Thursday, August 7, 2008

ACAS: Correction at JadedConsumer

I typed too fast.

That's my story, and I'm sticking to it.

At least I'm fessing up and apologizing.

Here's the deal: in my post on the risks of ACAS, I made the same boneheaded mistake others had made confusing taxable income and GAAP earnings. I said FAS-157 writedowns would tempt me to retain cash flow now being paid in dividends, so I could increase the company's reinvestment. If so, I'd be tempted to violate the laws governing ACAS as a BDC. Here's how the mistake works, and why looking at Yahoo's trailing-twelve-month income doesn't paint a picture of ACAS' dividend-paying capacity (or, given ACAS' tax status, its dividend-paying requirement).

ACAS' dividend payment requirement, which I described here, is based on ACAS' taxable income. Mark-to-market writedowns that appear in SEC-reported GAAP earnings don't change taxable income unless (and until) they are reflected in a realization that includes the writedown. ACAS made clear it doubts the FAS-157-compliant valuations state the immediate exit prices ACAS would achieve, which ACAS reports as "Anticipated Realizable Value".

In response to a caller question, ACAS clarified that its reported "Anticipated Realizable Value" isn't the value ACAS expects to realize, either. (This, despite ACAS stating on slide 71 that Realizable value is the future value ACAS expects to achieve on exit. I have an email in to those guys for clarification.) "Anticipated Realizable Value" is thus a misnomer: based on management comments during the call, ACAS would more accurately communicate its intent by calling the valuation category Anticipated Immediate Liquidation Value, as it reflects the price ACAS anticipates it would get if forced to market positions in the existing environment and under existing conditions, rather than pursue ACAS' intended exit strategies for various investments. (Actual exit strategies discussed by management in the call or noted in the slide presentation include continuing to grow a business' EBITDA to improve its market value in the face of falling earnings multiples, waiting for maturity at face value of unimpaired and still-paying debt instruments, etc.)

The upshot: since FAS-157 writedowns and other mark-to-market changes in reported asset values don't impact realized gains and thus don't impact taxable income, they are unrelated to ACAS' dividend-payment requirements (except to the extent they later turn out to accurately reflect exit prices). Tracking ACAS' taxable income isn't something Yahoo does, so the trailing-twelve-month number that makes it seem ACAS is paying over a dollar a share while losing money. This, in turn, gives observers the impression ACAS is in a death spiral and will die a terrible death by paying out its investment capital until the company is broke. With a story like that, it's a short magnet.

The story is based on confusion between GAAP earnings (which involve quarterly revaluation of holdings for liquidation value, regardless of the investment strategy applied to a given investment) and taxable income (which is concerned solely with realized earnings). To the extent a quarter's liquidation value fails to reflect actual achieved exits, mark-to-market changes reflecting changes in liquidation value will tend to cloud understanding of ACAS' actual taxable income, and thus its dividend capacity/requirement.

Since ACAS controls the timing of its investment exits, one would immediately want to know whether ACAS is gaming exits to make ACAS seem more profitable by having higher reported taxable income, by exiting all the good companies and withholding from sale all the losers. Anyone interested in looking at ACAS' portfolio holdings to ascertain whether management is withholding dogs from the market to artificially inflate taxable income can look at the portfolio. Management faced a question on this during the last conference call. Investors can make up their own minds, having looked at the reports and listened to the conference calls.

The potential game isn't that ACAS overpays dividends when it has negative income, dooming it to self-destruction. The risk perceived by casual observers of Yahoo's earnings and P/E info is that ACAS just can't afford its dividend because it has no profits to pay. The truth turns out that ACAS' dividend is based on taxable income, which isn't what Yahoo reports. If ACAS' taxable income and cash flow both sustain the dividend capacity of the company, the long-term holder probably couldn't give a fig what this quarter's mark-to-market is on assets ACAS is, other than on assets ACAS is actually liquidating this quarter.

The real risk is that ACAS' management games investment exits to accelerate earnings while withholding underperforming investments from the market. I don't see evidence that game is being played. If ACAS' earnings projections are generally met[1], ACAS looks doomed to keep paying a dividend something like its current dividend.

[1] ACAS' investment income from exits can be un-smooth enough that it varies easily between quarters, so one probably should look at numbers for reasonably long periods like a year rather than get excited about quarterly "misses" and "beats" which can simply reflect different-than-expected timing by a few weeks of deals ACAS knew were in the works and had forecast.

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