I appreciate the time folks have spent looking at my post. I don't want it to be taken as an uncritical statement of faith in ACAS; it is simply the blog entry I made on June 20, relating my thoughts on the quality of the poor stock analysis I'd seen. To get a clearer idea of what I may have said differently since, you can track the tag for the ticker symbol ACAS.
So far, the principal complaint I have as a consumer is that the company is awfully misunderstood (and therefore misrepresented) by people who seem to be making their livings telling people about stocks. This doesn't mean the stock might not have problems, but it certainly increases my index of suspicion that the shares might be mispriced. So I'm excited about the stock because it seems a good candidate for correction to rational pricing (e.g., pricing closer to the last-published NAV). When ACAS' quarterly earnings report comes out, we'll see whether NAV has continued to be hammered with FAS-157-related issues, or whether we see improvement.
Although there may be good reasons in the economy to expect some operating earnings to be down in some portfolio companies, ACAS should begin to get an extra $0.04/sh/q from its AGNC deal going forward. Given prior operating earnings of about $0.77, this isn't bad for steady income that doesn't turn on the availability of profitable exits. As a REIT, I would expect AGNC's non-rent, non-interest capital gains to be rolled into future investments in AGNC, increasing the size of the managed funds on which ACAS gets to take a management fee.
The meat of the querying post is here:
One question that always remains for me these days is "what part of their business model is outside of their control?". In other words, it appears that they do most of their financing with equity or debt. Obviously this isn't the best equity environment to raise cash in, and it also isn't the best debt environment to raise cash in. If those options become prohibitively expensive, can ACAS "sit on their hands" so to speak until the crunch is over? Or are they tied to these markets through periodic refinancing needs that could be pulled if liquidity didn't exist for it in the marketplace? If their secondary liquidity was not available, would they become insolvent? Or would their earnings simply decrease temporarily? It seems our whole economy (including our federal government) has become addicted to debt and without it I wonder which companies would survive.I agree the federal government is no better than kids who haven't learned to use credit cards. People looking to make a buck on ill-advised credit schemes turn up in the damnedest places. And it's a great place to start looking for issues in a financial company -- especially one with a regulated debt-to-equity ratio.
ACAS certainly can "sit on its hands" if required. Nobody is making ACAS do deals, much less bad deals. On the other hand, there's never a dearth of something to do. The business volume might move from M&A to restructuring, or it might move from mezzanine to full buyout or to investing in underpriced secured real estate debt or to something else -- but the deals don't stop. The only thing we want to see at ACAS is careful deliberation and willingness to say "no" when deals just aren't good enough.
The more inaccessible credit becomes generally, the more valuable ACAS' solid credit rating becomes. Part of ACAS' income results from deals to lend money at a certain premium to LIBOR (the London Inter-Bank Offered Rate), and the more desperate ACAS' clients are for the money the bigger the premium to LIBOR ACAS can command. ACAS, of course, can walk away from any deal that doesn't look like it offers enough return, so it's not like re-lending borrowed funds is ACAS' whole business. ACAS isn't a bank.
On the other hand, with ACAS' shares trading below NAV, ACAS can't realistically issue shares of ACAS. ACAS' management has been very good at issuing ACAS shares only when it is non-dilutive. Issuing shares above NAV actually increases the average assets per share after the issuance, so this is actually a good thing for paying down debt, positioning for new deals, and so forth. And, as ACAS showed with the AGNC issuance, management has more ways to grow its business than to issue shares of ACAS.
With the AGNC offering, ACAS invested money of its own and raised third-party money in a publicly-traded investment vehicle to make big bets in the home mortgage market in the wake of the subprime dislocations, presumably to capitalize on fire sales in the secondary market for property-secured debt backed by the U.S. government. In doing so, ACAS created a permanent fund to manage and ensured it would receive fees atop its investment returns. ACAS will thus do even better on AGNC than third parties who bought in on the IPO. The IPO buyers benefited from ACAS' investment, though: the stake ACAS bought in a private placement included no underwriting discount, so AGNC received the full price for the shares. (As a REIT, AGNC can lever quite a bit more than ACAS, so it offers ACAS a means to hold highly-levered assets that don't actually show up directly on its own balance sheet. Presumably, the AGNC holdings aren't consolidated on ACAS' balance sheet and simply show up as an equity investment, allowing ACAS to make 8x+ levered investments without tripping on its regulatory status. Slick, no?)
One thing I have noticed is that ACAS -- even with funds managed in AGNC -- has both long-term and short-term investments. I sat puzzled for a while, wondering how it was that ACAS had been able to avoid issues related to its regulated debt-to-equity ratio while its NAV was being compressed by factors impacting the valuation of its portfolio. It seems that ACAS' investments include a number of regularly-maturing holdings that enable ACAS to delever instead of re-investing as they mature. Additionally, ACAS seems to have a fairly good ability to exit investments: since its inception in 1997, ACAS has enjoyed 230 exits totaling some $10 billion. Individual investments may be illiquid, but ACAS' ability to create a steady flow of transactions seems to be fairly strong, given the broad range of portfolio companies and investment types ACAS has at its disposal to exit.
