One of my strongest memories from childhood is watching the Night Gallery episode about sin-eaters. In olden times, sin-eaters were wretches who would attend wakes, where food was placed around the recently deceased. The sin-eaters, for nourishment and a few coins, would absorb the deceased's sins through the food, thus absolving him and expediting his trip to heaven. Night Gallery featured Richard Thomas as the son of a sin-eater, who was forced by his mother to eat his deceased father's accumulated load, condemning poor John Boy Walton to a life filled with dread and death.
It scared the bejeezus out of me.
Sin-eater for business
Actrade Financial Technologies (Nasdaq: ACRT), a focus company in the May issue of The Motley Fool Select, is a sin-eater for business. The ideal company receives payment from its customers immediately, but takes a long time to pay its suppliers. By doing so, a company can increase its cash flow substantially, giving it the free use of cash for an extended period of time.
Both the cash conversion cycle and the Foolish Flow Ratio essentially measure how well a company manages its working capital, especially current accounts receivable (money owed to it) and inventory vs. its current accounts payable (money it owes). The quicker receivables are collected and the longer payables remain outstanding, the better for the business.
Actrade acts as intermediary between buyers and sellers in its Electronic Trade Acceptance Draft (E-TAD) program. It pays sellers within 48 hours for goods sold, minimizing accounts receivable. It then issues an E-TAD to buyers. E-TADs are basically promissory notes with a fixed duration of up to six months. Actrade charges the sellers for the transaction. The rate falls between 1.5% and 8.5%, depending on the duration and size of the note, as well as the buyer's creditworthiness.
For a fee, Actrade will eat away your balance sheet sins.
Actrade's patented E-TAD differs from other kinds of receivable financing in that it does all of the following:
- It funds the entire amount of a purchase.
- It takes the financing off the balance sheet, making financial ratios stronger.
- It removes all credit risk from the trading companies.
- It is pre-authorized, irrevocable, and can be transferred to third parties. Actrade resells about half its E-TADs to its main banking partner, ING Bank, the sixth-largest bank in the world. This cuts about 50 basis points per month off of Actrade's margin, but it relieves it of the credit risk and frees the capital for new loans, increasing asset turns.
It's a flexible system that addresses the needs of both buyers and sellers. It's attractive in a depressed economy, since it increases cash flow. The addressable market is enormous, too. Actrade has focused recently on mid-cap businesses, issuing over $100 million in E-TADs last quarter. That's a tiny slice of the estimated $470 billion in current worldwide short-term financing. As more customers use E-TADs, the more attractive it is for other companies to join Actrade's network. As the network grows, it becomes more and more powerful.
And grow Actrade does. The E-TAD business is growing at a 70% clip and accelerating. E-TAD operating margins increased from 7% to 21%, as investments in technology for Internet transactions began paying off.
Sound good? Consider this: Actrade is profitable, earns 40% profit margins, and trades at 12 times trailing earnings and 7.5 times forward earnings. It's a fast-growing company selling at a slow-growth price.
The trouble with Actrade
Why so cheap, you ask? And why is 30% of the float sold short? I can think of five possible concerns, in no particular order:
1. The other side of Actrade
E-TADs account for about half of Actrade's revenue. The other half comes from International Merchandise Trade (IMT), the company's overseas division. Based in Bermuda, IMT facilitates imports and exports between countries in much the same way that E-TADs do between companies. All business is conducted in U.S. dollars. IMT has never lost money or had a purchaser renege on it in 13 years. Despite a sales force of five lonely people (recently expanded from three) concentrated in niche markets, it's still growing at a 20% clip.
What's more, as a Bermuda company, it has never paid taxes. As a light, mature business outside of U.S. jurisdiction, IMT has huge operating margins and is responsible for around 90% of Actrade's net income. Grow as E-TADs might, this is the heart of the business in the near term. The trouble is, there are limits on how much of IMT's tax-exempt income can be repatriated to the U.S. This restriction on the use of IMT funds for operations causes some investors to discount its value.
2. Potential competition
Actrade has patented the E-TAD, but it is well within the power of Citigroup (NYSE: C) or Wells Fargo (NYSE: WFC) or American Express (NYSE: AXP) to introduce another, viable online financing option. If the return on capital is worthwhile -- and it seems to be -- competition will arrive sooner rather than later.
3. Credit risks
Actrade vets customers in its E-TAD network, but it still gets the occasional lemon. This hit home recently, when Actrade announced it would take a $5.4 million charge in the next quarter because of defaults from Amwest, a defunct insurance company. Such an amount isn't chump change to Actrade; it's almost a quarter of trailing annual income. Just before the default announcement, Actrade's stock fell almost 40%.
Management has not shied away from rewarding itself with options. As a result, the number of shares outstanding has increased by 25% in the past year. Had sharecount remained level, earnings per share (EPS) last quarter would have been $0.75 rather than $0.60. Net income is forecast to grow 37% next year, but EPS only 20%. Youch. That damages Actrade's valuation.
5. Management concerns
Sizable option packages are not management's only skeletons. Actrade was born under a cloud. Its founder and chairman, Amos Aharoni, left Israel in 1985 under pressure from creditors, who had descended on his international trade conglomerate. His assets were seized, but they weren't sufficient. Eventually, the creditors sued in U.S. bankruptcy court. Aharoni settled the case in 1998.
David Askin, the executive vice president of external affairs at Actrade Capital, was formerly a senior bond and mortgage-product analyst at Merrill Lynch (NYSE: MER), Moody's, and Daiwa Securities. He formed his own company, Askin Capital Management, which promised "15% returns with little risk." Well, that didn't really pan out: Askin Capital's leveraged trading in esoteric, illiquid mortgaged-backed securities led to a $600 million blowup in 1996.
Heck, Long-Term Capital Management, whose implosion makes Askin Capital's look like an accounting error, was led by Nobel Laureates. Smart people sometimes make mistakes. I'm not condemning either Aharoni or Askin. They deserve second chances. Their pasts, however, may scare some investors off, including us. We want superior management with high levels of honesty, forthrightness, and integrity. We could use more evidence of those qualities at Actrade.
I'm a sucker for financial companies. I've wanted to find a good one for the Rule Breaker. Actrade has a lot of the qualities we want. It's in an important, emerging industry, where it appears to have some competitive advantage, thanks to patent protection and network effects. Its customer base of 5,000 companies, 300 of which are active, is a little small, but it's growing.
Offshore businesses, though, raise some flags with me. I'm all for playing the game to best tax advantage, but I also like to have clear oversight of my companies. Call me crazy, but I like the notion that the IRS is watching. Toss in a chairman and 25% owner who's allegedly fled creditors in the past, and I'm a little nervous.
Faith in management is a central tenet of Rule Breaker investing. We're not finished looking at Actrade, the sin-eater of business, but we will have to be convinced that it is absolved of its own sins before we buy.
Brian Lund will eat your sins if you'll eat his. Of the companies mentioned, he owns shares of Citigroup. The Motley Fool is investors writing for investors.