Wednesday, August 6, 2008

ACAS: Serving Fresh-Squeezed Short Juice?

Yesterday, American Capital (ACAS) announced that it's post-FAS-157 net asset value per share (NAV) was over $27 and reiterated its intent to keep increasing its dividend in light of its favorable forward exit flow and its projected operating earnings. Shorts hoping for dividend cuts and near-term liquidity problems must have been disappointed, as the shares spiked to $22.25 this morning after closing yesterday at about $20.50. An orderly exit is possible for shorts if volume continues to be good, and the fact financials are basically hated (BRK.B and MKL being examples of consistently-profitable and growing businesses managed with genuine fiscal conservatism, but being despite this on sale compared to year-ago prices) should keep the exit door open. In the current environment of misunderstanding about the shares, and the sentiment against financials, I don't see a serious short panic.

However, shorts already have trouble finding ACAS shares to borrow. (The list there is ordered by days on the list, and ACAS was at 108 days in mid-July.) And ACAS has a share buyback authorization that's about 1/8 of its market capitalization at current prices. The big thing protecting shorts is that ACAS makes money in boring, low-profile ways -- mostly through ordinary earnings of portfolio companies -- so there's little chance of high-profile news suddenly changing the prevailing ACAS thesis on shorts in a way plausible in, say, Apple if it were heavily shorted. When the wind of sentiment changes on ACAS, it'll probably create ample opportunity for those with their finger to the wind to pack their bags before departing.

I added an update to my recent post On The Risks of ACAS, but I realize now that the update essentially hides the facts by stuffing them in the foot of the post. Folks just tuning in to ACAS coverage might want to have a look at its business and why it seems mispriced, a feature of an early post here giving the thumbs-down to professional stock analysts. I give the update again here because it really addresses the liquidity issues that make ACAS a scary short:

On 8/5, ACAS made an earnings announcement in which it stated reportable NAV stood at $27.01, and projected profit for the following quarter in excess of $1.05 per share, while reiterating its intent to pay $1.05 per share in dividends in the third quarter of 2008.

CEO Malon Wilkus stated:
With our visibility into additional exits of portfolio companies during the third quarter of 2008, we expect to realize earnings that cover our dividend. This is evidenced by our forecast to exceed $1.05 per diluted share in realized earnings for the third quarter of 2008, despite the troubles in the economy. In the second quarter we had exits and prepayments totaling $479 million. Our exits are accretive to NOI when we redeploy the capital into wider yielding debt investments.

CFO John Erickson stated:
We continue to sell companies at attractive multiples, generating good liquidity. Despite the economy, we are well positioned to maintain our dividend level in our steady state operating mode.
ACAS' President of North American Finance stated:
We exited eleven companies year-to-date through July 2008, receiving proceeds of $1 billion. The median multiples for these companies at the time of their 2008 exits were one turn higher than the median multiples when we entered into the investments, and their average EBITDA was 55% higher. We currently have 22 companies in various stages of the sales process, which is typical for the size of our portfolio. We are seeing robust interest from prospective buyers, so we continue to expect strong liquidity from our portfolio. Our ability to offer a staple financing package to buyers is a strong competitive advantage and advances our strategic initiative of increasing our investment spreads and moving up the balance sheet in this environment.
The update's upshot?

Liquidity concerns I discussed here don't seem a present risk. Forward business looks good not only from the standpoint of exiting deals, but making good new deals with proceeds.

It's good to be the king.

Management reports NAV considerably above current share prices, which suggests ACAS is in a position to consider repurchasing shares as liquidity permits. ACAS' resistance to share repurchases of ECAS when it was trading at a discount to NAV, at a time ACAS was trading at a premium to NAV, should be kept in mind, however: ACAS views wide shareholdership as an advertising advantage and as an asset in future issuances. That is, the more happy ACAS shareholders exist -- happy because they like their dividends -- the better management seems to think it will be able to price subsequent offerings and the more money it thinks it will be able to raise to manage.

