Wednesday, November 12, 2008

Responding to ACAS 3Q Comments

Thanks for showing up and taking the time to comment. The third quarter definitely got people's attention, and mostly for the worse. ACAS presented today at Merrill Lynch, and you can catch both the presentation and the Q&A on webcast. Make sure to look at the slides.

Kawa asked:
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.
I was sort of surprised that when this question came up, the discussion turned to a discussion of materiality. I think the questioner and the answerer were talking past one another. I certainly can't explain why the questioner was fixated on an unpaid future dividend that had not gone ex- by quarter-end when he seemed to agree it wasn't an enormous amount of money, or why it was important to the questioner that management express an opinion on accounting that might be required under Delaware law. I also can't explain why -- other than hypothesizing unpreparedness due to surprise -- management chose to tell the analyst to go build his own pro forma financial statementss and to value the stock on their basis if he didn't like the accounting ACAS believed required by GAAP. I tend to suspect management didn't understand the question as having any purpose than to allege the balance sheet understated liabilities, which would explain why materiality would be offered as an argument and why home-made pro formas would be offered as a solution.

My own take is that everyone is probably right. Different accounting is used at different times for different purposes. Tax accounting is rather different from the accounting that is used to gauge internal performance (some of this internal performance accounting, particularly within portfolio companies, might not even use currency units as its functional unit of measure), and the accounting required by the SEC is surely different than the statutory accounting that might be required by Delaware law. With respect to state-law accounting schemes, I offer a little perspective: insurers are required to apply a statutory accounting scheme that values assets with huge discounts to the values of liquid investments. This doesn't mean that the insurers must report these values when filing GAAP financial statements with the SEC, this simply means that the insurers must balance their books with the statutory accounting tools and have these books ready in case they are demanded by someone making a lawful request for inspection of the state-law accounting. You probably will never see these accounting products for any insurer, because they are different from the accounting required by the SEC and aren't required to be made publicly available. It's not fraud, it's just different accounting. Indeed, publicly-traded companies don't show the public the tax accounting they do, and they all do tax accounting in addition to the SEC-required disclosures. Moreover, if investors reading financial statements filed with the SEC expect the statements to be comparable, it's important that some standard -- even one with clear flaws -- be used across the board. No matter what Delaware would want an accounting produced (say, in litigation over the value of a closely-held corporation) with one set of rules and effective dates for future payment obligations, it's clear that whatever standard obtains with the SEC is what should be in SEC-filed statements.

I don't pretend to have special expertise in accounting for future dividends -- I've never declared a dividend or accounted for it -- but there are explanations more plausible than "evil conduct" that have the advantage of also explaining all the observed conduct.

All these accounting principles have a purpose, all have some legitimate use, and all give different numbers. The reason I bash FAS-157 is that it tends to cause strange problems unconnected with investment performance. Warren Buffett doesn't have to report from quarter to quarter what GEICO would be worth if he had to liquidate it, and he doesn't have to report what that Israeli tool manufacturer would be worth if liquidated. Berkshire Hathaway accounts for these in a much less responsive fashion, and the best you can hope for is to see earnings. The book values BRK gives for acquisitions are simply not numbers you can trade on. Indeed, reading Buffett's letters, it's clear that some of the numbers Berkshire has published (or, has been required to publish) are straight-up fictions -- whether done to appease accounting standards, or whether discovered after the fact as hard-to-value assets' values became clearer. The difference is that with fewer assets Berkshire must mark to market, the effect of comparables pricing isn't visible.

Also, since Berkshire isn't levered (it entered the financial blowup chock full of cash), and isn't regulated to 1:1 leverage, nobody is worried about Berkshire having a liquidity problem brought on by net asset value throwing debt-to-equity ratios into chaos. The fact that organizations that aren't BDCs can avoid some of the liquidity challenges ACAS faces are a reason Malon Wilkus gave a long and rambling answer to the question about BDC status: BDC status is great for some things and has done well by investors, but it also creates problems.

