Thursday, October 30, 2008

Congress Needs Risk Analysis Class

Congress seems on the brink of making homes harder to finance. It sounds backward, but bear with me. I'll try to explain why I'm concerned.

The mechanism Congress picked years ago to make it easier to get money into the hands of banks for making 30-year fixed-rate mortgages (which in the U.S. are common, but in the world at large are largely a fantasy) was securitization. Fannie and Freddie were set up to guarantee loans, and to repackage them for investors. Between the securitization and the guarantee, the promise of individuals whom investors never met to keep making interest and principal payments for possibly decades was thought to be suitably backed.

Exactly why was the promise of little strangers of interest to institutional investors with the power to buy any debt obligation from any business or government enterprise on the planet? A few points:
  • Principal backed by a hard asset -- a home being maintained by its resident
  • Timely payment of interest and principal guaranteed by Fannie or Freddie, or an insurer like AIG
  • History of home mortgages performing at a very high rate of promised performance
  • Ability to buy in bulk obligations based on the credit of very small borrowers, meaning investments with yields better than the secured notes of well-known, solvent obligors like General Electric
The key to the injection of capital into the home finance system, the lynchpin in the pitch, is that the investments perform as described.

A member of Congress from Houston appeared on C-SPAN recently, demanding to know why homeowners in bankruptcy shouldn't be allowed to have courts rejigger the terms of their home loans in the way bankruptcy judges rejigger other debts. Honestly, I'm not sure what the rationale is for allowing vacation properties' mortgages to be reworked by courts at the expense of secured creditors -- I mean, that's what you expect when you are a secured creditor, right? Security? I tried to imagine what would happen if the bankruptcy code was reworked to allow judges to dictate to secured home lenders the new terms -- principal and interest -- of their debtors' obligations.

Mind you, this change in isolation isn't the kind of opt-in system proposed and defended by officials who point out that offering lenders upside participation in property appreciation is a potentially appropriate quid pro quo for banks who don't want to suffer failed mortgages but don't want to unilaterally forgive debts, either. An opt-in system has problems, too, of course: it makes borrowers' outcomes depend on the whim of banks. On the other hand, government could condition lenders' gurarantees on the ability to step into the banks' shoes, become the secured creditor, and then renegotiate the mortgage so that it can be paid -- and so the government gets participation in the property's re-appreciation to recoup its losses and compensate taxpayers for taking the risk on a failed borrower.

Instead, the proposal to enact a one-way change to make home mortgages malleable in bankruptcy court would wreak havoc -- utter havoc -- in our system of getting thirty-year mortgages off the books of local banks so the banks would be in a position to make more 30-year loans. Who will buy a 30-year obligation that, by law, means only what a judge says a borrower can afford, and has a principal value that can be adjusted downward (but never upward!) when buyers make a bad guess about real estate value trends? What will the obligation of guarantors be for the timely repayment of principal and interest, if the underlying mortgages aren't backed by the security of the home but are subject to being rewritten at will by life-tenured federal appointees who may never have had a business course in their lives? Who will end up holding the bag?

If the answer is that lenders and those who buy mortgages from them will be holding the bag, you can expect the thirty-year fixed rate mortgage to become as uncommon in the U.S. as it is elsewhere in the world. Instead of helping people to own homes, we will price home mortgages so as to prevent home ownership. Instead of enabling people to build equity in homes by offering cheap credit for home owners, we will encourage lenders to price all loans with a skeptical view of borrowers' prospects -- and an even less encouraging view of the value of the collateral.

Maybe, somewhere, a conservative curmudgeon will argue that home ownership is for a privileged few and that some people are just not meant to be home owners because their character and thrift makes them unsuited to creditworthiness. I can see this kind of person eager to make lending scarcer. The people who are arguing that we should rewrite the obligations owed to secured creditors are hoping to make life easier for borrowers, not to limit borrowers to an elite class of Americans.

The solution the government might consider is as ancient as the hills: assignment. If the government wants to prevent a foreclosure, it can buy the offending note from the lender and assume the lender's rights -- security and all. The government can then negotiate as it likes, without harming the market for the notes, and without threatening to take property from its owners. Anything the government can agree with the homeowners -- changed equity, changed interest rates, lender equity participation, you name it -- becomes fair game.

Throwing secured creditors to the wolves will just make it more difficult for people who want to own homes to fulfill their dream.

Wednesday, October 29, 2008

Obama Baffled By Health Policy Debate

President Obama unfortuntately doesn't get it.

He recently claimed that a statement from a McCain health policy adviser, indicating that members of employee benefit plans with health coverage through their employer group would not abandon coverage as a result of the tax plan McCain urges, somehow proved that McCain's plan was a disaster. In the last debate, Obama claimed that McCain's plan was a disaster because it would drive people out of employment-based coverage. Obama: make up your mind. The punch line is that Obama's old claim, that McCain's plan would drive people out of employer-sponsored plans, was supposed to be a disaster because it would create risk segmentation as young healthy people bought coverage with McCain's tax credit. Risk segmentation exists now due to the coverage-selectivity of insurers, and their longstanding practice of setting up can't-opt-out health plans to capture cheap risks in the form of employably healthy workers. Driving up the cost of employer-based coverage by siphoning off good risks would actually decrease the problem of poorly-regulated employer-based coverage; people buying coverage in the open market get genuine insurance instead of the watered-down "rights" conferred under plans governed exclusively by the Employee Retirement Income Security Act. Regulated insurers offer superior rights and better risk distribution. Obama's own health care advisors, interviewed on television, made plain months ago that employment-based coverage was a drag, and that Obama's plan included it only because of inertia. Obama's more recent claims that there's a reason to want employment-based coverage to continue in perpetuity are so farr off the mark that it would make a genuine policy architect weep.

Oh, well. Obama, when he speaks, is apparently no different in substance from any other politician whose lips are moving.

And like most Americans, President Obama is bad at math:
And once you're out on your own with this $5,000 credit, Sen. McCain, for the first time, is going to be taxing the health care benefits that you have from your employer.

And this is your plan, John. For the first time in history, you will be taxing people's health care benefits.

By the way, the average policy costs about $12,000. So if you've got $5,000 and it's going to cost you $12,000, that's a loss for you.

-- Barak Obama, Oct. 15 debate (transcript)
In the hands of a person in the 30% marginal tax rate, a $5,000 credit would be as large as all the tax paid on the last $16,666.67 of income, if it were all taxed at the highest rate. In the hands of a person in the 15% income tax bracket, it would be equivalent to all the tax paid on $33,333.33 -- but of course one can't make $33,333.33 within the 15% tax bracket. Obama's claim that a $5000 tax credit won't put people in a satisfactory position if their health benefits are taxed -- that is, a financial position at least as good as before the change in tax status -- is absolutely false. There is no family at any income level that would suffer from a $5,000 tax credit in exchange for taxability of health benefits, even if the price of health coverage were as high as Obama insists.

The benefit of taxing health benefits is that employers' health expenses become more transparent, and price competition becomes possible. Cherry-picking by the insurers backing plans becomes easier to detect. Substandard plans become easier to detect. Employees have a stronger reason to seek better-priced coverage, because they know the costs and can do the math. Employees have better leverage to negotiate on wages because the illusion of valuable untaxed non-cash benefits is evaporated by transparency caused by taxation.

The tax credit proposed by McCain has a valuable purpose: to level the field of competition between the old, terrible employment-based health coverage system that so long has been subsidized by the federal government through advantageous tax status, and the older system of insurance that works just fine (e.g., for automobiles, homes, and lives) because its regulation hasn't been supplanted by a cloudy haze of federal law that provides aggrieved beneficiaries no useful remedy. Let's face it: the reason the insurers who work for employee benefit plans are working to prevent universal coverage under state law because it would result in clear rights, and prevent the windfall they currently receive with ambiguous plan terms they are free (under federal law) to interpret in their own favor (which is not allowed under state law). McCain's tax-and-credit plan would allow fair price competition, loosen the death-grip of employment-based coverage, enable citizens to buy health coverage with their tax dollars instead of their post-tax earnings, and set the state for state-by-state universal coverage just like we have for drivers -- without making the health care system a one-payor federal health care monopsony as proposed by some.

President Obama just doesn't get it.

Man Bites Dog, Is Ignored? (Politics)

If a McCain speechwriter were to begin supporting the Obama campaign, that'd be news, right? This is the thesis supporting a piece that argues mainstream media is pro-Obama. The idea is that the mainstream media should be publishing man-bites-dog stories, but suppressed it because it was harmful to Obama.

