Is Investing In this Firm Insane?

The days of easy credit are essentially over. The recession took a substantial toll on the financial services industry which remains at war with itself - and consumers are bearing the brunt of the liquidity loss.

As companies large and small struggle to redefine good business practices and figure out how to serve the customer without going broke, many consumers that had been previously spoiled by easy credit are now hurting. Many that didn't lose their jobs and homes during the recession are living paycheck to paycheck.

So investing in the financial services sector right now is sketchy at best - and downright insane in most cases.

But markets have a funny way of allocating capital to beaten down sectors, and one financial services microcap in particular has caught investors' attention.

***That company is CompuCredit Holdings (Nasdaq: CCRT), an Atlanta-based company that provides financial services to those less-than-prime customers that have been abandoned by the big banks.

As part of its business strategy, CompuCredit contracted with credit-card issuers to provide consumer accounts. The firm would then purchase the receivables from those financial institutions. But in the current credit-crunch environment, much of this business no longer appears feasible.

According to CompuCredit, 1-in-4 Americans have a FICO score below 650, the level generally regarded as the cutoff point by traditional lenders. But underserved markets create opportunities for growth, and CompuCredit says its goal is to serve the 75 million underserved consumers.

Achieving this goal carries a hefty price - hence the question about this strategy's viability right now. For the June quarter CompuCredit reported a net loss of $29.6 million. However, SEC filings also showed an allowance for uncollectible loans of $48.5 million, a 10 percent improvement since December.

Before the recession, CompuCredit was gaining ground - and recognition. In 2004-06, it was on the Georgia 100 Best of Business list, and in 2005-06 it made Fortune Magazine's list of 100 Fastest-Growing Companies.

***But CompuCredit has a bit of a checkered past. In December 2008, it paid $114 million to the Federal Trade Commission (FTC) to settle charges of deceptive marketing practices involving its subprime credit cards. When the Credit Card Act of 2009 took effect in February, the high-fee products offered by CompuCredit and other subprime credit card lenders were outlawed.

However, a website that follows the credit card industry, creditcards.com, reported in February that CompuCredit was no longer marketing its subprime cards.

So where is this company headed, and who cares?

Let's handle the second question first...

According to Seeking Alpha contributor Market Folly, hedge fund Second Curve Capital has amassed a pretty nice position in CompuCredit and now holds 4.1 million shares, or about 11.5 percent. The fund is operated by Tom Brown, who previously ran the financial services portion of Tiger Management.

CompuCredit's share price has risen 80 percent this year, but earnings are nonexistent. For the June quarter, the company's loss amounted to 73 cents a share, an improvement from a loss of $2.81 the year before.

So with a gloomy balance sheet, what might Second Curve be looking at?

***CompuCredit Holdings does have a few positive metrics. With the stock trading around $6, the stock has a price-to-free-cash-flow ratio of 1x, as pointed out at the SmartTrend website. Typically, a low ratio means better value.

Last December, the company issued a special $0.50 per share dividend, and also said it was considering a tax-free spin-off of its micro-loan businesses in the U.S. and the U.K. Those are primarily payday-lending companies for the underserved consumer. The proposal states that a subsidiary, called Purpose Financial, would take up the micro-loan business and become publicly traded.

The proposal launched a flurry of lawsuits against CompuCredit, claiming that the spin-off would excise the only part of its business that's generating cash. It still faces regulatory hurdles.

***But CompuCredit seems to be cutting through the muck and mud to get set for something. In May, the company completed a "modified Dutch auction" of debt due in 2025 and outstanding shares at $7 apiece. It reacquired $85.3 million in stock and $14.7 million of the senior notes.

I don't know exactly what will transpire with CompuCredit, and wouldn't suggest you run out and buy the stock without further research. But the company's recent activities, and the sizeable ownership of Second Curve, suggest that something is brewing in the financial services sector right now.

***It's always wise to do your homework, because you never can tell what is motivating a hedge fund or other investor to plunk down their cash for stock. If you'd like some help with your research, click here to sign up for a risk-free trial subscription to Small Cap Investor PRO. We're currently up 30 percent, 55 percent and 15 percent on recent additions.