Then, Kawa said:
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?
I'm not sure how banks will view amendment's to ACAS' credit line. I think ACAS wants to maintain a big credit line so that as the current multiples compression expands, and as bond-yield analysis begins re-inflating ACAS' debt holdings' value, ACAS will be able to quickly produce cash to make attractive deals even if share price remains below NAV. Therefore, I expect ACAS to try as long as possible to cling to the current credit facilities. It wouldn't take much more abuse from the marketplace (in terms of FAS-157 valuations using bond yield analysis and comparables-based pricing) to bust the current debt covenants. I think management recognized that, which is why I believe Wilkus brought up operating with no leverage at all while answering questions. He's looking at the possibility of disaster on the horizon, and planning accordingly.

Management's credibility has taken a hit for several reasons. First, the stock price last summer nearly hit $50, and it's threatening now to scrape $5. People are scared. Yes, ACAS announced a NAV close to $25, but let's face it: on the date that NAV was calculated, the share price was close to $25. Heck, the NAV was just under $25 and the price was just over $25. And the share price is now about $6. Management's comment that ACAS was trading above NAV at quarter end tends to frighten people into wondering about present NAV -- a topic ACAS didn't provide insight on because calculating NAV for quarter-end takes lots of time for a three-digit number of people, and ACAS doesn't calculate NAV for any other purpose. However, failing to deliver a current NAV number leaves the door open for frightened investors to speculate that ACAS might still trade above NAV. But perhaps the biggest reason management has taken a credibility hit is management's own rhetoric. ACAS has long pointed to its dividend as evidence of ACAS' ongoing and increasing profits. ACAS has repeatedly stated that the paid dividends are a performance measure that cannot be faked in the marketplace and cannot be restated. ACAS has essentially instructed the public to look at ACAS' dividend as proof of management's competence and good faith. Cutting the dividend simultaneously admits that management was mistaken about its ability to set dividends at levels that would never require reduction and reduces to zero the performance metric management had been holding out as the gold standard and indisputable proof that management continued to execute successfully on behalf of shareholders.

The concern about management is therefore not without basis. However, management could have done what others have done and cooked the books -- but did not. Management produced the ugly numbers of increased debt:equity, and published the unvarnished FAS-157 writedowns exactly as required by the regulations governing its structure. Moreover, management didn't say that it had everything in the bag and all was hunky-dory, it admitted frankly its view that the economic situation was likely to continue forcing write-downs as multiples compression and bond-yield-analysis painted worsening pictures of existing holdings even though they performed as underwritten. In other words, ACAS openly stated that there is no good-case surprise scenario in which its effective due diligence would protect the company from writedowns: it repeated that regardless of credit quality, the existing accounting rules would cause ongoing mounting of paper losses provided the economy continued as badly as management expected. This kind of brutal honesty -- which as ACAS' chart shows does not help share prices during the quarter and doesn't set up ACAS to issue equity above NAV -- is not what one expects of a management that is out to cheat its shareholders. Openly admitting that ACAS' tax status is a subject of potential future review tends to reassure investors that management is willing to look at every option in order to keep the company operating for the long run, while in the short run driving out investors who invested in ACAS in tax-advantaged accounts and liked getting paid pretax dividends.

Management is clearly looking to the long term and not the quarter, and it doesn't conceal this when it explains its behavior or gives guidance.

Peachberry_Tea wrote:
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".

...

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.
I'm as disappointed as you that ACAS has been slammed like it has. For the reasons I state above, though, I don't think the 3Q2008 quarterly conference call or the subsequent presentation to analysts at Merrill Lynch are indicative of character flaws or of poor judgment. I can't imagine anyone planning to model for a VIX of 90. I myself got slammed as the markets tanked. Being levered less than 1:1 was a great benefit when considering that firms like Merrill Lynch that were levered 40:1 have already failed (Okay, been bought by a bank that itself is on sale and taking federal handouts), and management's prescience to have entered the quarter at even less leverage probably meant the difference between surviving the quarter and being destroyed in a liquidity crisis.

ACAS' willingness to announce it plans to use cash to de-lever is an admission that it will be focusing defensively on surviving for the future, rather than snapping up bargains now in the hope that a quick turnaround will make it possible to eke by with clever accounting. ACAS is really working to reduce its risk, not to play games or pray for federal deliverance. Nowhere in the conference call did I hear false hope offered to investors. ACAS did stress that its assets were performing, but was clear that this didn't protect it from FAS-157 in an environment of severe and widespread financial recession.