Apparently, one of the (likely many) speechwriters involved in Obama's campaign grew disgusted actually watching the sausage made, and switched brands. Disgust with politics isn't new, to be sure, and the quoted description of why she defected doesn't seem particularly shocking. It's not clear this is serious news. It's also not clear the new brand offers a better sausage-making environment.

What does seem clear is that (a) people can change their minds, (b) this is completely legal in America, and (c) if her disgust catches on, her former candidate will have some serious selling to do in four years. In the meantime, a Democratic House, Senate, and Presidential Mansion will be something to see. When it fails to deliver -- and when have politicians ever really delivered? -- it'll simply put the shoe on the other foot: we'll have Republicans complaining that Democrats squandered the country's trust with all the power to enact anything they pleased, and they just voted themselves into more money to share with their favored interests.

Business as usual.

Before we get a wave of explanation that the Democrats rescued the United States from war in Iraq, it might be worth reminding everyone that on the watch of the outgoing, can't-run-again, second-term Commander-In-Chief, troop reductions had already been scheduled and Iraqi provinces (currently 13 of 18) had been regularly turned over to Iraqi control. For example, Anbar province -- of which we've heard so much -- was turned over last month, and just now Iraqi control has been returned to the province of Wasit. 13 of 18; mostly done, no? An estimate earlier this year suggested that post-surge security improvements might enable Iraq to take control of all provinces this year. What an embarrassment that might be to the Obama campaign, eh? Obama's threat to bomb America's ally Pakistan has even been one-upped: not only have enemy sanctuaries in Pakistan continue to be targeted, but the existing Commander-In-Chief just bombed an enemy nation to deny al quaeda sanctuary, halting a cell directing foerign fighters into Iraq. How embarrassing is that?

Just wait for it. Obama will take credit in due time both for withdrawal from Iraq, and for the drop in oil prices. As the economy recovers, he will take credit for "making" the jobs.

Why is it that the resident of 1600 Pennsylvania Avenue always seems to want to take credit for the work of better men? The work of people with real jobs? People who risk their own life's savings, or lives, to improve the world around them?

Politicians make me nearly as ill as those who try to paint them as great idols to be worshipped.


Afterward: In lampooning Palin on funding fruit fly research in Paris, France, Huffington Post authors seem to miss the part about funding frogs to do what Americans could do just as well, with perhaps a bit less corruption. The concept of studying fruit flies didn't strike me as the principal jibe -- it's not like Palin criticized in any way the fruit fly research done in the U.S. every day -- but the fact someone in Congress had arranged to fund research to be conducted in a country whose laboratory ethics and results seem to be influenced by nationalism rather than a love of the truth. It's not like there is any evidence the French could do a better job than Americans designing and carrying out research on the same strain of flies. Paying foreigners to do research where they will be influenced to find specific results has a nasty history, and we'd have more accountability (and employement) employing American scientists.

Tuesday, October 28, 2008

Where Good Ideas Come From

I read that there was an old joke among sci-fi authors (possibly originating with Ray Bradbury, and definitely leading to the title of this book) that their ideas came in brown-paper-wrapped packages from Schenectady, NY.

Then, I saw this documentary proof that there are other places to get good ideas.

Imagine the possibilities!

Saturday, October 25, 2008

On Noticing The Obvious

Sometimes the things that are most important are so obvious that nobody bothers to think about them.

Take air, for example. Since you were separated from your mother's blood supply -- before which you leeched your own oxygenation from her blood to keep you going -- you've been utterly dependent on a ready supply of breathable air for every moment of your life. As a kid, when you thought about all the things you could wish for if you were to find a genie bottle, you probably never even considered "breathable air" as a worthwhile wish. Why prepare for a risk like that? It's not like over three thousand Americans die a year in drownings ...

So let's step back a bit and ask what kinds of things it is that we so take for granted that we wouldn't deign to waste a wish to insure, but without which we'd be so, so screwed. This may end up taking the form of a series -- there are likely lots of nominees for this list -- but I thought I would start with widespread violence and destruction carried on by warlords and would-be tyrants operating without concern for the rule of law or the intervention of outsiders for the protection of the oppressed.

In Africa, where millions have died and more have been displaced in disputes over territories full of natural resources, what do you reckon to be the cost of a homeowner's insurance policy? Maybe in the safer parts of South Africa, there's an insurer that will lend against a home located where the threats are mostly against personal property and life, rather than against the insured homestead. It's possible, of course, that the list of exclusions in a policy issued on property situated in Africa may look a bit different from the list of exclusions in your own homeowner's policy, even if you do have the budget of a war zone security contractor. But suppose you are a local -- what will you be able to afford? Then you have the question of how to buy the house. Except where insurance is available to secure the collateral against losses caused by explosions, fire, and occupation by hostile warlords looking for a regular weekend retreat, would any bank loan against such a property? Heh. But it gets worse. Where illiteracy is high, the rule of law unknown, families large, deaths common, and refugee status a growing problem, how will you prove title? After generations of deedless title transfers, how on Earth will a lender or title insurer acquire confidence the seller has anything to sell at all?

Untangling title can occur when a nominally functioning government enacts measures to make clear declarations of title, but for much of Africa there's no way to prove title. This means there's no way to buy or sell land, only trade occupancy. It means there's no way to pledge the land as security, and no way either to get loans against it for purchase or to unlock equity in the land for use developing a business or improving the fixtures on the land.

So it seems the small businessman in Africa is in trouble: due to endemic poverty, he may own little; what he owns beyond what he can carry, he may be unable to protect; he may be unable to insure what he can prove he owns; he may be unable to prove ownership to land and unable to borrow against it to improve it; he is screwed. Because the public education suffers from undertrained instructors and a preference to shower plums like government employment on political allies rather than to squander such largess on merely competent employees, public health initiatives are likely to be utterly botched -- and infrastructure, and what have you.

Africa isn't alone in this, it's simply a high-profile victim. China pretends to respect the rule of law and the rights of individuals, as it has adopted new constitutional amendments purporting to enshrine them as the highest law of the land, but these have no more effectiveness on their own than the staple-pierced condoms distributed by incompetent anti-HIV workers. Russia's campaign to re-create the police state of the Soviet Union is founded on intimidation, confiscation, and a strengthening partnership between organized crime and government insiders. Venezuela is still working on formalizing permanent unlimited emergency powers in a president-for-life, but in the meantime has driven out competent engineers due to political concerns and is driving its principal national business (petroleum) into the ground through incompetence. In some Central American countries, certain banks and utility companies have been nationalized and privatized so many times as governments sieze profitable enterprises then drive them into worthlessness through mismanagement that it's almost a predictable, cyclical industry.

The Jaded Consumer derives from these observations a few conclusions about what must be working in the United States to keep it as consistently high-performing among the world's various populations. It's not like the United States has different genetics than those of the many countries from which its residents emigrated. It's not like the United States has more oil than Saudi Arabia, or better literacy than Cuba, or smarter bankers than Switzerland. We spend a fortune on education and get results that come nowhere near those of Japan, which spends far less per pupil.

Relatively Low-Risk Environment.
America's murder rate may be consistently higher than Canada's, but it's nowhere near that of Russia, Venuzeula, Mexico, or South Africa. Maybe we haven't got a public works project to protect New Orleans that comes anywhere near the Netherlands' solution in the Delta Works, but we have taken meaningful steps to mitigate storm damage along out most vulnerable coast. Going into business in the United States, you can usually find who owns title to property, and when you buy property you can not only insure the title and the land, but get a lender to help fund the project. Corporate taxes are high -- so high you may want to take advantage of LLCs, LLPs, trusts, or other organizational types that enable one to pass income through the entity tax-free. Income taxes are modest in comparison to many foreign countries, making the United States a relatively low-tax jurisdiction for some businesses.

