Monday, November 10, 2008

ACAS: 3Q2008 Report

In the quarterly announcement, ACAS' management explicitly addressed the liquidity threat created by the tangible asset value in its recently-renewed debt agreement.

Performance for the quarter
Net Asset Value at close of quarter was $24.43, down from $27.01 at the close of the second quarter; the reduction is driven chiefly by FAS-157 writedowns of unrealized depreciation resulting from multiples compressions as the worldwide markets' pricing decreases, the drop in price of shares of publicly-traded companies to which portfolio companies are compared, and the effect of changing interest rates on valuations generated with bond-yield-analysis techniques. Because ACAS is not a bank and is not permitted to carry performing loans at face value, but must re-value fully-performing loans on the basis of market factors that are beyond ACAS' control or that of its paying obligors, the risk remains that these wrote-downs will continue evan as portfolio income remains strong and debt obligations continue to be paid.

Net Operating Income -- a number that will be more important going forward due to announced changes in dividend policy -- increased sequentially from $0.71 to $0.74 per share, though it was down from $.81 in the year-ago quarter. It's worth noting that in 2007, ACAS' operating income involved a rather

Pretax Earnings were $0.98 compared to a projected $1.05 for the quarter; however, because ACAS elected to retain capital gains and was obliged to pay on behalf of shareholders the taxes on the "deemed dividend" represented by this retained amount, the earnings involve a tax charge, reducing the earnings to $0.72. Even the $0.98 is below estimate, though: ACAS expected to close deals that didn't close, and missed out on some realizations as a consequence.

Shareholders of record on September 30, 2008 are entitled to a $0.25/share tax credit (this means when one files an individual Form 1040 for 2008, one is entitled to claim having already paid $0.25/share in taxes above whatever else was paid or withheld for the 2008 tax year), and also to adjust their basis upward $0.49 per share (which only helps at exit). This is a result of retaining long-term capital gains that would have been payable under the prior dividend policy.

Realized Earnings -- the number that drives ACAS' BDC-related dividend-paying requirement -- were $0.72 for the quarter after taxes associated with the deemed dividend and other items.

GAAP Earnings -- the SEC-reported "earnings" that reflect mark-to-market price changes as if they were realized -- were negative to the tune of $2.63, giving rise to the NAV decline of $2.58 to $24.43. Due to ACAS' changed dividend policy, dividends will be driven by NOI rather than net taxable income, and will still bear no definite relation to the "earnings" reportable under GAAP. The GAAP earnings will be as crazily out of whack with dividend-paying capacity later on, when multiples expand and asset values explode beyond actual earnings.

Although ACAS' management claims that its net realizable value is hundreds of millions of dollars above GAAP values, the utility of this measurement seems slight in light of the fact that it represents neither ACAS' current liquidation value for the assets, or ACAS' expected actual return on exit. (The number sounds like that, but when faced with a question last quarter about the losses baked into the non-GAAP valuations given, management said it didn't expect to realize those losses, either, and that it expected the future to hold, in fact, some other undisclosed return.) The non-GAAP numbers are thus not so much a beacon illuminating the coast as yet another siren amidst the rocks, offering only puzzlement.

ACAS' portfolio company exits were within 1% of the prior quarter's valuations. The thesis that ACAS' management is lying about valuations seems further weakened by actual sales performance. This doesn't mean there's not a case to be made against ACAS, but it's not based on malfeasance by management in stating portfolio company valuations. The best thesis against ACAS is the thesis against any financial: the economy is heading into the crapper.

Management believes the company is operating amidst in a severe recession and is conducting itself accordingly, including by de-levering. Valuation drops pushed ACAS' debt:equity ratio back to 0.9:1, and management is working to reduce it again.

ACAS is addressing the liquidity threat with several initiatives
In a return to its older dividend policy, ACAS will retain capital gains (and pay taxes on them) rather than pay this portion of earnings to shareholders. ACAS needs the money to cushion its asset value's distance from bare-minimum debt-covenant levels. Future dividends will be driven by operating income, not capital gains. This dividend policy is far more apt to result in steadily-increasing long-term returns than a policy in which all gains are distributed, preventing increases in invested capital. Interestingly, the incentive of ACAS was reversed when shares ordinarily traded materially above NAV. Under the DRIP at prices well over NAV, ACAS kept more money by keeping pretax capital gains and issuing shares than it did by retaining post-tax capital gains and then reinvesting only operating income pretax. The policy of paying all earnings was sustainable only to the extent that above-NAV share pricing remained the normal state of affairs. In the last year, above-NAV trading has gone from uncertain and unpredictible (between the announcement of a share-buyback program in January due to the below-NAV share prices, and the next trade above NAV, was sixty-one days) to doubtful (ACAS has continuously traded below NAV for months).

