Update: Yes, the company has declared bankruptcy and the bonds, being junior to the bank debt, have been damaged done badly, having been converted to rights to purchase up to $90 million in equity. I confess I got this one wrong, but I’m not going to cover over my mistakes by deleting this post.
As I’ve said before, high yield debt, or junk bonds tend to be among my favorite assets. Not my favorite asset class, mind you, just my favorite assets. As an asset class, high yield debt straddles the line between debt and equity, combining the capped appreciation potential of the former with the latter’s inability to diversify an existing equity portfolio the way investment-grade debt would. This conclusion, as stated in The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly (which is a good introduction for the non-professional wealth manager), was the fruit of a number of fairly lengthy and impressive studies that managed to conclude essentially what Benjamin Graham figured out in the 1930s from ordinary common sense.
However, value investors look at assets individually, not as asset classes, and the returns available from an underpriced debt instrument can rival those of an underpriced equity. True, a bond can rise only so far before the issuer calls it, but a stock can only rise so far before it ceases to be underpriced as well, and on an annualized basis the returns can be quite impressive, particularly if the bond price appreciates to fair value rapidly.
Aspect Software is a privately held company with publicly traded bonds. According to the company’s filings with the SEC, the company sells fully-integrated customer interaction management solutions, including workforce optimization and back office products, using cloud, hosted, and hybrid development options, so that contact centers and back offices align their employees, processes, and touch points to deliver remarkable customer experiences, and integrating customer self-service, contact center operations, workforce optimization and back office workflow solutions into existing enterprise technology investments to remove communication and workflow barriers and/or create more productive business processes. Or, in English, they sell software and IT for call centers.
The company is currently migrating its systems from a traditional hardware-intensive setup to cloud-based solutions. The company claims that this move will allow it to lure a broader base of customers which may be reluctant to make a larger capital commitment. Also, the company provides support for web-based or app-based live help and e-mail and SMS-based systems.
Aspect Software claims that about 2/3 of its business is recurring, as switching providerscauses a significant disruption in operations and a consequent decline in customer satisfaction, which tends to outweigh the potential benefits of a new provider. Because their client base is therefore a “captive audience,” stability of revenues is enhanced, which is an attractive feature that also played a role in my recommendation of CSG Systems, and that went very well (Past performance is not necessarily indicative of future results).
Aspect Software’s capital structure, like most issuers of junk bonds, consists of a substantial bank debt that has priority in security over the bonds, which are more readily available to the public. Again, the company is privately held, but the 10-K is riddled with suggestions that there are plans to go public at a future date, such as the granting of stock options to employees. The bank debt balance is about $440 million, and it bears interest at the greater of 7% LIBOR plus 5.25%. This debt falls due to be refinanced in May of 2016.
The bonds that concern us have $320 million in face value, pay 10.625% interest annually and fall due in May of 2017. Recently the bonds have traded at a price of around 96, making a yield to maturity of approximately 13%. The bonds have traded as low as 90.25 within the last 30 days. Over their lifetimes the bonds have frequently traded at a premium to par and even to the call price.
Turning to Aspect Software’s financials, in 2014 the company had sales of $445 million and reported operating income of $62 million. Depreciation and amortization came to $23 million and capital expenditures were $13 million, producing operating cash flow of $72 million. Income taxes are negative because the company has net operating loss carryforwards and significant noncash charges that make it unprofitable in accounting terms. The company’s cash interest requirements that year were $68 million, which produces an interest coverage ratio of 1.04. Although that coverage ratio is far, far away from investment grade, Aswath Damodaran states that in the current high yield market such a bond is normally entitled to a mere 8% premium over a comparable Treasury. This bond, at a 13% yield, offers a premium of over 12%. In 2013 sales were $437 million and operating cash flow was $73 million, and in 2012 sales were $443 million and operating cash flow was $103 million. Much of the decline in operating cash flow was the result of a large excess depreciation and amortization allowance, since Aspect started investing in its cloud offerings in 2013, which required a higher level of capital expenditures.
The first quarter of 2015 showed some improvements. Sales declined slightly, but the company was able to save in cost of revenue and in general and administrative expenses, improving operating cash flow to $24.8 million versus $16.5 million for the first quarter of last year.
Taking $72 million as the company’s earnings generation power, the $440 million in debt that is senior to the bonds will consume about $31 million in interest payments. If we collapse the bonds and the equity (not an unfair assumption considering the face that the residual value of the equity is likely to be minimal), we would find that $41 million of cash flow against $320 million in bonds is a multiple of just under 8x. This strikes me as rather conservative, if the company’s claims about their high degree of repeat business and the cloud-based solution requiring less resources on everyone’s part hold true. In fact, the company’s publicly traded competitor, Interactive Intelligence, has a price to sales ratio more than twice as based on its entire capital structure, and it has negative free cash flow (although it is free of long-term debt).
Therefore, I think a 13% yield is sufficient compensation for the risk, as even in the event of a bankruptcy the bonds should retain nearly all of their value as the company is showing no signs of declining business. Thus, I can recommend Aspect Software’s bonds as a candidate for portfolio inclusion for investors who can find room for high yield debt in their portfolios. I would add a caveat, though, that the bank debt falls due to be refinanced before the bonds do, and depending on how well that process goes, this refinancing could be an important positive or negative catalyst for these bonds