Ever wonder why so many companies organize in Delaware? There's a theory known as the "race to the bottom" (inspiring the name of the blog linked here) that postulates that companies organize where the law offers the best opportunity for managers to oppress minority owners and passive investors, and that the nation is in a cycle of competitive lowering of standards intended to draw incorporation fees from companies whose managers hope to loot their companies with impunity. The theory has some strength -- a comparison of officer responsibility under different states' standards might reveal a preference for incorporation volume where officers were freer to misbehave -- but analysis is complicated by confounders like Nevada's zero-tax status, and so on. The Jaded Consumer points out that Delaware has something even lower-standard-jurisdictions cannot offer: known law. Delaware's courts handle so many questions of corporate governance that there is great certainty among practitioners in the field how the Delaware courts will rule on many common issues -- and the commentary on developing lines of case law offer some insight into the areas in which clear guidance cannot be offered to corporate officers. Delaware courts take pains to rule as consistently as possible, fully knowing that their principal constituents are businesspeople who incorporated in Delaware to enjoy a governing law free of surprises. Elimination of legal risk is one of the reasons to incorporate in Delaware, and may be the only reason to explain incorporation in Delaware in light of the jurisdictions with lower costs (e.g., filing fees and franchise taxes) and lower standards for corporate officers. Incorporation in Delaware isn't the cheapest in the nation by either franchise tax or by filing fee, yet it is awfully common for businesses with no connection to Delaware at all to incorporate in Delaware. Why doesn't everyone just re-incorporate in Nevada? Nevada is a race-to-the-bottom state and has zero taxes and extremely modest filing fees, and so should win on "low standards" or "money", either alone or in combination. The distinctive asset Delaware can offer is stable law.

The avoidance of risk is a nontrivial proposition in the large-scale growth of business. There may be money to be made driving a truck in Iraq -- but would you do it? At any price? Thrill-seekers may be willing to accept (or ignore) terrible risks in exchange for possible financial rewards, but imagine selling the idea to investors. The illiquidity in penny stocks (go look at the bid/ask spreads, and the numbers of shares traded for most of the pink sheet issues in the current market) goes a long way toward proving that high-risk, high-yield opportunities are only of interest to hobbyist speculators or people with "mad money" to blow, and aren't a place to establish a serious portfolio of investments. People hoping to capitalize on opportunity in Russia's illiquid, opaque investment environment have been hit pretty badly, for example, as risk exacts its toll in fearfulness and prices plummet. Earlier this year, the story told to me was that Russia had so much money it didn't need outside investment; now, the story is that Russia's financial institutions are faltering and their outlooks seem poor even in light of government intervention. The United States may not have any prospect of a turnaround in the next six months, even if everything is done right to shore up the ailing financial sector, but for some reason -- and I suspect relative risk is key in this -- the world is buying United States dollars. The Euro never traded so low. A year ago, who'd have guessed? Russia is trying to devalue the Ruble now, in an effort to prevent outright collapse. Only months ago, it was talking about pricing its oil in Rubles; now, it's happy to get hard currency.

Why America Is Good For Business
When I walk down the street I spend very little time worrying about the possibility that thrill-seekers, gang members, militia inductees, or organized crime initiates will swerve off the road to kill me -- or that I will be sniped where I stand, or that some parked car will explode beside me. In the United States, people mostly walk about unarmed because – even where weapons are lawful – they perceive themselves safe. Curious about the cost to prepare one's self for a world in which this safety could not be taken for granted, I tried to price a bullet proof vest. The gun shop owner looked at me like I was from Mars: civilians don't need these things in America. I couldn't get him to tell me what it'd cost to order from him!

The leading causes of death in America are natural causes -- cancers and cardiovascular illnesses. Motor vehicle deaths far outpace suicides, which outpace intentional killings. Americans don't die at a particularly high rate for a high-growth jurisdiction. Property isn't routinely destroyed in riots. Businesses and their employees can buy property by borrowing at fixed insterest for decades. "Normal" in the United States is a pretty good situation for doing business. "Normal" in the United States may not, in this century, mean movement from unindustrialized to industrialized, as is offered by the vast bulk of China, South America, and Africa; however, "normal" in the U.S. does generally mean that large bribes aren't necessary to carry on business, that the laws governing imports and exports are likely to have relatively consistent meaning between amendments, that ownership of companies isn't likely to be refabricated by courts or bought officials in government records offices, that risks to business property are likely to be insurable, that deposits in banks can be withdrawn as promised by the banks, and that sort of thing.

Normal in the United States is ... normal. And that's pretty much the point of this post. Much of the world has a far looser grasp on the rule of law, much riskier environment in which to acquire and use business assets, and a much more expensive environment in which to obtain credit. Especially when fear grips the world, the American idea of "normal" begins looking pretty good.

The quality of the normal business environment in the United States, and its tendency to offer stable law and a lack of unexpected risks (e.g., political risk; we have a revolution every even-numbered year here, but it's fairly tame and little changes), may be part of why Warren Buffett remains consistently bullish on the long term view of the American economy. The fact that the stock market offers current buyers irrationally low prices makes U.S. equities an especially attractive deal.

Normal is good. Mispriced normal? Very good.

AGNC's First Full Quarter Conference Call Scheduled

For those of you keen to learn about American Capital Agency's first full quarter -- and what a quarter for that to be, eh? -- it's been scheduled for October 29. Investors can follow it live at the AGNC web site.

During the last ACAS conference call -- that is, the conference call of the company managing AGNC -- managers indicated that AGNC was at that time providing the exact performance anticipated, yielding a return on equity north of 25%. I'm intereste to see what the recent market dislocations has wrought, and how interest rate spread changes are expected to impact AGNC's profits. Unless the spreads narrow, AGNC's government-guaranteed underlying investments should put it into a position to continue performing. The question is, how long as AGNC got under its current borrowing arrangements. Currently, AGNC is producing pretty good income for itself and for shareholders.

Since AGNC gets monthly payments of not only interest but principal and prepayments, AGNC is in a position to regularly recycle capital back into its business as the illiquidity problems make it difficult to market securitized home mortgage products. One advantage of easily-timed liquidity is that an illiquidity crisis seems easily avoided. Additionally, AGNC's ability to reinvest at current rates presumably will enable increasingly superior investment entries as the economy worsens, as instrument pricing will deteriorate (and reinvestment opportunities will improve) with confidence losses at a rate faster than the deterioration of instrument performance. In light of the govenment guarantees behind AGNC's underlying investments, this last point is more than a speculative bet.

The fact that the government-backed guarantors of AGNC's investments have recruited from the board of AGNC's manager ACAS to find a new Chairman of the Board of Freddie Mac suggests that AGNC's manager is a fairly good place to find expertise in the field in which AGNC invests. In an era in which knowledge is golden, ACAS may well be a gold mine -- and AGNC a well-positioned prospector.

Friday, October 24, 2008

Apple's Value Clearer

Not long ago, The Jaded Consumer ran a piece criticizing Apple as hard-to-value due to earnings opacity. Apple's recent conference call, though surely not intending to respond to The Jaded Consumer's inquiry into whether Apple's price has a safety net, made an argument that $25 Billion in cash was a solid reason to think Apple would weather the current storm better than most. In response to the hard-to-value argument, Apple has offered something new: a non-GAAP earnings measurement that backs out the effect of subscription accounting, so that investors can see the true impact of iPhone sales on Apple's profit.

The materiality of iPhones to Apple's bottom line is clear: abandoning the pretense that iPhone revenue occurs over twenty-for months in favor of recognizing revenue in the month of sale more than doubled Apple's earnings per share from $1.26 to $2.56 (per the conference call statement that sales adjusted to eliminate subscription accounting were for the quarter "$1.68 billion, 48% higher than the reported revenue of $7.9 billion, while adjusted income was $2.44 billion, 115% higher than the net reported income of $1.14 billion"). The fact that Apple's iPod units maintain Apple at the apex of the music player market (and music vendor market), and that its Mac units show consistent strong unit growth, are strong assurances that Apple's brand remains valuable and that its customers continue to respond to its products and promotions. Despite fears of margin erosions, and Apple's own guidance, Apple has managed to increase gross margins over the quarter to 34.7%; Apple turned in unexpectedly high profit despite total GAAP revenues lower than some expected.

Apple's retail stores continue to expand the worldwide footprint of the Mac, selling an all-time quarterly record of 596,000 Macs, a 26% increase -- half of them to buyers who'd never owned a Mac. Folks buying an iPhone and activating it in the store spend about one minute longer doing so than they'd spend buying an iPod.

The phones have exploded. Apple sold 6.9 million of the phones, beating RIMM in units (6.1M Blackberries v. 6.9M iPhones) and becoming the world's third-ranked phone vendor by revenues (with $4.6 Billion in sales, third behind Nokia's $12.7B and Samsung $5.9B; Apple stood ahead in the quarter of Sony/Ericksson's $4.2B, LG's $3.4B, Motorola's $3.2B, and RIMM's $2.1B). Apple's sales included both expansion into new countries (a growth that won't happen twice) and initial channel fill (a few million units that won't ). Over 5,000 iPhone applications are available on the App Store globally, enabling third parties and Apple to make each others' products more valuable. The iPhone platform will only get more valuable.