Rather than announce in advance a schedule of dividends and stick to it, ACAS has announced that its board will set quarterly dividends after each quarter, based on quarterly results. Consequently, the pre-announced $1.10 dividend projected to be paid for the fourth quarter of 2008 will not be declared as predicted; any dividend to be paid on the fourth quarter of the year will have to be set after the quarter is over. Given management's repeated discussion of protecting capital, I would not expect to see a dividend from ACAS regardless its quarterly performance for some time. The benefit of longer dividend retention is lowered cost of cash: ACAS is borrowing it interest-free until earnings turn into declared dividends. When ACAS' shares traded above NAV, dividends didn't result in loss of liquidity, but in the issuance of shares above NAV. With a share price below NAV, cash dividends sap investable equity and threaten liquidity and drive the company toward the minimum tangible asset levels established in its debt covenants. Do not expect to see ACAS with a pre-annouced all-income dividend again; the procedure of having the Board set dividends following each quarter will place ACAS in the best possible position to game the dividend game on the basis of share price, market conditions, and tangible net asset value. The new policy is wiser and more fiscally conservative in addition to being more flexible.

The ECAS Transaction
Assuming all the necessary approvals are reached, asset volatility attributable to share volatility in ECAS -- whose below-net-asset-value price of its publicly-traded shares has given rise to terrible volatility in ACAS' portfolio value -- will be subdued in a financial engineering exercise in which ACAS will purchase ECAS' outstanding shares in an all-stock (1 ACAS share will buy three ECAS shares) transaction; the result will be the destruction of the NAV discount in ECAS and the increase in ACAS ownership of ECAS, which will mean an increase of about $1.25 per share in NAV for ACAS (and presumably the elimination of expenses related to ECAS' publicly-traded status). The 11.5 million ACAS shares issued in this transaction would bring ACAS' outstanding shares to 218.5 million shares, meaning that the anticipated $300 million in net operating earnings being rolled from 2008 into 2009 for payment of dividends would be about $1.37 in operating income ACAS would be required to declare by the end of June for payment by September 30, 2009.

Tax Status
ACAS addressed a question about its tax status with a long exposition about the fact that BDC status had been good for a long time, and that many investment forms (banks, BDCs, REITs, C-Corps like F, government-chartered entities like FRE, you name it) had suffered during the quarter, and that careful thought would need to go into long-term decisions on issues raised by the last forty or so days. It became clear that abandoning BDC status in favor of treatment as a bank or investment holding company or some other form of investment was not being clearly taken off the table as an option, and that management would continue to evaluate all the options available when deciding how to protect shareholder value in light of developing conditions.

Conclusion
ACAS' share price (under $8 as I write) is less than a third of its NAV. ACAS continues to enjoy liquidity from investment exits, its debt portfolio is performing extremely well for an economic catastrophe such as that we see now (nonperforming loans are less than 3% of marked values), and its net operating income appears strong. The 2008 profits rolled forward into 2009 must -- in order to avoid threatening ACAS' status as a regulated investment company -- be declared as a dividend by the end of June 2009 and paid by September 30, 2009; these appear to be approximately $1.37 per share. Assuming ACAS paid no other dividend in 2008 besides this minimum regulatory requirement (if ACAS retains its RIC status, 2009 profits would face a similar distribution requirement but with dates in 2010), ACAS would still have a double-digit dividend yield in 2009. ACAS' plan to use returning profits to reduce debt will protect ACAS from liquidity emergencies, ensuring that ACAS isn't placed in a "forced sale" position that would destroy the investments ACAS has made, and obliterate the prospect of participating in these companies' return to performance as the economy improves. The slowdown in exits -- and I believe there has been a slowdown in exits, as evidenced by the deal closings that didn't occur, no doubt related to the contraction in liquidity on the part of buyers -- makes ACAS' strong NOI that much more attractive. (ACAS has deliberately invested in counter-cyclical portfolio companies as the recession approached, and NOI continues to look good even though it is dwarfed by FAS-157-related writedowns that haven't been realized as losses and may well never be realized as losses.) As a long-term investment, ACAS at about a third of NAV and in light of its steady NOI seems a solid holding.