Peachberry_Tea also wrote:
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 don't think the only explanation is that ACAS' due diligence proved faulty. Especially in light of the continued NOI and ongoing syndication of senior debt, it seems that the investments are performing and that third-party buyers (who are buying senior debt at par rather than at FAS-157 discounted rates) also see the investments as performing. Rather, the FAS-157 valuation reductions have caused a liquidity crisis of the sort I described in earlier posts (such as after the second quarter's report). With its debt-to-equity ratio regulated as a BDC at a maximum of 1:1, ACAS need not have investments fail to perform as anticipated (i.e., it need not suffer a reduction in operating earnings) in order to face a liquidity crisis. Moreover, the debt covenants create a further cause for concern.

As for the worries facing investors in the form of a prolonged recession: investors in anything should consider worry. Gold isn't safe, as the destruction of so much value by the financial implosion could cause deflation. Debt instruments aren't safe, as the valuation concerns that decrease the market value of ACAS' deb holdings will hit anyone's debt holdings (except, haha, for banks which are allowed to carry performing loans at face value) and credit deterioration could endanger repaymet prospects. Heck, with benchmark interest rates heading into the toilet to make money available in the economy, inflation is a serious risk -- especially as the turnaround gets underway and credit actually becomes available. Many vendors are in danger as consumers threaten to tighten their belts and unemployed people have to hock their belts for bread. Investing in criminal defense or bankruptcy representation might be an angle. Of course, betting on short-play instruments isn't safe: multiples are so compressed and investments are so historically undervalued that one would need great care in choosing an exit, or one would risk being slaughtered as prices return toward historically more common multiples.

On the news I heard that safes and firearms are currently enjoying a sales boom. This is probably a sign that many people view the investment markets broadly as a place to avoid. While this sentiment persists, where will investment come from?

If you have the skill to time the market, God bless you -- it'll be a fantastic opportunity as the market's gyrations unfold. I have no claim to such skill and am simply working to ensure I have no leverage with which a crazed market can destroy my portfolio without my having to have picked poor investments. Interestingly, this seems to be exactly what ACAS' own management is doing: de-levering to reduce risks generated by third-party pricing lunacy.

Although some folks have lost confidence in ACAS' management, and it's certainly worth running for the doors if your investment thesis has been undermined, I haven't gotten there yet. I bought ACAS because Berkshire Hathaway was too big to capitalize on the small opportunities that are ACAS' bread and butter. I wanted a company that was able to find something to do with its cash, and didn't have to sit on tens of billions because no good deals were big enough to bother. Obviously from the standpoint of a short-term trade, BRK.B would have been far superior to the performance we've gotten from the stock price of ACAS over the last year. On the other hand, ACAS turned in $0.74 in operating income last quarter, or more than 10% of the current share price; BRK.A earned just $1335 per share, which given today's $97,000 share price (a 2-year low) is still less than 1.4%. Derivatives contracts weren't much more gentle to Berkshire Hathaway than to American Capital, but just looking at operating earnings, it looks like ACAS is the one in the sweet spot.

Moreover, Berkshire Hathaway has been on a buying spree -- including in financials -- as the market has gone into a panic. Buffet doesn't claim to time markets, he claims to spot deals. The fact that Buffett can find "deals" in companies so large they are worth his time to invest in (read his letters to the shareholers about this; the company just can't make material amounts of money on little deals) offers serious reason to rethink the hypothesis that nobody can find deals, even if they are willing to look in illiquid, hard-to-value, smaller companies. I think this latter class of companies offers a better long-term return. I love Berkshire's management, I just wish they were small enough to make money on the little deals where the explosive growth lay. In the meantime, since BRK.B doesn't have mark-to-market pressure because it doesn't have a requirement to place quarter-by-quarter values on its portfolio companies (it's not a BDC), nobody is going mad over Berkshire's "losses" (because it isn't required to report them as losses; it's just, you know, depreciating goodwill and that kind of thing). Instead, Berkshire has suffered a substantial operating earnings haircut as its main-line business (insurance) comes under pressure. ACAS, which has nearly three hundred portfolio companies, hasn't got this kind of risk concentration in one industry.