Apple's position in music is strong. A relative's new car had built-in support for iPods and iPhones -- not through an audio-in jack, but through a special iPod connector licensed from Apple, allowing control of the player from the steering wheel. Apple music players are featured in third-party promotions featuring high-profile music brands. Apple's music store offers millions more tracks of music than competitors, making it an attractive place to shop.

Apple generated $9.1 Billion in cash over the year. Apple achieved this while increasing sales, expanding product lines, growing international stores, and maintaining strong gross margins. Apple's cash creation per share was $10.27 over the year, and its accounting profits higher. Apple claims that it will use this downturn as it did in the last one to invest its way forward. During the last downturn, Apple developed retail stores, for example -- an expensive undertaking, but ultimately extremely positive. The ability to afford to take risks in R&D to compete effectively going forward will help Apple, and Apple's current management has shown the ability to capitalize on these opportunities.

Assuming that Apple's annual easy-to-understand profits are in the neighborhood of $10, and depressions are associated with a P/E around 8, then Apple might be viewed as having a "floor" of $80. Panic selling substantially below this level might indicate the kind of buy opportunity The Jaded Consumer failed to identify earlier. Remembering Apple's cash of $25 Billion, Apple may have an effective shock absorber against some of the crazier pricing shocks that may come to the market over the course of this downturn.

ACAS plummets to new lows!

Earlier this morning, when the ask on shares of Americal Capital (ACAS) stood at $9.00, I realized that illiquidity panics are far from over among traders with exposure to ACAS. People interested in high-yield returns like those historically offered by American Capital are perhaps more likely than other investors to take risks with leverage that tend to place them at risk of margin calls, and yesterday's plunge after removal from the Regulation SHO list creates an excellent opportunity to catch people over-leveraged. Although leverage may create a panic in investors, it does not follow that the underlying company itself is at particular risk of a liquidity crisis.

The question about leverage and liquidity isn't trivial, however. American Capital historically solved liquidity issues -- whether driven by a desire to de-leverage, or a simple hunger to enter good deals -- using techniques that may not be available in the current market environment. The usual trick -- issuing shares above net asset value to create cash and increase average net asset value in one stroke -- is unavailable while shares trade at less than half ACAS' last-published net asset value. Forward sales contracts, that gave American Capital the right to put millions of shares to various counterparties at prices well north of $30, have all been exhausted. American Capital's management has stated that it hasn't got a liquidity problem because it has excellent deal flow and knows the content of its pipeline, but without knowing about ACAS' counterparties in these deals investors can't know the buyers of ACAS' portfolio companies will be in a position to close deals they've struck. American Capital has strong operating earnings from its portfolio companies, but these earnings aren't all free cash flow, and ACAS has for some time paid a dividend that exceeds ACAS' operating earnings.

Liquidity is the main concern raised about American Capital both here and at the Enlightened American blog. The Enlightened American, for example, mentioned liquidity twice in his August discussion of American Capital's balance-sheet trends: in connection with ACAS' dividend coverage, and in connection with its leverage. Bullseye.

The biggest worries I have for American Capital in this market turn on the valuation of its assets. The first problem -- leverage -- stems from the fact that ACAS must maintain very modest leverage in order to avoid liquidity problems caused by its tax status; the debt:leverage ratio is capped by ACAS' tax status at 1:1. As asset valuations fall (and the debt doesn't), ACAS' debt:equity ratio will rise. Although ACAS' assets are illiquid and may be challenging to value with transparency (depspite that ACAS has been routinely able to obtain within a few percent of its claimed prior-quarter valuations on portfolio company exits), the valuations of ACAS' equity holdings are driven by models that look to publicly-traded "comparables" for its various portfolio companies. This is akin to looking at real-estate "comparables" to determine either the tax valuation of one's real estate, or the likely selling price of a home that hasn't been in the market in years. The performance of "comparables" will impact the valuation of ACAS portfolio companies. Over the last six months, we've seen the broad market take a pretty bad hit:
This six-month Chart (warning: Yahoo product) depicts the S&P 500 (of which ACAS has been a component over the whole period), the Dow Jones Industrial Average, and the NASDAQ (the exchange on which ACAS trades) all declining significantly -- between 30% and 35%. Over the last year, ACAS has stated repeatedly how great it is to be levered less than 1:1, and has pointed out that it's levered either 0.8:1 or 0.7:1, as matters then stood. To be levered 0.7:1 after a 33% gain in holdings valuations, one would have to start levered at 1.06:1. Working this backward, one sees that unless the company is shedding debt -- which requires expending assets, which works against de-leverage and against bank net asset covenants -- an asset drop of 33% would push ACAS past its regulatory limit of 1:1 debt:equity ratio. Over the past year, however, ACAS de-levered from 0.8 to 0.7 while paying a fat cash dividend.

However, the worst of the price plummet in the chart above is more recent than ACAS' latest debt:equity pronoucements, or net asset value news. The worst is just recently, in September and October. On November 10, we will see what the state of ACAS' financials was at the end of September. On November 10, we will see what deal flow has brought ACAS in terms of liquidity, and we will see what comparables' pricing has done to ACAS' equity value. We will see on November 10 whether ACAS appears set to maintain the four-plus-billion net asset value it promised its lenders when it renegotiated its unsecured line of credit recently, or whether it looks like ACAS is set to have bust the covenant in October when the collapse continued to crush the share price of equities. Considering the possiblity that comparables' pricing could get hammered another 50% as stocks settle into downturn-era P/E ratios, ACAS hasn't got the luxury of just "hanging on" while the world turns around: it plausibly needs to continue de-levering, and it to renegotiate credit lines around different (lower) net asset levels.

I pointed out that, following the recent market crash and ACAS' updated net tangible asset value covenants, ACAS faced an acid test as its dividend date approached. Having successfully paid its most recent dividend timely -- and driving the share price up significantly through reinvestment purchases by its hamfisted plan administrator, which is not an ACAS affiliate -- ACAS is either going to show the world that it made the money in deals ... or it is going to show the world that it levered back up a few hundred million in order to make sure the checks didn't bounce. The truth -- that ACAS is regularly levered while it holds cash due to delivery requirements in deals and in order to make quarter-end dividend payments -- may be lost on critics.

It's hard to get a useful earnings number from which to calculate a P/E on ACAS, because FAS 157 makes ACAS report unrealized losses not just as decreasing net asset value, but also earnings. Given the results of some FAS 157-compliant pricing -- for example, certain especially illiquid investments in sectors that are hated, but which are performing and are expected to continue performing for years -- it's hard to imagine thinking about the liquidation value rather than the income produced by these investments, and hard to imagine considering as "lost" amounts due under properly-performing debt obligations owed by solvent obligors. Yahoo-published "earnings" doesn't help ACAS investors to understand either what's happening to ACAS' investments, or to understand what ACAS is likely to do with its dividend. Since ACAS' dividend is driven by its taxable income, which is a bit less subject to estimate error -- the IRS enforces rules designed to tax incomes, not accounting principles, though Congress is apt to give comfort to businesspeople in industries Congress loves, like energy and the nonprofit sector -- the Jaded Consumer suggests looking at this taxable income as an alternate window into what is happening financially at ACAS (in the "good case").

Smoothing out the lumps in ACAS' earnings and assuming that ACAS' management is right about its deal flow and liquidity, taxable earnings of about $1 per quarter would, in a P/E environment of 8, result in a price of $32. If ACAS is wrong and deal flow slows materially, and ACAS ends up living largely on operating earnings, then ACAS' taxable profits will result even more predominantly from the operating earnings of portfolio companies. Those operating earnings, which stood at about $0.71 a share per quarter when last I looked, could be battered down a bit in a nasty economic environment. Since ACAS' due diligence has proved effective in avoiding lemons, I won't predict broad failures -- but let's look at what happens if we assume a bad pricing environment and lower earnings. Let's assume lowball market pricing leads to zero deal exits, below-NAV pricing prevents new share issuance, market illiquidity and fear leads to no new funds under management, and nothing goes right for ACAS. Let's imagine a P/E of 8 across the broad market, and within ACAS' own portfolio companies, meaning that ACAS' equity decline forces ACAS to de-lever at the expense of its equity, meaning unreplaced deal exits to reduce debt. If ACAS sold off businesses to raise funds for de-leverage, and ACAS saw operating earnings fall by 50% to $0.35/q (remember, we're modeling business shrinkage and a bad economic environment), and we applied a P/E of 8, we would see this: annual taxable earnings of $1.40, and a share price of $12.80.

As I write, the market is pricing ACAS' shares under $11, a level at which its current dividend is approximately 10% per quarter. The market is pricing a scenario rather worse than a protracted P/E-of-8-depression and the shrinkage of ACAS' operating earnings to half their current levels. It's understandable why investors with a personal liquidity crisis must exit positions in order to raise cash, but shorts taking new positions at this level must be betting on a collapse in ACAS -- not just a bad quarter or a nasty short-term liquidity problem, but something like complete failure. In light of ACAS' historic deal exits, one wonders how a prediction of utter gloom like this would seem rational. In the absence of fraud by the management, a profitable business like ACAS (taxable profits, the kind the IRS cares about and the kind that creates dividends for ACAS shareholders) and its portfolio companies can hardly be thought a candidate for collapse. The current pricing doesn't seem to reflect ACAS' long-term prospects for returns any more than the FAS-157-compliant valuations of some of its assets reflect the long-term prospects of their returns.

Remembering that some of ACAS' assets are priced below the current value of their expected future returns due to FAS 157 and the illiquidity of some of the investments, one might expect that the worst-case scenario is likely to play out only if ACAS is crushed by an unexpected liquidity crisis. However, the writing on the wall has been legible to ACAS managers since last year, when they issued shares above $40 to de-lever. ACAS has continued de-levering -- which hurts earnings, as it reduces invested equity per share -- to avoid a liquidity crisis, and to be prepared to make deals as competitors lost the power to do so. The last couple of months have been nasty -- perhaps nastier than anyone guessed -- and ACAS has managed to cough up huge dividends timely despite outsiders' liquidity concerns. ACAS has entered new deals that presumably enable better understanding of the value of the assets with which they exited the deals -- and presumably involve debt rates based on today's tight credit market and offer high rates of return going forward.

ACAS continues to be able to exit deals, though the rate at which these deals are closed won't have another data point until November 10. The fact that ACAS continues to succeed as it syndicates senior debt to third parties in even recent transactions shows ACAS as a credible seller, and demonstrates ACAS' management both understands how to sell its products, and knows buyers willing to pay for ACAS' deals. Creating new deals -- and acquiring high-yield investment assets as part of the deal exits -- was clearly still possible for ACAS over the course of the quarter. ACAS did a brisk business over the last downturn, and it seems poised to make good deals during this one -- assuming it avoids destruction by a short-term liquidity crisis.

American Capital faced a question in the last conference call that I think elicited an answer relevant to this issue:
As I said, I think we prepared for this environment and delevered specifically for this environment. Now clearly, every day, every month, every quarter, we're managing... we're analyzing the data and one of the options is to delever some more if we feel the need is there. We've certainly put our self in a position where we can do that on a proactive basis as we see things develop rather than have a gun to our heads.

So we are managing that and I think it just depends on our outlook day by day and quarter by quarter in terms of where we think the portfolio company valuations are going anywhere we think the capital markets are going. We have plenty of flexibility given the capital that we have coming back to make a decision on whether to reinvest it or whether to pay debt down, and it's likely we could do both.
ACAS Second Quarter Conference Call Transcript, via Seeking Alpha (p.4)
Either management was correct when it said it was prepared -- or it was not.

On November 10, we will hear what comparables' pricing has done to ACAS' NAV; we will hear what ACAS' leverage was exiting the month of September; we will learn what deal flow was really like in the third quarter; we will see how management's deal flow predictions stacked up against reality; we will find out how operating earnings are holding up as the economy worsens; and we will find out what guidance management gives for the next few quarters. On November 10, we will have another opportunity to see whether the Emperor has clothes or not.

Thursday, October 23, 2008

Shorts Spike ACAS

American Capital, whose shares' short interest had declined to about 16% of the float, are back to over 19% of the float as of the close of trading yesterday. The assault of the shorts was made easier by the removal of ACAS from the NASDAQ list of securities subject to enhanced delivery requirements under Regulation SHO. With the stock off the list -- and it takes five days of violation to return to the list -- ACAS will be subject to selling with even less delivery requirement than characterized its selling in the last ... oh, half year or so. In July, ACAS had been on the list over a hundred days, and only left the list yesterday.

The increased selling opportunity means that from the standpoint of market mechanics, seller interest will have an easier time placing orders than buyers. The marginal increase in selling pressure will have an outsized impact on per-unit price. There's no ACAS-specific news that would impact the valuation proposition. While everyone is in theory subject to depressed earnings in the event of a protracted recession, ACAS' low leverage and consistent operating earnings suggest ACAS is more a safe haven than a risky buy.

Today I was joking with someone about waiting for shorts to create a buy op at $9. Maybe it's not a joke. The thing that I keep asking -- to no answer -- is why ACAS' hundreds of sound portfolio companies should be on sale so far below their apparent ability to produce earnings. At these prices, ACAS could suffer terribly from a destroyed marketplace and still be a good buy. At half its dividend, it would produce a yield of about 20%. However, ACAS hasn't cut its dividend, but has reiterated more than once that it will pay $1.10 per share in dividends for the next quarter.

The only sign of "backtracking" to be found in ACAS is that ACAS' description of the 4Q2008 dividend has been clarified into $1.05 of ordinary dividend -- the same as the dividend paid Oct. 14 -- plus a "bonus" of $0.05. The designation of 5¢ of the last dividend of the year as including a "bonus" rather than being entirely a regular dividend is likely an effort by management to stick with its prior dividend guidance while not obligating itself to never-ending dividend increases while the economy appears poised on the brink of what may be a protracted recession. ACAS' management has made clear that it views the dividends as an objective performance meter, and stated in its 2Q2007 earnings call that it intended never declaring a regular dividend it would have to lower. By designating only $1.05 of the 4Q2008 dividend as a "regular" dividend, ACAS opens the door for maintaining a $1.05 regular dividend -- the level it paid in 3Q2008 -- without facing the charge that ACAS had been forced to cut its dividend, or that management had been unable to maintain its intended dividend policy.

The November 10 earnings announcement and its associated conference call will definitely offer concerned investors illumination into the company's thinking about the developing economic situation, and its impact on the company.

Although ACAS' "blackout" dates, set by its compliance officer as disclosed in its 2Q2008 earnings conference call, have made share repurchases under the $500,000,000 buyback authorization something of a rare bird, the theoretical prospect raised by the current price depression is interesting. When ACAS announced its share buyback plan, the authorized amount seemed set to enable ACAS to retire "almost 9% of the company's outstanding shares". At $11 a share -- above ACAS' current trading price -- ACAS could buy back quite a bit more of ACAS' outstanding equity. Given that ACAS spent only $6 Million in share buybacks so far (0.2 million shares as described in ACAS' 10-Q from the first quarter, and zero in the second quarter), ACAS could theoretically spend $494,000,000 on buybacks under its existing authorization for as many as 44,909,909 shares -- over 21% of the company's outstanding shares. Retiring 21% of its outstanding shares would boost an operating income per share of 70¢ to over 89¢ a share. This would go a long way toward reducing the impact of a deal slowdown brought on by a protracted economic slump.

Does ACAS actually suffer from such a slump, though? We've seen that ACAS' earnings attributable to deal closings is "lumpy", and we've heard ACAS claim that the problem wasn't yet preventing those operating in its market segment from making deals. If ACAS' deal flow and cash flow are good, but the market as a whole is circling the drain and pressuring ACAS shares downward, perhaps ACAS' best use of its cash is to wait for ACAS shares to get even cheaper. At $7.95, ACAS would be able to retire 30% of the shares oustanding after ACAS issued 8.7 million shares for $36.41 in March, and another four million shares at $35.61 under a forward-sale agreement disclosed in the second-quarter 10-Q.

The fact that the forward-sales agreements are exhausted and that ACAS' trick of raising capital with above-NAV issuance is unavailable, it'll be important to see just what ACAS achieves when it announces its third-quarter results on November 10. The fact that ACAS received in cash 30% of the purchase price, when ACAS sold Contec Holdings Ltd. to Bain Capital, says something about the flow of ACAS' portfolio company exits as a source of cash. The question is how much cash flows directly to ACAS, and how many such deals ACAS works out in the quarter. November 10 should provide some valuable education in the reality of ACAS' ability to create liquidity from deal flow.

In the meantime, ACAS is at record lows. Whether this proves a bargain or not likely turns on the evidence adduced November 10. For my part, I added shares in an IRA at 11 today, so you know how I expect this to turn out. However, market mechanics will continue to rule trading prices until the market participants become less fearful and less illiquid: it'll be much easier to sell than to buy.

Tuesday, October 21, 2008

Modest Marginal Demand/Supply Changes Cause Big Price Changes

The demand for petroleum in the world hasn't dropped over fifty percent in the last several months, but the price has. Once over $150 a barrel, oil recently traded under $70.

The price of a barrel of oil at a given moment isn't determined by some economic calculation predicting its downstream economic impact, but by the demand that exists for the last barrel offered for sale. The marginal demand -- that is, the hunger for that last barrel offered for sale -- is what sets prices. Trucking companies are going to deliver food across America regardless what happens on Wall Street. Commuters will get to work, and children will motor to school. Power plants will keep making power, and home heating units will keep heating homes. Most of the demand continues.

However, when drivers are inclined to make fewer (and fewer) discretionary trips, those unburned gallons of fuel begin to dampen demand for petroleum being pumped worldwide at sellers' best possible speed. The American decrease in driving -- over fifty billion fewer miles driven since last year -- mostly impacts gasoline demand (explaining in part, perhaps, why Diesel remains relatively costly). But it definitely impacts what people will bid on yet another barrel of oil offered for sale at a given moment.

The balance of marginal demand against marginal supply is the reason d'ĂȘtre for market-manipulating schemes like the Organization of Petroleum Exporting Countries (OPEC), which tries to keep prices high by limiting production. (The fact that production is limited because of terrorist attacks on production facilities in the Middle East, and incompetent management in Venezuela, and not in fact orders from OPEC bosses -- and that the producers are largely incapable of producing any faster than they presently produce -- is an entertaining observation about the organization's current utility, but says nothing about the reality of producers' ability to manipulate prices if they did agree to limit production.) Artificially manipulating supply to game pricing in the face of a relatively constant demand is attractive if cooperation is available among suppliers.

The reason that markets for goods "work" in the sense of producing "rational" prices is that, in the absence of manipulation, supply and demand check each other: if demand falls enough, the marginal cost of production will make further production a bad bet, and production will fall. Equillibrium is restored not by economic modeling of the intrinsic value of the goods for sale, or predictions about the goods' utility, but by the simple action of supply and demand "responding" to one another through the self-interested business decisions of market participants.

This doesn't mean that markets "work" all the time, though: where manipulation exists on either side of the equation, prices will move to wherever the market plus the manipulation cause marginal transactions to be priced. The ability of vendors of intangible goods on securities markets to "sell" securities without ever delivering them, with no cost of production, ensures manipulative pricing will continue until the law is enforced. The law, of course, is that securities sold in the marketplace must be delivered to the buyers. This, of course, isn't enforced, or lists like this would be very short and would not have the same securities on them month after month. It's not like the exchanges keep these lists secret.

The fact that a slight depression in demand can cause petroleum prices to drop by over half in the space of a few months offers us some insight into the scale of the value destruction potentially at work in marketplaces in which sellers artifially inflate supply by enjoying freedom from any actual requirement to deliver the things they are selling. By mopping up genuine marketplace demand with bogus sales that never result in the delivery of securities, bad-faith sellers who don't own the securities and make no effort to obtain them even by borrowing them can have a significant impact in the markets for some securities.

Securities like Sears Holdings, which last month was short-sold for over 55% of the stock's entire float, remains vastly manipulated with "only" 40% of its float short-sold. Imagine someone added 56.81% to the world supply of collectible automobiles overnight -- production runs of 100 cars now suddenly have 155 specimens on offer, for example. Exactly what, do you imagine, would happen to the price of the next one offered for sale? It's not like the holders of those extra 56.81% of Sears Holdings will ever get to vote -- the company can't count votes for more than 100% of the outstanding shares -- it's hard to see what a buyer of a non-delivered security gets, other than the possibility of becoming the next seller to fail to deliver. It's a fraud.

In the case of OPEC, where supply is (in theory) constrained by cooperation, the supply manipulation is geniune even if it's not the natural behavior for individual market participants (a fact that explains why historically, OPEC members routinely produced over-quota). In the case of naked shorting, it's illusory supply added to a market whose buyers can't know -- because their intermediaries conceal the sellers from the buyers -- that they are being cheated. In the end, it's the market as a whole that is cheated, by destroying the price on which participants are encouraged to rely as the "correct" price for a particular security on a particular day. In the case of a short-oversold stock, it's a price that makes holding look like a loser's game, and drives out investors in favor of a security that displays a more optimistic price.

Monday, October 20, 2008

Getting Harmed Without Firearms

Korea just suffered an arson-plus-stabbing attack that killed six and injured seven. It's not the first time this sort of homicide has taken place in an industrialized country in Asia. Earlier this year, a Japanese man plowed his truck into a pedestrian-filled intersection and assaulted passersby with a knife. The attack, which killed seven and injured ten, came unusually close to home: my relative had crossed the same intersection with her daughter in the Akihabara electronics district just hours before the killings occurred.

These attacks aren't just an Asian phenomenon fueled by lifelong martial arts training. A "wave" of knife crime in the United Kingdom has killed twenty teens this year in London alone. The United States isn't without exposure to knifing fatalities, either. One woman, who stabbed the same husband two hundred times (naturally, he died), is hoping to get a new trial. Seven years ago, a single attacker on a California knifing spree killed five family members before disappearing with his three-year-old son (whom he later also killed, for a total of six knifing homicides; he finally committed suicide in police custody, but that death did not involve a knife). Later that year, nineteen men armed with boxcutters caused the death of over three thousand in New York and the District of Columbia when they added to their on-aircraft boxcutter killings the people trapped in buildings into which they then collided the aircraft.

Americans' disagreements about firearms policy seem to blind them to the larger problem of violence, which is that people who want to cause mayhem are free to select the tools of their choice. While her daughter looked on in horror, one angry Texas woman did doughnuts atop her cheating husband in a hotel parking lot with her SUV. It's not like cars are either hard to come by in this country, or require great strength to use. Mayhem is only one pedal away.

Safety isn't about the lack of tools of mischief. Safety is about a culture whose values don't escalate avoidable conflicts. To the extent we are unhappy with violence -- whether it involves firearms or not, whether it involved strangers or family members, whether it is fueled by religious hatreds or ethnocentric supremacy theories or despair over economic threats and the death of one's life's dreams -- we should be looking to solve the problem of the people. Jurisdictions with radically different laws on weaponry have violence problems at least as bad as exist here.

Jurisdictions with nominally mandatory firearm possession don't seem to be at particular risk of violent crime. Twenty-five years murder-free, Atlanta's neighbor Kennesaw has a high firearm ownership rate that has fallen to 50% as the town has grown, while lowering its overall crime rate -- a rather better result than Morton Grove, Illinois earned after passing a gun ban. The murder risk in Switzerland is not alarmingly high -- though males from 21 to 32 all must keep an M-57 automatic rifle and 24 rounds of ammunition at home. (Older males below retirement age are in the reserves, also able to access military-style weapons.) Something beyond mere convenience drives violent crime.

Long touted as evidence that gun control reduces violent crime, the United Kingdom slowly surpassed the United States in its rate of assaults, robberies, and thefts; Scotland's non-homicide assault rate is now higher than than the 2.4% rate shared by Australia and New Zealand, which is exactly double the rate in the United States. (Unless I misread the numbers, however, the U.S. still leads all three in murders.) Meanwhile, the Vatican seems to have more criminal cases than residents -- though this is surely an artifact of its enormous non-resident tourist population and the petty thieves who prey upon them. There's serious disagreement about the impact of weapons legislation on violent crime, making it an ideal field for serious policy research.

When Scotland announces plans to strengthen knife control legislation, perhaps it's barking up the wrong tree. Perhaps the problem, like vehicular mortality in the United States, has cultural roots that require a national change in attitude and a broader public health intervention than a mere uptick in the mandatory minimum sentence.

Saturday, October 18, 2008

ACAS' DRIP Pops Price

On October the 14th, when ACAS issued its dividend, the price of the shares popped past $17 during the day. As ACAS paid a couple hundred million dollars in the form of a cash dividend, shareholders participating in the company-offered dividend reinvestment program (DRIP) had their millions plowed into the shares. Unless the shares trade at such a premium to the net asset value that the reinvestment shares are issued by the company rather than being bought on the open market, the plan administrator has the authority to spend up to thirty days making open-market purchases for DRIP participants. Based on the DRIP reinvestment price of $15.936 and the fact these shares are already in participants' accounts, it's clear the administrator didn't wait long at all to buy the shares -- but immediately rushed out to make purchases, and bid the shares up materially in the process. The $17 price hit Tuesday wasn't seen again since. Over the rest of the week, they slid below $15 again.

Myself, I didn't observe this. My broker TD Ameritrade, which has silently dumped me from the ACAS-run DRIP before, did it again. I only learned about the ACAS reinvestment price from a friend with shares in two accounts -- one in the ACAS-run DRIP, and one in a Schwab-run DRIP. The Schwab-run DRIP systematically purchases shares the day following the dividend, and makes all these purchases at ten o'clock in the morning. You can see the share price flicker up a bit as the buy order hits. This so irritated my friend that he started signing up accounts for the ACAS-run DRIP, having seen that I got a slightly better price.

Well, in the past, anyway. When ACAS trades at a 10%+ premium to NAV, ACAS doesn't buy back shares at the market but issues shares to DRIP participants at 2% below the market price (which is above NAV, and is accretive rather than dilutive to existing owners' net asset value). Below this level, ACAS has a plan administrator buy shares for DRIP participants. At market, ACAS can obviously make purchases at better prices than Schwab's 10AM purchase system (as in the past), or worse (as this time; $15.905 < $15.936). This difference seems immaterial, though -- it's less than 1% of the purchase price. Below NAV, where the bet is that returns on higher-than-trading-price NAV will result in outstanding returns, this slight difference doesn't seem likely to move the needle on shareholder returns. Above NAV, the 2% discount to market value seems small but likely to add up over time. I've bought above and below NAV, and when I have to buy above NAV I enjoy getting at least a little discount to market value. With TD Ameritrade having mucked up my DRIP participation, I will be manually entering trades in my regular account and a series of tax-advantaged accounts -- and will be unable (due to whole-share purchases) to invest the exact amount of the dividend. In tax-advantaged accounts (to which I am limited in making at-will capital additions), this means I'll end up with some "extra" money earning a slight fraction of a percent in a money market account. Ugh. The only silver lining is that the current per-share price, being about $2 cheaper per share, may allow me to get a bigger bite for the same invested funds. I will be looking to turn the DRIP back on, but I'm worried that TD Ameritrade has dumped accounts from ACAS' DRIP before. When TD Waterhouse merged with Ameritrade, I was told the problem was due to the switch to the new systems. This current problem can't be attributed to anything so easily understood. Further, getting these accounts all set up on ACAS' company-run DRIP -- the only opportunity for below-market reinvestment -- takes a lot of time on hold with the reorganization department, or folks talking to them. I'm thinking I need to find a broker with more consistent service. The upside here is (a) TD Ameritrade has credited me a trade to cover the manual purchase of shares that should have been bought automatically, and (b) my reinvestment price will be better, so I will get extra shares for the money -- shares that will be paying me a dividend for years to come. Since these dividends are not only growing in per-share amount, but are reinvesting, I take consolation in the discount. Other note: shorts seem to have reduced their ACAS exposure to about 16%; short interest has dropped from 39 million shares to less than 34 million. Maybe actually paying these dividends will start to hurt after a while :-) The money made as ACAS plummeted from $44 to $14 may make a good cushion, but from the perspective of prospective returns, I'd think that folks short now are betting not on mere price erosion but on the complete failure of the firm. The folks short now -- when the dividend amounts to nearly 30%, and not the under-10% yield offered over a year ago -- seem to be playing chicken with a management team with a track record of strong execution and the ability to make deals happen in nasty environments. Indeed, the ability of ACAS to make lucrative deals seems to have been aided by the cash crunch: selling Contec Holdings for 10x EBITDA seems to have been aided by ACAS' ability to both raise senior debt from third parties who trust its due dilegence, and its willingness to hold subordinate (high-yield) debt to show it believes in the company it's selling. ACAS seems, in short, to benefit from good due diligence twice: first, on buying a good growth prospect, and second, on disposing of it to firms relying on ACAS' willingness to hold debt as an indicator of quality.

Thursday, October 16, 2008

Baffling Apple Monopoly Suit Filed

Luxpro, which has suffered from competition with Apple in the market for portable music players, has filed suit against Apple. Luxpro's principal claim is that Apple has injured it through illegally creating and maintaining a monopoly, and has used dominance in the music sales business to force customers to buy its music players to the detriment of smaller competitors.

This is so bogus. Anyone claiming Apple has forced people to use its players hasn't been paying attention. The fact that the Luxpro's Original Complaint specifically discusses an Apple effort to dominate the MP3 player market draws attention to the very problem with the claim: anyone's players can play MP3s, and all Apple's players support DRM-free formats like MP3.

  • MP3 files have no DRM, and can't be locked to Apple players as Luxpro suggests;
  • Apple's music player synching software has always been designed to make playable files of any music customers already own, including at present the non-DRM AAC (aka MP4) and MP3 file formats that can be played without restriction on competitors' players as easily as Apple's own players;
  • Apple's music store sells non-DRM music for whatever tracks it's been able to obtain on DRM-free terms from music vendors, and thus itself undermines lock-in by offering as broadly as it is able file formats that are supported by competing players;
  • Non-Apple stores sell non-DRM music cheaper than Apple sells DRM music for tracks for which Apple offers no non-DRM alternative (say, Dig on Incubus' album Light Grenades, which when I tried to buy it for L was available only for more money and with DRM from Apple, so I bought it from Amazon and have been happy as a clam -- playing the song just fine the whole time on the iPod and on the Mac), meaning that Apple has been unable through its maket position to exercise pricing controls to prevent competition on price -- if Apple is succeeding at selling digital music downloads, it's not because others can't sell songs cheaper or with a non-proprietary interface.
The "Apple locks you in" meme isn't new. It's just strange that anyone who's been to school long enough to learn to read can look at the marketplace and its varied offerings and conclude that Apple (a) forces music listeners to use iPods or (b) forces iPod buyers to use Apple's music store. Apple offers a store that has cost-competitive competition and is compatible with the non-DRM offerings of every other vendor. (OK, if you bought something encoded in Ogg Vorbis, you might need to use an MP3 converter; but if you bought Ogg Vorbis, you know that and aren't bothered about it.)

The real story in Apple's music store is that it was a defensive measure to avoid being barred by proprietary file formats from selling music players and content editors without being forced to pay competitors a licensing fee. The fact that Apple's defensive move put it at the top of the digital download heap hasn't exactly caused it to roll in profit, either. The store's margins are slim -- and intentionally so -- to prevent competitors from having much room in which to undercut Apple while establishing a moat with Apple-incompatible DRM.

Unable to prove Apple had an evil motive (it was just trying to protect its backside from Microsoft), or that it wields pricing power in the music business (competitors are able to sell the same thing for less, with less restrictions by suppliers), and unable to prove would-be music buyers get locked into Apple hardware (the numbers on the amount of music Apple sells per iPod make this pretty plainly a bunch of bunk), Luxpro seems up the creek without a paddle proving antitrust wrongdoing. All Apple's done to acquire and maintain a monopoly is to build attractive music players and make them as easy as possible to enjoy with customers' music collections. The fact Luxpro got crushed when the industry faced serious design competition from a solvent competitor able to buy parts in bulk isn't Apple's problem. Maybe Luxpro could have improved its margins by shucking compatibility with Microsoft's DRM scheme ....

The Jaded Consumer gives this suit an 'F' and predicts a slow death in federal court, where there will be no way to prove Luxpro's claims of illegal conduct, or to prove Apple's conduct caused antitrust damages to Luxpro.

Monday, October 13, 2008

ACAS: The Liquidity Acid Test

Tomorrow, American Capital Ltd. (ACAS) will have to show the world that, despite a market cap under $3 Billion ($207 million shares outstanding, and a price of about $14 a share today, for a market cap of about $2.9 Billion), it can pay a declared cash dividend exceeding $217 million (based on a $1.05 per-share dividend and 207 million outstanding shares).

The Jaded Consumer is among those following ACAS who have considered liquidity to be a major concern in determining its ability to continue executing successfully. Since ACAS' investments are illiquid and its leverage is circumscribed by both regulatory limits and lender covenants, ACAS could theoretically be forced to de-leverage if asset values fell in line with a dismal market. Last quarter, ACAS reported $0.95 in realized earnings, below forecast due to transactions delayed from the second quarter into the third quarter. Nevertheless, management forecast a deal flow fully adequate to satisfy ACAS' liquidity needs and revenue projections, and went so far as to forecast rolling $500 million in 2008 taxable profits into 2009. (Taxable income is the metric that drives ACAS' dividend policy, which results from the company's tax status as a BDC; this status enables it to pay dividends from pretax income rather than after-tax income.) On the basis of this deal flow, management projected adequate liquidity. ACAS' last-quarter cash flow also offered reason for optimism.

