ACAS 1Q2009: What The Losses Mean

Yahoo Syndrome
I've commented before about "data" reported in summary form on free sites that fail to convey important information about the companies thus described, which seemingly causes uninformed people -- suffering from a delusion of informed-ness -- to make trades that appear irrational to people paying attention. Thus, partial-year dividends are assumed to reflect annual yields going forward, and historical yields and reported incomes may have little to do with solvency. ACAS is subject to Yahoo syndrome because SEC-reported profits, taxable profits, and cash flow are different animals -- and Yahoo reports only the FAS-157-compliant SEC-reported "income" is printed on Yahoo's financial site.

Wild Ride
It's been suggested in comments to the post on Piper's sale at a third above its FAS-157-compliant prior-quarter valuation that ACAS might be in the process of renegotiating its debt covenants with its banks, and that this is what's behind ACAS' >30% gain in a day. Well, let's face it: ACAS has been volatile as all get-out for a while now, with +/- 10% days being fairly common over the last months. Earlier today, I saw a quote of ACAS down well over 10%, and by the day's close ACAS had moved between 2.87 and 3.38 -- a range exceeding 50¢. On a stock trading near $3, this is crazy, no? Well, maybe not. It's the price action you see when there's not a broad concensus what the company is worth.

Wasn't broad mispricing of ACAS my basic reason it was worth buying? That its returns would exceed expectation because analysts weren't clued into what was right at the company? (Mind you, I wasn't clued into the company's exposure to market price chaos, especially in the bond market; I assumed foolishly that holding until maturity to get outstanding returns on debt was proof against exposure to market volatility ... but I was educated by ACAS' experience with its debt:equity ratio as its apparent equity shrank while its debt did what debt normally does when it's not subject to the same discounting as the equity.) My personal education -- and ACAS' -- that a long-term view doesn't insulate one from short-term volatility when leverage and external markets are involved was certainly painful -- but doesn't prove any thesis against the quality of ACAS' underwriting, diversity, or profitability.

ACAS: Worth It?
To understand whether ACAS is really sound near $3 (at least in the long term, assuming ACAS isn't crushed by a liquidity crisis before "long term" can arrive), one needs to know whether ACAS' investments are doing what ACAS expected them to do when ACAS entered them -- in short, whether ACAS was right about their long-term capacity for return when it bought the investments (when they were valued much higher than now).

1Q2009 Overview
From the end of 2008 to the end of 1Q2009, ACAS reduced debt by $51m and derivitive liabilities by $120m, while reducing "other" liabilities by $22m -- in all, reducing liabilities from $4.755B to $4.557B, a net improvement of $198m. Due to debt covenant breaches (following FAS-157-compliant reporting of the liquidation value of ACAS' intended-to-be-held-till-maturity debt portfolio), the "current" debt is substantial -- but ACAS reduced it from $2.512B to $2.419B during the quarter. ACAS reduced these liabilities even as its income fell.

Comparing ACAS' 1Q2009 to its 1Q2008, interest and dividend income fell from $258m to $179m, a reduction of $79m; asset management and other fee income decreased from $34m to $16m during the period, a decrease of $18m. In all, income decreased by $97m to $195m. Operating expenses shrank by $11m from $142m to $131m. Exluding the effect of ACAS' realized losses on exits from investments, ACAS had an income of $64m, plus a gain of $12m on the extinguishment of outstanding debt (presumably bought below par from owners who lost faith in its value), for an income of $76m.

However, ACAS realized a loss of $131m on investments in the quarter. This is different from the unrealized changes in value that create such confusion about ACAS' fortunes; it's also a substantially smaller number than the $492m unrealized decreases in FAS-157-compliant values (down from an unrealized decrease of $997m the prior year's first quarter). In short, during the first quarter of 2009, it looks like ACAS experienced a taxable loss of $55m ($76m income, less $131 realized losses), or a tax loss of 26.6¢ per share, while reducing liabilities by $198m. One might conclude that, following the quarter, investors should feel something like $143m better off. However, this would ignore the hard-to-quantify impact of reported unrealized losses which, for reasons discussed on this site before, are going to be very hard to pin down due to the apparent disconnect between how the government requires these values to be calculated and the way these transactions are priced when ACAS actually exits a position. Due to FAS 157, ACAS reported a per-share loss of $2.65 (down from $4.16 in the prior year's quarter). Recent exits range from within 2% of prior-quarter valuations to a third above that level, so even the current validity of the reported NAV is in question, much less the validity of the reported NAV as a predictor of the current value of eventual performance.

