ACAS: Profit Isn't Cash Flow

Now that The Enlightened American has bailed on ACAS (and after his parting post, and despite continued traffic on the stock, bailed on new analysis;  but this is easy to understand and forgive, as the poor fellow was burned pretty badly in his investment), Nivdung has taken up the ACAS-critic's mantle.  As linked in his recent comment here, Nivdung has offered a rebuttal against ACAS as a prospective investment.

I think Nivdung misses two things.  First, it seems difficult to base a thesis for or against a stock on the basis of a dividend policy when that future dividend policy remains unclear, and thus a matter of speculation.  On the other hand, Nivdung criticizes ACAS for making historic dividend declarations that exceeds its cash flow.  Nivdung seems to ignore two things:  (1) ACAS is required by virtue of its tax status to make dividend payments on the basis of its taxable gains, and (2) taxable gains are a matter of accounting profits -- that is, they are an accounting fiction based on things like basis, depreciation, and the like and ignore the cash outlay made for new investment, which may not be expense-able but may be subject to depreciation or may not impact profit except as the payments form part of the basis for a future exit transaction -- and have no particular relation to cash flow.  The fact ACAS is required to make payments that exceed its cash flow aren't a particular problem, provided the company has access to other sources of cash than cash flow from operations.  Borrowing money to make payroll or to avoid retaining sums that would crate enormous tax expenses is as reasonable in this regard as borrowing to make payroll in a quarter full of production costs while goods are made for sale in a later quarter.  Businesses respectably do this all the time.

The fact that ACAS had profits that exceeded net cash is especially easy to understand when one considers ACAS' effort to (a) grow assets under management (i.e., ACAS was reinvesting profits, including cash, so the cash didn't end up becoming net cash), (b) remain levered to cheap debt to magnify the returns on high-yield debt instruments held in portfolio companies, and (c) close good deals ready for closing, and promising excellent future returns.  As ACAS plows cash and newly-added debt into new deals, ACAS will pour incoming cash into deals rather than purely into tax-compliance-mandated dividends.

But investing in ACAS today isn't about living in the past.  ACAS has announced a much more conservative dividend policy, in which ACAS stands potentially ready to withhold dividend payments as long as ACAS' tax status permits.  ACAS gets to retain cash longer -- still not paying taxes on the profits -- and will decide after each quarter what if anything to declare on a quarter-by-quarter basis.  Investing in ACAS today isn't about whether all the good deals are gone (the old worry was that above-NAV issuance was dilutive because the old deals were better than the new deals), but instead are about whether the crazy prices potentially available during a liquidity crisis will enable below-NAV fundraising nevertheless to provide superior returns (in the form of accretive NOI, future capital gains, etc.).  

The question of prospective investment in ACAS is all about ACAS' management, management's ability to navigate the troubles caused by tightening credit, risks raised by ACAS' net worth covenants, and the like -- and have very little to do with ACAS' past dividends.

Incidentally, I recently received an interesting document in connection with my ACAS holdings.  The long-term capital gains ACAS withheld in the end of 2008 turn out to have been rolled-over from 2007, and the tax ACAS paid on behalf of its shareholders in connection with this "deemed dividend" is capable of being credited against shareholders' 2007 tax obligations.  Since those tax forms have been turned in already, shareholders are in a position to get a refund -- a dividend received by way of the United States Treasury, if you will -- by virtue of the fact that individual shareholders' long-term capital gains rate for 2007 (e.g., 5% or 15%) is much lower than the rate ACAS delivered to the Treasury (the corporate rate, 35%).  ACAS' non-dividend is a pretty good deal.

I'm interested in a discussion about ACAS' likely future prospects.  Debating ACAS' past prospects isn't exactly sporting:  we know how ACAS suffered while it entered the last third of 2008 levered to assets whose valuations were squeezed by bond-yield analysis and comparables-based valuations when the whole world entered a liquidity crisis, and the (apparently still performing) debt instruments in which ACAS enjoyed substantial holdings became nearly-worthless because no other lender would issue such debt anew during the trough of a credit crisis.  ACAS' past, and the impact of its illiquid holdings on near-term NAV, may be lamentable but it is past.  To ask about the future, we need to know things like this:

• Will ACAS' NOI remain solid?
  
• Will ACAS' ECAS transaction increase NAV as expected?
  
• What will ECAS do to ACAS' NOI?
  
• What will non-ECAS transactions entered with funds raised below NAV do to NOI?
  
• Will ACAS' below-NAV issuances occur substantially above market price, or will they be near market price?
  
• What is ACAS' NAV as the ECAS transaction is approached?

Some of these questions are simply beyond outsiders' ability to know, particularly as ACAS' activities to navigate its liquidity crisis remain known only to the parties involved.  The challenges of valuing ACAS' illiquid portfolio probably make some of these questions hard for even insiders to do better than estimate.  This makes ACAS considerably more speculative than when ACAS' price and dividend chart showed a slow march toward the heavens and the company stood barred from below-NAV issuance.  (Of course, the complaint then was that above-NAV issuance could still occur below market price, and thus was potentially "dilutive", presumably on the theory that all the good deals were gone.)  If ACAS' management is able to build shareholder value by new issuance above share price, ACAS might be a terrific entry prior to such issuance simply because the fact of issuance is likely to raise share price toward issuance.  Moreover, as ACAS becomes more clearly capable of avoiding destruction in bankruptcy due to a liquidity crisis, ACAS' ability to obtain near-NAV market price improves.  

I suspect that ACAS' NAV exceeds $15, that ECAS will positively impact both NOI and NAV, and that modest issuance (whether to raise cash, or as in the ECAS transaction to issue shares in lieu of cash consideration) will enable some transactions to enter crazy-good deals ACAS' management just can't in good conscience allow ACAS to bypass.  I think NOI will come under the same pressure of any company's NOI in a depression, but that ACAS' effort to enter countercyclical and acyclical portfolio acquisitions will support ACAS even as this occurs.

By the way, look at the athletes on the big football games on your set.  Those Riddell helmets are all good ACAS products:  following an exit at a 20% compounded return, ACAS retains a 2.4% equity interest in Riddell.  Portfolio companies like Piper Aircraft, on the other hand, are suffering terribly at present -- but may serve as a springboard once the economy turns around in a few years and investment is again contemplated in aircraft training fleets and the like.  The task for potential investors is to examine what ACAS currently is worth, its prospects for the future, and the possibility that short-term worries have hammered current prices well below reasonable valuation.

In my view, ACAS will be approved to conduct the below-NAV issuance needed to close the ECAS deal and others like it;  the result will be ACAS surviving its liquidity and net-worth crunch;  and the due diligence that has produced ACAS its historic returns will continue to produce future returns, possibly amplified by the availability of insanely good deals during a time of broad economic crisis (though mediated by the possibility that access to capital is particularly costly at this time, whether measured by the price of debt or the dilutive cost of new equity).  The most serious question is not whether ACAS' profits and net worth make $3 a steal, promising excellent investment returns in the next three years (I view this as certain), but whether management manages its below-NAV issuance authority to grow NOI and NAV rather than to allow NAV to be eroded by entry into deals that aren't worth the cost to existing shareholders.