Another point to keep in mind is that ACAS has shown pretty good planning. Ordinarily I would hesitate to discuss prescient calls on the whole of the economy as a thing to bank on, but ACAS was prepared for 2008 in large part because of repeated accretive issuances during 2007. ACAS was able to raise funds repeatedly during 2007 at prices above NAV, and even did so during the first quarter of 2008. De-levering the balance sheet via accretive issuance is a pretty neat trick: how many companies facing a liquidity crisis are able to issue shares without diluting existing owners of the equity behind each of their shares? By issuing shares above NAV, ACAS has been able to issue shares under conditions that increase per-share assets values, even as other firms are rendered illiquid.
However, the fundamental issue remains: as a business development company required by law to maintain a 1:1 or lower debt:equity ratio, what will happen to ACAS if the NAV plummets? The answer is, I think, that ACAS will be hard at work exercising its imagination to raise funds to de-lever the balance sheet back into line with its regulatory requirements. The fact that the shares are trading below $20 mean that ACAS has a great investment to make in retiring its own shares, if and when it cooks up a means to access funds. (The $500 million buyback authorization might be an interesting place to look for a short squeeze, considering the naked shorting seen in this stock.) Heck, if it were me, I would be tempted to chuck the dividend and take advantage of the big FAS-157 related write-down as a means to get "free" money it doesn't have to pay as dividends (the dividend is high because it's required to pay over 90% of its earnings to shareholders to maintain its tax status). However, management at ACAS has made it clear that it never intends lowering the dividend, ever. (See the 2Q 2007 conference call; I can't find a link just now. If you spot it, send it here and I'll add it!) Management at ACAS views a dividend cut as an embarrassment to management, and is clearly opposed to such a move.
And how desperate is ACAS? ACAS' operating profits actually improved in the first quarter of 2008 compared to the first quarter of 2007, despite the economy. ACAS previously stated it had looked intentionally for counter-cyclical portfolio companies as a hedge against economic downturn. Additionally, ACAS routinely models being required to exit investments under lower-multiple scenarios than those in which it made its acquisitions, so there's some protection built into ACAS' exit planning. The Enlightened American offers a look at ACAS in the face of nasty economics, in which it mentions ACAS' forward exit timetable for the next six months as looking good according to management -- which should provide protection from illiquidity worries. Also, the post mentions ACAS' 1:1 leverage regulation and the possibility that further NAV write-downs might create a liquidity crisis -- not because of inability to service debt, but due to regulatory limitations governing leverage. This was actually a recent concern of mine, when I pondered what broad-scale financial disasters could do to ACAS in a worst-case scenario. Trouble with the 1:1 ratio topped the list.
The theoretical problem exists that in a falling NAV situation, ACAS might be forced to raise capital to avoid violating its 1:1 ratio requirements, and would therefore be forced into unfavorable exits and/or dilutive issuance. Practically, however, ACAS has shown it routinely makes exits even while the rest of the industry is characterized by illiquidity, and it's announced for some time that it's modeling for recession. Moreover, it's likely ACAS would delever gracefully rather than panicking, and would post a ratio that wasn't within spec once or twice while re-attaining compliance if needed to avoid catastrophe.
The upshot is that ACAS has a theoretical liquidity risk -- not caused by inability to service debt (it's making lots of money) but by its one-to-one debt-to-equity ratio requirement, imposed as a condition of its favorable tax status. The risk posed by this requirement has been mitigated by repeated above-NAV issuances and by investments like AGNC, in which leverage is taken on by investment vehicles rather than ACAS. (One wonders what ACAS is doing with managed funds that aren't subject to ACAS' 1:1 debt:equity ratio limits. Are these managed funds levering up in order to cash in on crazy deals? I reckon they're not snapping up underpriced AGNC shares, or ACAS' control over the funds would spark regulatory filings since ACAS is already a huge owner of the shares.) More importantly, ACAS avoids illiquidity through routine exits and realizations and maturities of investments, which seem to look perfectly on-track for the next couple of quarters.
As prices rationalize, I'd expect the FAS-157 values to approach the values that ACAS had correct to within 1% of actual exit pricing, meaning that NAV will expand again. I'll be interested to see how the naked shorts handle the ongoing dividend, and the retirement of shares under the buyback program if the price remains below last-published NAV. I continue to participate in the DRIP, and I continue to regard ACAS as one of the better ideas I've got at the moment.
With the dividend guidance being reiterated every time ACAS is asked about it, I'd expect the guidance to be kept. I expect exits and operating profits to cover the dividend, and any "shortfall" in profits compared to the dividend to be accounting artifacts generated by implementation of FAS 157 and other incidents that cause ACAS to state a NAV beneath genuinely expected exit prices.
It's lunacy like that that assures me this stock is just flat-out mispriced. I'll look to the conference call for evidence to challenge my liquidity thesis or to concern me about the deal pipeline. However, I don't expect to find shocking news at the conference call. I expect to find due diligence paying off in the form of solid profits steadily realized by a well-managed business development company.
And I expect the dividend to be paid on time.
UPDATE: On 8/5, ACAS made an earnings announcement in which it stated that SEC-reportable NAV was $27.01, and projecting 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? 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 absurd, 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.
This quarterly announcement brings ACAS' take-home stats to $29.25 per share in dividends paid or declared since ACAS' 1997 IPO at $15 per share. ACAS cannot retain much earnings without jeopardizing its tax status, which 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.
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.