So, you might not want to hold your breath on the share buyback. If ACAS was awake and not barred from buying when the shares were under $16 under the terms of the not-fully-disclosed share buyback plan, then perhaps some shares were bought back during the quarter. On the other hand, ACAS may be sipping gently as it buys back shares, doing so only when the price is particularly absurd, or would make a good press event, and refusing to make purchases when there's a liquidity risk. We might see ACAS sipping on that $500 million for another quarter or two, yet. (On the other hand, ACAS' comment on 1Q2008's relatively miniscule buyback seemed to indicate management would have liked to have bought back shares near $25, but was barred from doing so.)

This quarterly announcement brings ACAS' "take-home" counter to $29.25 per share in dividends paid or declared since ACAS' 1997 IPO at $15 per share. As has been pointed out before, dividends paid to shareholders can't be restated. And the dividends can't stop: ACAS cannot retain much of its earnings without jeopardizing its tax status, though this special tax status enables it to avoid double-taxation of shareholder dividends by paying dividends from pretax earnings. So long as ACAS expects earnings, shareholders should expect dividends. Given ACAS' view that dividends serve as a scorecard for management, shareholders should expect dividends not to be cut.

As for the title here: OK, 8.5% may not be a big short squeeze, but the trend is a long-term problem for shorts -- increasing dividends safe from cutting by a proud management intent on showing its cash flow will do what it promises isn't something to bet against. When the trend against financials turns around and ACAS trades at a premium to NAV, purchasers at these levels will be looking at nice gains. In the meantime, they'll have a nice dividend to console them. There's probably a short thesis for a trade, but the idea ACAS should trade a few dollars lower next year requires a special calculator, or certainty that people's craziness will get a lot worse. I do consider lunacy a plausible thesis, so don't think I'm bashing potential shorts. I just think it's got to be an idea for a short-term trade (say, one that doesn't cross a dividend ex-date) and not a long-term investment hypothesis.

Since it's illegal to sell short without first borrowing the shares, I'm interested to know why the SEC hasn't bothered to do something about folks not bothering to rent the shares they want to short-sell. Ahh, well. It'd sure be nice to get a rental fee atop my dividends.

The $64,000 question: in what time frame will ACAS' unrealized depreciation, taken in accordance with FAS 157, begin to evaporate from its balance sheets? When will financials be loved again, so ACAS trades at a premium rather than a discount to NAV? Here, one will find the capital gains angle on ACAS. Trading this far below NAV, ACAS isn't just a dividend play but a play on misunderstood and mispriced securities.

Remember: reported profit and actual cash flow can be wildly out of whack when things like amortization and depreciation become significant, and they have. ACAS is reported to have negative profit for the trailing twelve months due to FAS-157-related write-downs and other unrealized depreciation, some of which will likely evaporate from the balance sheets as investments mature or are exited. Income attributed to ACAS in some reports take into account only operating income, and neglect ACAS' steady deal flow (the $1 billion in exits so far this year, among which was not only principal but gains that form part of ACAS' earnings). Folks trying to work out on the back of an envelope that ACAS must cut its dividend, and haven't done their homework, will be drawing a very different conclusion about this stock than I did when I wrote about how poorly analysts seemed to be doing when describing ACAS to their customers.

And the dividend isn't $0.31 a share a quarter, either.

UPDATE: the day's gain, after the conference call, was 9.79% of the prior day's closing price. Whether liquidity news impacts sentiment -- or is even picked up as news -- remains to be seen. The prediction for the shares is to languish for a year until last quarter's paper loss falls off the trailing 12-month metrics and people think ACAS is making money again. I don't expect people to seriously look past Yahoo's metrics summary page in making investment decisions at the retail level. Given that ACAS has -- both last year and the year before -- found buyers for a cross-section of ACAS' portfolio company investments without actually having to exit whole positions or effective control, I wonder whether ACAS is looking to pull a hat-trick by raising private funds again, for long-term or permanent management, at its expected exit price rather than FAS-157 NAV, to create additional liquidity to take advantage of ACAS share prices too crazy to pass up.

I'd give a good nickel to know what ACAS management considers a sufficiently attractive discount to NAV, though it was clear from the prior conference call that ACAS management wished it could have picked up more in 1Q2008 near $25. And what, exactly, are the restrictions in ACAS' buyback program? I imagine liquidity restrictions, but I'm guessing here. The Enlightened American blog hasn't got insight on this point, either.

No comments: