Friday, October 24, 2008

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.


Anonymous said...

Does the ECAS price drop scare you at all with the notion ACAS will have to re-value and be in violation of debt covenants?


Jaded Consumer said...

Not just ECAS, but all the comparables against which ACAS' holdings are priced. ACAS has debt outside the recently-renegotiated line of credit with the ~$4B covenant, but suddenly having to close that down would again be a liquidity problem. ACAS' near-term future depends on management's correctness about the company's prospects for liquidity.

November 4 will be interesting indeed.

Anonymous said...

I can't tell you how helpful your posts are. Thanks so much. I learn something each time and gain a bit more understanding of ACAS.

- a gentle reader

Anonymous said...

Its official! The emporer has no clothes!