In keeping with ACAS' de-leverage program over the last year or so, in keeping with ACAS' OpEx control (ACAS consolidated its San Francisco office into its Los Angeles office), and reflecting its relatively light debt load, management announced in its last quarterly conference call that it would be reducing the size of its lines of credit. Credit line reductions have some beneficial impact to ACAS: it lowers the amount of credit on which ACAS must pay commitment fees to maintain the line of credit (an operating expense) and it reduces the capital requirements ACAS must maintain as a condition of keeping the line of credit (protecting ACAS from liquidity crisis in the event of equity value declines). ACAS subsequently shrank a $1.3 Billion secured credit facility on renweal by amending it to $500 Million (freeing from encumberance some of the debt instruments securing the line and feeing them for sale, or else reflecting their impaired market value; the unsecured credit line costs 0.50% to keep open and LIBOR+2.50% when in use, and had no borrowings outstanding under it at renewal) and shrank an unsecured $1.565 Billion line of credit to $1.409 Billion (the new cost on the secured line is 0.50% to keep open and LIBOR+3.25% to use; ACAS' tangible net worth covenant under the new agreement has been reduced to $4.5 Billion plus a fraction of new funds raised). The unsecured line of credit, though managed by Wachovia, is actually funded by 31 participating lenders. One might view the renewal as a vote of confidence by the lenders in ACAS' credit, though it's also worth noting that the commitment fee quadrupled and the spread payable on borrowings under the facility grew by nearly 28% (from 0.90% to 3.25% above LIBOR). It's possible that the cost of borrowings increased in part because of the elevated cost to financial institutions of borrowing; perhaps they themselves can't borrow at LIBOR under these financial circumstances, and are passing the cost along.

The Story Behind The Credit Reductions
ACAS surely didn't go on purpose to its banks to renegotiate its cost of borrowing up. Management explained when it shrank its secured credit line that ACAS was operating at a steady state, and could re-invest proceeds of transactions into future transactions without needing the higher prior credit limits. This sounds nice, but the truth of the matter is that (a) ACAS' ability to obtain liquidity from deals is more speculative than from established banking relationships, and (b) in 2Q2008, ACAS was already experiencing unexpected deal closure delays, moving $0.12 in net into 3Q2008. The idea that material 3Q2008 deal flow could be delayed into 4Q2008 raises liquidity concerns.

ACAS announced last quarter a Net Asset Value of $27.01 per share, for a net asset total of $5.59 Billion. Since ACAS' investments are not generally susceptible to exchange on in a liquid market, most of the reported asset values derive from models that look to the values of comparable assets. After last week, one wonders at what price comparable assets might trade, and what this might do to ACAS' debt:equity ratio.

Liquidity Nightmare At ACAS?
American Capital Ltd. uses leverage to invest -- though less than banks -- and this leverage is subject to regulatory limits. Investors might liken this to the margin limit in a brokerage account: if the asset valued dwindle, something must be done to decrease the leverage. The nightmare case is that illiquid assets in a fire sale would be liquidated for a song, leaving ACAS broke in the aftermath of a liquidity crisis.

The way a margin account works is this: the investments and borrowings against them have a certain maintenance requirement, and as the equity in the account plummets during a protracted panic, the investor gets notified that if money isn't forthcoming, the broker will begin liquidating the account's assets to bring the account into line with the maintenance limits. Looking at ACAS' last-quarter net asset values and the size of its commitment fee, one applying this model would conclude ACAS must have been in effect about one billion bucks away from a margin call. Thinking about the movement of the markets since the last quarter, and the illiquidity of ACAS' investments, one might imagine that valuations based on comparables might have dipped over 20% with the rest of the market last week, leaving ACAS well below its promised asset levels. Unable to borrow under its credit facilities, desperate for cash from operations trying to run during a recession, and possibly suffering more deal delays due to a broad-based liquidity crisis, one would conclude that ACAS is probably broke.

We know from the questions and answers in the earnings conference call for the second-quarter of 2008 that one reason ACAS sometimes has both substantial cash and substantial short-term borrowings on its books at quarter-end is that it needs cash to pay its dividend -- and often has just reinvested capital in an attractive deal. If ACAS didn't succeed in achieving its liquidity goals, or lacks the covenant-specified assets to make use of its credit facilities, ACAS won't be able to pay its dividend tomorrow.

ACAS Doesn't Have A Margin Account
American Capital Ltd. doesn't have a broker looking over its shoulder on a daily basis waiting to execute immediate forced liquidations depending how ACAS' holdings seem to be valued on a daily basis. Management has also made clear that liquidating some of ACAS' investments takes something on the order of seven months. There is no emergency liquidation market for ACAS' holdings, and no authority for external forces to cause a liquidation.

Moving $0.12 of realized income from 2Q2008 into 3Q2008 doesn't mean ACAS moved $0.12 in liquidity into 3Q2008. ACAS moved to this quarter realized net in the amount of $0.12, which means ACAS receives not only the net this quarter -- the $0.12 -- but also any of the principal ACAS didn't choose to finance. ACAS made clear that management is not desperate to finance bad deals to get them closed, but that are outbid in financing them half the time. Moreover, ACAS' deal flow is a two-way street: ACAS need not enter deals any faster than makes sense, and can sit on its hands if need be as it waits for deals to come available on terms that are adequately attractive under all known existing circumstances.

ACAS has already announced a several profitable exits this quarter ($37 Million from PaR Systems, $57 Million from Contec, and $36 Million from SSH Acquisition), presumably facilitating substantial gross receipts even after providing financing to buyers in two of the three deals. ACAS' liquidity will depend on ACAS' hunger to reinvest in its currently-available deals, which may be tremendous. On the other hand, there may be a tremendous deal in ACAS' own shares.

ACAS Attractive
If ACAS were to repurchase 15% of its outstanding shares -- at $15, this would cost $465 Million, within the remaining amount in the $500 Million share buyback authorization -- ACAS could increase operating income per share nearly 18% -- for example, from $0.71 to $0.84. The net realizations per share from investments would similarly improve. A 15% reduction in outstanding shares bought below NAV would increase the net asset value for the remaining shares, and offer substantial future magnification in gains in NAV associated with eventual improvements in the economy (and thus improvements in the trading prices by which ACAS' asset values are estimated). Because the shares trade at a discount to NAV at present but traditionally trade at a premium of 1.4x NAV, the share price impact over time should be substantial. Improving NAV from a hypothetical $25 to over $29 would be a substantial boon, given the likelihood within the course of a year or so for ACAS to trade at at or above NAV. At $15, a share buyback seems to offer both excellent medium-term return and a great opportunity to protect ACAS' coverage of the dividend.

In the first quarter of the year, when the $500 Million share buyback authorization was new, ACAS had few trading days in which it was not barred from trading. Management said on the confernce call that they wished they'd been able to buy more shares in the twenties. During the 2Q2008 conference call, ACAS' management said that during the time shares traded at a discount to NAV, there were no days ACAS' compliance officer would authorize management to make share repurchases. There's no way to tell when or if ACAS would be in a position to buy back more shares, even if there were adequate liquidity to do it. However, even a few trading days in the teens should permit meaningful share retirement. With shorts again holding positions exceeding 19% of the float, effectively flooding the market with additional shares and depressing the price at which they are exchanged, management at ACAS has an excellent opportunity to concentrate value in shares. This would improve the value of both shares held by insiders (just over 1%), and the value of the shares held by those whom management wishes to reinforce that it will continue to provide a long-term value -- the very people to whom ACAS intends offering newly-issued shares above NAV in the future.

If ACAS can pay its dividend tomorrow, we'll know ACAS isn't out of money. The people on the DRIP will be buying shares near $15, and looking forward to a quarterly dividend of over 7% next month -- a dividend that, without increase, would yield over 28% a year. If ACAS is free to buy shares near this price, and prefers it to getting over 40% annualized returns on investments that work while risking the occasional dud when it invests in an unsustainable business, investors will see some stability increase in earnings as income from portfolio companies' operations grows on a per-share basis. If ACAS' liquidity is really good, we'll see both solid deals from this quarter and a meaningful share buyback.

American Capital has been lauded by its management as the top of the heap in middle-market buyouts, and a king of private equity deals. Although its track record has been great since inception -- if it went to zero after paying the dividend tomorrow, original investors would still have doubled their money -- this financial crisis offers a situation nobody on the ACAS management has previously weathered. (Buffett is older, and said he finds the market sentiment more fearful at any time in his adult life.) American Capital has come through hard markets before and claimed in the last conference call that it was in a better position to profit from this one than it was when the Internet bubble burst.

Tomorrow, we see whether the Emperor has any clothes.