGW that described why the firm had become a top shareholder in the company. Kerrisdale cited JGW's valuation and the competitive advantages of its settlement funding business model versus competitors as reason why the fund had become an investor.

Kerrisdale has $300 million in assets under management, meaning its JGW stake represents about 5% of the firm's overall portfolio, founder Sahn Adrangi said in an email to TheStreet on Monday.

In a Friday interview, Adrangi said he believes JGW's business model means it will "always be the low cost provider" in a niche market for structured settlement payouts. Kerrisdale disclosed a holding in JGW of 6.08% of the company's outstanding shares, or 682,630 total shares.

The fund, which also shorts stocks and made its name shorting Chinese reverse merger stocks in the U.S. a few years ago, said on Monday it believes JGW trades at multiples of about half of the company's intrinsic value.

"We are long shares of JGWPT Holdings (NYSE:JGW), which, via its J.G. Wentworth and Peachtree brands, is the number-one player in an attractive consumer-finance market niche," Kerrisdale said on Monday. JGW provides liquidity to personal-injury plaintiffs, lottery winners, and others who are receiving long-term payout streams but want cash payouts in the near term.

The fund's investment boils down to a few major points: Kerrisdale believes JGW has a scale that will be hard for competitors to breach. Meanwhile, the company's use of securitization markets after operating in the space for over two decades means it offers consumers the industry's best pricing.

"JGW is the only structured-settlement firm with access to cheap, consistent institutional funding via the securitization market. Having the lowest cost of funds in its sector allows JGW to offer settlement sellers the best price," Kerrisdale said.

The firm calculates JGW has recently been able to purchase settlement assets from consumers using an 11% discount rate, while competitors have been charging discount rates on settlement assets of between 17%-to-18%. Kerrisdale attributes that cost of funding advantage to 4%-to-5% financing JGW can access in the asset-backed securities market.

One part of JGW's earnings stems from the spread it generates in buying and then selling settlement assets. The other driver of the company's earnings is the residual interests that the firm takes in its securitizations, and fees it earns in marketing those transactions.

"[The] gap between the value that the bond market ascribes to JGW's securitizations and the price that JGW pays to acquire assets is so large that JGW can crystallize almost all of its gain upfront. In effect, JGW's working capital is negative. The robust cash flow provided by the arrangement differentiates JGW from other securitization-funded finance companies, like mortgage originators, that often receive cash in a slow trickle over a period of many years," Kerrisdale said.

"On average, JGW buys payment streams at 34% of face value and sells them at 60% of face value, for a tremendous gross return on investment of almost 80%. Viewed from a different angle, we estimate that JGW spends $6,700 to acquire a new account, which in turn generates $15,400 of pre-tax earnings net of imputed costs," the firm added.

Other tailwinds for JGW are the company's ability to conduct acquisitions and ability to invest more than industry peers in marketing to bring in new business.

The firm believes that JGW trades at about half of the company's intrinsic value and said other consumer-finance IPOs suggest a fair value in the mid $20-to-$30 share range.

"Despite its 60-70% market share, attractive organic growth rate, and ability to compound capital through acquisitions and platform expansion, JGW trades at a consensus P/E ratio of 7x, an EV/EBITDA multiple of 8x, and at nearly half of our estimate of intrinsic value," Kerrisdale said.

On a Friday phone call with TheStreet, Adrangi downplayed some criticisms of JGW such as the company's high cash flow leverage.

JGW is currently given deeply speculative bond ratings because of its high operating leverage and its use of warehouse credit lines to originate and distribute payment streams to institutional investors. In 2009, the firm went bankrupt when it drew on warehouse lines of credit to buy payment streams but was unable to sell them via then-frozen securitization markets.

Adrangi said that in the wake of JGW's bankruptcy, the company has emerged with a cash flow profile to sustain its high debt load. Acquisitions like Peachtree have also improved JGW's cash generating abilities Adrangi said.

After emerging from bankruptcy, JGW diversified its warehouse credit lines, potentially mitigating some liquidity risks that came to a forefront in its bankruptcy.

Private equity firm JLL Partners took control of JGW in the wake of its bankruptcy, and through a series of dividend recapitalization's that dramatically increased the company's debt, the PE firm made a gain of over two times its initial investment, even before the company's November IPO.

JGW's IPO may have also presented an opportunity to investors like Kerrisdale, who believe in the long-term prospects of the business. The offering was expected to price at $19-to$22 a share but went to market at $14 a share and quickly fell in trading on public stock markets as low as $12.50 a share.

Since then, some investors have come around to JGW. Kerrisdale, is the first major hedge fund investor to explain why it believes JGW is undervalued.

In a series of critical articles, TheStreet highlighted JGW's leverage and a business model that resembled subprime lenders as risks ordinary investors should be wary of.

JGW shares were gaining less than 1% at $17 a share in early Monday trading. Shares have gained over 20% since JGW's IPO pricing in November.

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