Speaking of Taxation
Outside a tax-deferred account, the case for holding ACAS has become painful: ACAS will "pay" a dividend to remain compliant with the BDC Act, so that owners can be taxed instead of ACAS, which will eliminate the double-taxation ordinarily associated with receipt of dividends -- but since ACAS will "pay" 90% of that dividend in stock instead of in cash, owners will be in effect taxed on a stock split. Those who hold ACAS in tax-deferred accounts will be able to avoid this nuisance.

Also, this year's owners will be soaked with last year's tax bill, but they won't be able to enjoy the losses of recent quarters. This is because although ACAS' BDC status allows it to pass tax obligations uphill to owners through dividends, deemed dividends, and so-called dividends that are in fact stock splits, there is no mechanism by which owners can benefit from tax benefits that might accrue by virtue of ACAS' losses: ACAS isn't a partnership, and no K-1 losses will flow uphill to owners. The tax-deferred account is looking better and better, eh?

The Future
Whether ACAS has a future depends on whether it can keep creditors at bay long enough for the quality of ACAS' due diligence to manifest in the form of returning portfolio performance. ACAS reported an "interest coverage" (EBITDA divided by cash interest expense) of 2.2x. This non-GAAP measure, not appearing on Yahoo's summaries, reflects capacity to keep creditors paid off. ACAS' debt covenant breaches have hiked ACAS' interest rates (in addition to bringing billions of its debt current), so this 2.2x metric will worsen even if earnings are maintained. Assuming ACAS' earnings don't deteriorate more than, say, another 50%, ACAS should be able to weather the storm. Decreases in earnings impact interest coverage: 1Q2008 showed ACAS with interest coverage of 3.5x, so the 2.2x that looks good now is a serious deterioration of an important metric. Whether ACAS' debtors can pay ACAS will impact ACAS' power to pay its own creditors.

Earnings doesn't pay interest as it comes due, or repay principal at the expiration of notes and bonds. Cash pays this stuff. ACAS' cash has diminished seriously in the last year, which is unsurprising considering the liquidity crisis that brought ACAS and the rest of the financial world to the present state in which we find them. Just because ACAS has an accounting profit doesn't mean ACAS is solvent. $82m of unsecured private debt, still on the books at the end of 1Q2009, will become due in September. There are supposedly rumors about ACAS negotiating a solution to ACAS' debt issues, but you can't eat rumors.

ACAS' debt ratings deterioration has driven up the interest rate ACAS must pay on publicly-traded debt to 8.6%, and no acceleration actions have been taken by holders of either public or private debt. 8.6% isn't terribly bad, but increases in ACAS' interest rates shrink the spread between what ACAS is owed and what ACAS must pay, and thus shrink its earnings. Shrinking earnings isn't something ACAS really needs.

What 2Q2009 shows us about ACAS' NOI will be very instructive to shareholders regarding ACAS' capacity to function with increased interest expense.

Upshot
As illustrated by this kind of news, ACAS can still close deals. To the extent ACAS can exit deals, ACAS can raise funds to deal with its upcoming bond expiration. Exiting deals at current valuations might not seem exciting to those who bought when NAV was north of $30/sh, but given that NAV is now several times the trading price, it seems exits even at current prices offer tremendous stock price upside. The question is, how much of the exits will be in cash and how much will be in some kind of debt that holds its own future valuation and performance risks.

To the extent ACAS can negotiate a deal with its creditors to re-arrange its debt covenants (e.g., to offer some metric other than FAS-157-compliant valuations -- maybe interest coverage, or percent performing, or the like as an alternative), ACAS may be in a position to improve its solvency and drive stock price back toward NAV. And NAV itself will presumably improve as the economy, and the valuation of ACAS' portfolio, turns around. If ACAS' underwriting was as good as I have been betting all along, ACAS will do very well on its NAV recovery and its capacity to generate income regardless what happens to its share price.