Management seemed to warn of expected future FAS-157 writedowns as the economy continues in recession. It's possible that ACAS will consider steps such as abandoning its BDC status and becoming an entity whose accounting enables it to value its assets differently, in order to avoid liquidity pressure caused solely by accounting issues and not by investment performance. (Becoming a bank, for example, would allow ACAS to carry performing loans at face value rather than at a value modeled on the basis of bond yield analysis; being treated as an ordinary C-Corp would enable ACAS to retain earnings like most corporations, and support its value with earnings accretions; and so on.) ACAS is battening down the hatches for a financial storm, and as usual is willing to upset analysts in the current quarter in order to protect long-term interests.

Summary:
Management takes a dim view of the current economic environment and its future, but is impressed by continued performance of portfolio companies, including some selected for being acyclical or countercyclical. Credit market issues will likely cause further FAS-157 writedowns in irs debt portfolio -- not because of credit or performance issues, but because bond yield analysis will drive down current holdings' values as credit becomes less available (more costly) to current credit seekers in a worsening economic market. ACAS cannot be treated as a dividend stock until further notice. At one less than one third its NAV, and with new access to earnings for reinvestment and for de-leverage, ACAS' shares represent an opportunity to make a value play at a diversified portfolio of well-managed middle-market companies that are still making good money in a crummy market, and allows participation in a diverse debt portfolio.

In the short run, more scares lie ahead. In the short run, multiples compression and debt-revaluation on the basis of bond yield analysis will continue to threaten equity levels, requiring earnings retension and forcing debt retirement. Expects shorts to return in droves, no longer fearful of having to cover ACAS' dividend as they bet on a financial meltdown at ACAS. In the long run, this company will do extremely well on investments made at a bargain and as holdings are re-valued in economic environments that support higher P/E multiples.

6 comments:

Anonymous said...

Monday was truly a black day. Now, with your usual thoughtful analysis, Tuesday -- even with continued weakness in stock price -- is looking a bit less grim. Thanks!

Jaded Consumer said...

re Black Monday:

Some thoughtful observers were less excited than I was about Monday's action, to be sure -- and there's no guarantee that management's effort to position the company against an economic tsunami will ultimately succeed. My confidence in management is based largely on (a) my observation that management has been willing to blow quarter numbers in the short term to avoid bad long-term positioning (as with Merisel and the first-quarter conference call of 2007), (b) management's success in growing EBITDA in portfolio companies, and (c) -- related to (b) -- ACAS' seemingly steady operating earnings.

The Enlightened American has announced loss in confidence in management. If you believe as he does that management has been dishonest (I think I read him correctly to conclude this), then you should find a nice alternate non-dividend-paying holding company full of good investments, like Berkshire Hathaway (which is unleveraged and contains significant non-cyclical holdings) and put the money there. The B shares are below $4k and not a bad buy, in my view.

I just think ACAS will explode better out of a turnaround than BRK.B; the bond yield analysis that is killing the FAS-157 valuations of ACAS' debt holdings will make ACAS look like conquering heroes in three years when credit is loosening again. BRK.B has had hundreds of millions in derivatives losses and bad assets on the books -- it's just that on Berkshire's books, these are insignificant next to the cash created by GEICO. Some of ACAS' losses -- like those in interest rate derivatives -- won't come back. Some of the portfolio companies may just fail. Overall, though, I think EBITDA in portfolio companies in the aggregate will continue to be managed well with the assistance of ACAS' operations team, and ACAS' additional due diligence team (which it didn't have during the last recession) will in my view prove to have protected ACAS from numerous investments that really would not perform.

I think ACAS' investment selection has improved since the last recession, and that ACAS will prove its investment acumen over time. Meanwhile, expect shorts to swarm like sharks now that it's a cheap short to approach.

If de-levering requires more liquidity than ACAS can bring to bear, expect ACAS to change its business form to one with accounting rules that are less harsh in the treatment of fully-performing loans' valuation, abandoning BDC structure if need be.

