Wednesday, August 20, 2008

Irrelevant 'News' Yields ACAS Buy Op Again

Merisel (MSEL) reported a loss today for its second quarter of 2008. The press release mentions American Capital a couple of times in connection with material legal, merger, and acquisition expenses. American Capital (ACAS) shares are trading down on the news.

Ahh, you say. American Capital's portfolio companies are dragging it down. And surely that's what the news suggests. But to get the real story you need to look a bit further.

Merisel is not a portfolio company of American Capital. ACAS decided not to buy MSEL, and that's the only connection between the firms. (The link is to MSEL's press release, which explains its spin on the transaction's collapse.) The two companies had inked a deal under which MSEL would be bought by an ACAS subsidiary, but ACAS determined the deal was bad (the sides naturally tell different stories about why) and invoked its termination rights under the parties' contract. ACAS' worst-case exposure in the deal (if MSEL is correct and ACAS has no grounds to terminate and merely breached the contract) is a sum so small as to represent a rounding error on ACAS net assets. Whether Merisel sinks or swims is thus of no moment to ACAS at all; a failure at MSEL means nothing except, perhaps, that due diligence at ACAS successfully protected the company from a bad deal before it was too late.

Avoiding bad deals is a major lesson in growing wealth. According to Warren Buffett, it's the first and second rule of investing. It's easy to see why. That's one major reason I like ACAS: consistent management with its eye on the long-term ball, willing to walk away from bad deals even if it means blowing some analyst-fixating number this quarter.

Yet, mindless bloviators happily report that American Capital shot itself in the foot by not buying Merisel last year at a premium to its trading price. I note that the author of that piece is a manager at an "event driven fund" which, I imagine, is code for investing wishfully on anticipated news rather than on existing research into the fundamental competitive and profit-making characteristics of proposed investments. Well, of course this guy is excited about ACAS proposing to buy MSEL shares at well above market, when the dead deal pushed MSEL shares underwater: deals like this are the kinds of news events he hopes will drive his holdings to profitable levels.

For folks who actually intend holding investments, though, the fact is that MSEL wasn't making money last year; its large loss carryforward confused even the linked article's author's own analysis of the company's worth; and the company is losing money now. Avoiding a non-producing dog like this (or alternatively, postponing purchase until the price rationalizes and MSEL shows it can make some money) is a feather in ACAS' cap. Why should ACAS tie up good money in a dud when there are better pitches for hitting?

Don't swing at bad pitches. It's not only risky, but unnecessary to ACAS' business. It's part of what originally started me blogging on ACAS. This lesson is utterly missed by the autor at The Deal Sleuth:
It is difficult to see what ACAS is thinking. As a business development company, it relies heavily on deal flow from small companies like Merisel. A scorched earth strategy with Merisel would damage its reputation and make building trust with other small firms difficult. Who wants to deal with a ruthless financier ...?
-- Thomas Kirchner
Kirchner apparently believes ACAS has a hard time luring companies into deals. As discussed in my first ACAS post, the reverse is the problem: sorting through the deluge of garbage deals looking for not mere recyclables, but genuine pearls. Since ACAS is the premier firm for middle-market buyout -- it owns or manages the capital that makes the deals possible -- ACAS is the go-to shop for people who think their deal is salable. People who know their deal isn't salable ... well, should I as an ACAS shareholder miss 'deals' like that? Not just no, but hell no.

ACAS continues to be hated and misunderstood. ACAS' recent earnings report (links and notes) shows the company has adequate liquidity for the foreseeable future, and solid deal volume going forward. European Capital continues to provide good income, and American Capital Agency demonstrates management can still raise funds without diluting shareholders, and has the ability to capitalize on temporary credit dislocations to provide good income. ACAS' funds management income has increased with the AGNC offering, and can be expected to grow with net assets under management -- enabling ACAS to better fund its due diligence with others' cash.

So long as ACAS' share price remains well under its net asset value per share, reinvestment seems to offer screaming returns. The company-run Dividend Reinvestment Plan enables slightly-below-market-price reinvestment when the shares trade above NAV, though, so increasing NAV doesn't pose much risk to the use of the DRIP. I consider the DRIP a fire-and-forget tool on a company with this kind of performance.

I expect continued lunacy in the pricing of these shares until it's clear (not from analysis but from ongoing performance) that the macro environment poses no threat to the company's operations or liquidity. We could see below-NAV trading for a half-dozen quarters or more, unless someone actually read by the wider public exposes the lack of sense behind the shares' pricing. Ironically, the senseless bouncing between 20 and 22.5 may generate trade opportunities for folks lacking the patience to make money the traditional way (letting strangers write them dividend checks).

Please let me know if you see something in this stock that I miss. I've really tried to look at the company's risks, and I'm keen to hear any thoughts you may have.


Nick said...

August 25

American Capital Realizes a Gain of $19 Million From Sale of PaR Systems.
The proceeds received by American Capital were less than the second quarter 2008 valuation of the investment by $0.6 million, or 3%.

August 20

American Capital Realizes $57 Million Gain from Sale of Contec.
The proceeds received by American Capital were less than its second quarter 2008 valuation of the investment by $1 million, or less than 1%.

I think this means the downturn does have an effect on sales price, maybe limited but tangible. Tough a couple of other sells like that and this quarter targets will be met ;-)

Jaded Consumer said...

ACAS seems to have exited investments in portfolio companies within 3% of prior-quarter valuations. Given the illiquidity and difficulty of valuing ACAS' not-publicly-traded portfolio companies, I consider within 3% to be a rousing endorsement of ACAS' valuation accuracy.

I don't expect ACAS to wildly exceed projected numbers for the quarter, as management has made clear that the sale of portfolio companies -- which are non-public, and require more and different analysis by the parties to pull off the transaction -- takes something like seven months to accomplish. The possibility of a transaction moving across the boundary of a quarter has materialized, and ACAS has backed out of transactions when it became clear the deals didn't adequately reward ACAS, but the idea of unexpected increased deal volume seems challenging to understand.

The questions to ask about ACAS aren't whether the company can pay its dividend or make money, but how its operating income will perform under various kinds of economic and competitive environments. Sure, ACAS is growing management income, but most of ACAS' profits seem to come from the aggregate performance of ACAS' many individual portfolio companies.

ACAS has been adding non-cyclical and counter-cyclical business, but the question surely remains how ACAS' mix of businesses will happen to perform in the near term.

So long as I get to reinvest well below NAV I'm uninterested in doing anything with ACAS but adding to the shares via the DRIP, and I view ACAS as a company to own for the long term, but I do see some room for uncertainty for specific performance numbers in the near term.

Thankfully, ACAS' management has shown it'd rather do good deals than try to game quarterly numbers, so the long-term thesis isn't threatened by short-term questions about whether there's a penny miss or the like.