Consider ACAS' requirement to apply FAS-157 across the whole of its portfolio with this comment about Berkshire's need to apply it to a couple of classes of investments:
The company has disclosed many derivative contracts tied to the performance of the Standard & Poor's 500 and three foreign stock indexes, and to the credit quality of high-yield bonds. Accounting rules require Berkshire to regularly report unrealised gains and losses on those contracts.
Reuters, "Berkshire Hathaway Q3 Profit Down 77pc"
Instead of having its operating income of $1335/sh turned into a quarterly profit of $682/sh, imagine how FAS-157 would have caused a massive loss as Berkshire Hathaway's performing intra-holding-company loans had to be written down, and the value of its numerous holding companies had to be slashed as multiples compression killed the value of tool makers, ice cream franchisers, print newspspers, and insurance companies. Were Berkshire Hathaway required to apply FAS-157, what kind of haricut do you think it would have?

So I don't think ACAS is somehow bad at managing a portfolio of companies, or has bad investement picks, or the like. ACAS' transparency makes it an easy target for people afraid of the market as a whole and who don't want to wait around to receive operating earnings from profitable portfolio companies and think they must liquidate everything, now, to obtain value from holdings. Frankly, I think that's crazy.

Peachberry_Tea offered:
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.
Insiders like the pricing created by this uncertainty. Why shouldn't I?

Peachberry_Tea concluded:
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.
I'm all ears on investment ideas. I'm particularly keen on ideas that call for solid earnings growth through a severe recession. I don't invest for a living, so I don't end up with tons of investment ideas. ACAS has been a long-term pick of mine, and remains one. I've not sold. If I should see my thesis collapse -- that ACAS is an underpriced way to buy a diverse lot of medium-sized companies which have been selected through a gruelling due diligence process to offer outstanding opportunities to provide a return -- then I'm sure I'll bail. However, I am not inclined to bail from fear of near-term pricing. Moreover, I'm still confident that I'm no good at all at picking entry points, and will continue to have to make due understanding the companies in which I risk an investment.

That said, if you want to be sure you have money at the end of the recession, the value of a safe and an array of firearms with which to defend its contents is probably not as volatile as the value of most of what you might buy after reading the financial section of the newspaper.

9 comments:

Anonymous said...

best.post.ever

Anonymous said...

best.post.ever

Jaded Consumer said...

Thanks :-)

Anonymous said...

Recent developments still seem to give credence to the argument that dividend payments were being made, at least partially, from share offerings. Otherwise the dividend could have remained constant indefinitely funded fully by current investments, right?

Jaded Consumer said...

Cash is fungible. If you want to argue therefore that funds raised from equity issuance improved the liquidity that made payment of dividends easy, you're not insane; however, you need to look at the business before you decide it's a Ponzi scheme.

Much of the cash raised over the last year or so was plowed into a de-levering program; much of it went into buying counter-cyclical or acyclical portfolio companies. Looking at quarter-end financials, it's clear that the money that paid the dividends actually came from lines of credit, and that ACAS tends to plow cash into investments or use it to save money by reducing debt. ACAS doesn't keep "extra" cash around, just that needed to handle expected upcoming cash requirements.

ACAS as a BDC has a dividend that is determined by looking at the taxable profit of the enterprise; 90% of this sum must be declared by the end of the second quarter of the following year, and paid by the end of the third quarter. If ACAS didn't have taxable profits, it would not be obliged to pay a dividend.

The watershed event in my book was ACAS deciding to stop retaining capital gains. When that happened, ACAS was (on my first glance) effectively capping itself from growing the investment base unless by issuing shares above NAV. Of course, when ACAS instituted the then-new dividend policy of not retaining capital gains, it was issuing shares above NAV and had no trouble growing the portfolio with it. Go figure.

Your question boils down to this: could ACAS have paid its dividend without share issuance. The answer comes pretty clearly from ACAS' investment exit volume: ACAS has had lots of cash coming back to it from deal exits, and could easily have met its dividend with this -- except that ACAS wants to have a bigger business for competitive reasons and reasons of scale, so ACAS has been issuing equity whenever issuing equity above NAV has been on the table.