Management appears to have every option on the table. If the economic environment becomes as dire as they seem to convey they believe, they may have to do wild things to survive. I have confidence that ACAS will survive, though.

The questions are (a) am I mistaken about the quality of management, (b) is management incapable of managing the unknown risks and challenges ACAS will be thrown by what is thrown from beyond the veil of the unseen future, and (c) will shareholders be better of in ten years if they had liquidated this morning instead of holding?

There are several companies that interest me, but honestly I can't say with confidence which are better positioned to rock in miserable economic times. Apple is a consumer electronics company, for example; how will that do in a protracted depression?

In a later post, I'll discuss diversity. Especially in highly uncertain times, avoiding over-exposure to one risk is worthwhile. The question is how to do it without getting involved in under-researched investment ideas that you won't know have become strong exit stories. In short, I want to talk about diversification for lazy people. Hint: ACAS' international collection of portfolio companies plays a role in my diversification thesis.

Thanks for Visiting, and Happy hunting!
--J

peachberry_tea said...

The thing I hate about ACAS is that it's opaque. You really can't see how the portfolio companies are going, and it seems like management won't say anything in reassurance except they're "continuing to perform".

The fact that they confirmed the dividend a few weeks back, and now all of a sudden this - this certainly shows cracks in their armour. Assuming management really believed that they would be able to fund the dividend a few months back, the only thing that could've caused the dividend to stop altogether is that some of their investments exits have seriously turned sour. Which again points to the health of ACAS' portfolio companies. I think this and the possibility of a prolonged recession should have ACAS investors worried.

I listened to the conference call and it didn't sound anything like ACAS management was letting the quarter's numbers go to hell for the long term good of the company. To me it sounded like they screwed up big time and they didn't exactly just come out and admit it. I had a lot of faith in management with the deleveraging they've done, but today I didn't get the impression that management was being honest and upfront. With a black box company like ACAS, again, this should be cause for worries for shareholders.

So there is a lot of uncertainty with regards to ACAS. I'm not sure that it deserves the valuation it does ($6 a share now) but then again, even firms without this uncertainy are priced this way at this time.

I honestly think your analysis of ACAS has been excellent. But as to what to do with one's money in this market, there are certainly better places for your money than ACAS. That would be my take on this.

Kawa said...

Thank you J for your consistently insightfull analysis and comments. I look forward to your lazy diversification as well as I have positioned my funds into different asset classes mainly through ETF and CEF but also through individual companies such as AAPL, NLY, when I'm relatively familiar and think it will outperform its peers by a good margin. ACAS is one of the individual companies I hold (for a small position) but relatively not familiar due to a lack of better private equity asset class choices (PSP is more general but I don't have confidence in a lot of private finance equity companies, such as Blackstone due to its employee-favored terms over shareholders).

I would appreciate if you can share some insights on my following two questions:

1. Missing dividend payable- I thought a company incurs a liability when the board declares a dividend; so even though the record date of Q308 dividend is in October, I still expect to see a dividend payable line in its balance sheet dated 9/30/08. In the conference call when being asked, they replied that GAAP doesn't require it, but the analyst can do their on calculation and trade the stock themsevles; I'm a bit concerned/confused why they choose such response.

2. Management credibility and NAV- I have no problems with cancelling the dividend to weather this financial storms with better capital position; I am delighted to see their NOI results; I think they have managed well given the tough mark to market and bond yield analysis rules. I can see the NAV for Q408 might go down another $1000M (20% down with market, 200M of dividend?, offset by realized gains and potential increase in NAV due to ECAS deal); however, I also think they'll successfully amend their ~1.3B credit facilities with Wachovia even though the covenant is breached. All in all, what is your view of a potential NAV range and why are many people stating management is losing their credibility?

Many thanks,
Starkawa

Anonymous said...

J, with the price below 6 dollars are you holding your position or are you adding to it?

Jaded Consumer said...

Thanks for the comments. I spent last quarter and some of October aggressively fighting to de-lever so I didn't get crushed like a bug as the market tanked. I frankly haven't got money to add to my position.

Claiming I would isn't helpful, but maybe the insider buying at these levels is of interest.

To keep up with my ongoing comments on ACAS, try this link.

Best regards,
--J