At the moment, ACAS has a liquidity crisis. This doesn't mean it's not making money; it's got net operating income of $0.74, and unlike Berkshire Hathaway didn't lose most of that to imploding derivatives. Net at ACAS was $0.72, and that was largely because it retained capital gains and thus faced a huge tax bill. Shareholders are getting a $0.25/sh tax credit as a result.

ACAS is making enough of a taxable income this year that, in addition to the retained capital gains, ACAS will have a nine-digit taxable profit that it will have to pay shareholders as a dividend in 2009, unless it changes its tax status. Based on the dilution expected from the ECAS all-stock going-private purchase, ACAS will be forced to pay $1.37 in dividends next year on the basis of taxable profits made in 2008. This isn't some FAS-157 valuation exercise; these are realized, actual profits.

In addressing how to handle this requirement, ACAS has to do something Warren Buffet does not: it has to think about the financial models that create the valuations for all the components of the company's entire portfolio, and make sure it doesn't blow some ratio or threshold that keys off these numbers. In an ordinary company, you don't give a darn what your presses and machines would go for in a fire sale if you are making a good profit from month to month. At ACAS, the rules require the company to present every quarter a "fair value" for a bunch of assets for which there is no liquid market, meaning that there is virtually no use at all to the resulting numbers.

The real question is whether ACAS generates cash from its operations, and whether it is making a profit that can endure. The steady NOI seems good evidence this is the case. The fact ACAS must de-lever further to avoid liquidity scares will certainly threaten NOI; but ACAS is apparently buying ECAS for a song and should get some discounted NOI-bonus as it raises NAV.

Expect more of ACAS' cash to go toward de-levering. Enough de-levering, and ACAS can tolerate a much smaller debt arrangement with its slew of banks -- something it will likely need to do to accommodate the risk of further stress created by valuation issues.

The principal problem I see for ACAS is the one I outlined here: if ACAS needs to eat its seed corn to stay alive, profits will drop. ACAS makes more money when it's levered, but in these markets leverage is more dangerous than virtuous and management has made clear it intends taking the wise path, the safe path, and protecting the enterprise from liquidity risks.

So, to respond in short: No. I don't think dividends were paid from equity issuance, or that there is a connection between equity issuance and dividends. There is a connection between above-NAV share offerings and issuance, but that works to the benefit of NAV and is hardly a reason to complain.

Take a look at the NOI. The NOI is what will determine whether ACAS survives or is killed. Share issuance or other fundraising is window-dressing. Either ACAS can do quality due diligence and the companies will perform, or not. If not, my thesis is bust. If so, then ACAS' efforts to avoid a liquidity crisis may look scary, but NOI should save the day.

Kawa said...

Thank you for a very thorough comment that is backed by fact-based analysis and long-term perspective. I am grateful that I've invested ACAS to lead me to this blog site as the learning has more than pay for the loss I have "in the short term" acknowledged.

It is my belief that few win in a recession, but the wise ones survive it and retain its fundamental strength to redevelop. Therefore, I welcome ACAS's focus on liquidity to survive and the emphasis on its team talent (Fiscal responsibility aside, CEO values his team talent so much as to say that he will hate to let any one of them go) and diversified, solid portfolios to redevelop after the crisis is over.

Thank you again for your excellent comments to shed light to my questions.

Starkawa

Anonymous said...

What do you think of The Enlightened American's comment on where ACAS is headed? Have you also given up on ACAS since your last post?

http://enlightened-american.com/2008/11/21/acas-survival-chances-your-guess-as-good-as-mine/

clb said...

I have enjoyed your commentary on ACAS (and many of your other posts) and it has given me some reassurance in my investment decision. But here I sit at -86% on my investment and I suppose that you are probably in the same boat. Dividend suspension adversely affected the share price more than I would have expected and they are now going through layoffs. I have read a few other articles that put serious question on ACAS ability to survive. Any new commentary or thoughts on the direction of this company?

Jaded Consumer said...

Thanks for following the ACAS story here, and posting your observations. I'm making more ACAS posts, and all will be found on the ACAS Ticker tag.