ACAS: Studying Apparent Duds

A little while back, Jaded Consumer described a couple of profitable exits that demonstrated actual sale prices above FAS-157-compliant "market value" reported to the SEC. There is a serious bias to suffer in observing only exited investments, and an even more serious bias in looking only at investments that are described in company press releases. Of course those will look good! (The idea behind those posts was that ACAS could raise cash, and it could get a good return in the process.)

The Jaded Consumer then strolled briefly through ACAS' 10Q for some interesting-looking holdings for times of recession, the idea being to find out what kinds of preparation ACAS might be able to rely on for income after those high-profile exits.

But folks worried about the company have a totally different focus: what's with the companies that have "fair value" below ACAS' basis? What about the dogs? Should we be worried? Without cataloguing the whole portfolio (for which you can look here), it seemed possible to look at some holdings that looked bad on paper, and ask just how bad they in fact likely were. This process is complicated by the fact that each of the portfolio companies is free to disclose or to conceal what it likes, and ACAS has routinely expressed disinterest in entertaining holding-specific questioning about a portfolio containing hundreds of companies. We're kind of on our own, though we have some help: we know how badly hated some classes of assets are now, and that nonpaying illiquid debt of privately-held companies isn't considered much of an asset, so we can draw some plausible conclusions about the quality of an asset's performance based on the value that survives FAS-157.

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According to Answers.com, Money Mailer LLC at the end of 2007 had annual sales of $25.1m and is controlled by Roark Capital Group (ever heard of Cinnabon? Schlotzky's? Carvel? All are Roark portfolio companies I recognized). Money Mailer is the nation's second largest shared-mail advertising company; it bundles local businesses' ads into one mailer and targets shoppers, those who've recently moved, and other targets in exchange for advertising revenues from local vendors seeking customers. It operates through a series of franchises, which tithe uphill to Money Mailer LLC – whose tens-of-millions in revenues isn't anything to sneeze at. It'd be nice to know the overhead at the level of the franchisor (what does that franchisee support cost to provide?), but we're left guessing.

ACAS' 3.5% interest in Money Mailer was surely entered on the expectation of receiving a share of distributable LLC receipts (and not resale; a 3.5% owner lacks the control required to effect a buyout). After all, unlike ACAS investments in which it took equity stakes with zero basis while spending money recapitalizing portfolio companies in connection with buyouts, ACAS actually spent $900k on its interest in Money Mailer. Interestingly, Money Mailer as an LLC presumably ticks the "tax me as a partnership" box when filing with the IRS. ACAS being a BDC, ACAS pays no tax despite holding the bag for its share of Money Mailer's taxes (instead, you do as a shareholder). From ACAS' perspective, there's no tax loss anyplace in the chain unless ACAS retains capital gains and pays tax on shareholders' behalf in connection with the "deemed dividend" associated therewith. However, in a tax-deferred account, ACAS income from an enterprise like Money Mailer would reinvest without losses from annual taxes -- something one doesn't get from most other investments (American Express, Berkshire Hathaway). The fly in the ointment? Money Mailer has been non-income-producing for at least a couple of quarters.

Anyone know what the present, or future, of advertisement mailings holds?

Anyone with information on how MoneyMailer LLC is doing, or what kinds of benefits LLC members might be getting from their interest, is invited to post. Unless ACAS expected a distributable income share, I'd be hard-pressed to imagine why it'd have bought a minority equity stake. The fact that it isn't making districutions at present could be a result of any number of things other than imminent business failure (like strategic reinvestment, which might make sense in a downturn). Assuming business just sucks for Money Mailer and that there's no profit to distribute, the fact that the company is structured to depend on independent franchisees means that it has partners working to make the organization succeed, which may be valuable if its survival is at stake. If ACAS entered Money Mailer with the expectation of being paid when Roark Capital Group structures an exit for itself and its equity partners, Money Mailer could be a long, tiresome road for ACAS' shareholders.

Running Big Rigs
ACAS holds both senior (12.8% on $23.9m face; $23.9m basis and $21.1m fair value) and subordinate (16.3% on $17.8m face; $16.9m basis and $11.4m fair value) debt of Phillips & Temro Industries, Inc., an auto components supplier whose products seem to include noise reduction, cold-start technology, and green idle-free cab support for rigs. The company also offers power generation equipment, a business likely buttressed by its cold-start tech and noise reduction products. Somebody else holds the equity, meaning that ACAS is toward the front of the line if things really head into the toilet. Assuming they don't tank and stay there, ACAS' long-term return looks good. The company supplies OEMs with technology to help keep rigs from idling when they need to run A/C and heat while not driving, and technology to help get them started from a cold start in frigid conditions. The company seems owes ACAS nearly a million and a half per quarter in interest, though the subordinate debt recently went on non-accrual (leaving $764.8K a quarter in not-non-accrual senior debt payments). The lower-returning senior debt retires in the next couple of years, and the subordinate comes due in 2013. Based on comparisons (basis and face face value) to prior periods, it looks like the company is paying some of its debt in additional notes, rather than all on time in cash.

Temro is an investment that is collateral on an ACAS secured-debt facility.

Golf, Anyone?
When Audax bought Nivel Holdings, LLC in 2007, ACAS kept 10.6% senior debt (face value $61.8m). Nivel makes aftermarket parts for golf cars, and ACAS hasn't any apparent interest in its profitability -- just its ability to make good on its senior debt. ACAS' basis of $61.3m leaves it with an investment valued at $55.0m, which presumably means that Nivel is still paying its bills. It just means that Nivel, as a private company with modest overall value, is hated by people who are putting price tags on debt that's not being traded. Presumably ACAS' $61.8m principal earns it over a million and a half per quarter in interest, and will do so most of the way through 2013. (If the company weren't making its interest payments, would the debt of this unheard-of little private company be valued so high?)

The Nicel Holdings debt is used by ACAS as collateral in a secured credit facility.

Retailing Stuff Without A Storefront
Orchard Brands Corp. (a Golden Gate Capital company) issued two classes of senior (7.3% on $170m face, 10.2% on $150.6m face) and one class of subordinate (9.8% on $63.3 face, which I assume means there's a conversion feature that results in ACAS enjoying upside if things go well; else, why would the subordinate coupon be lower than the second class of senior?) debt still held by ACAS. Orchard Brands runs several catalog businesses with niches ranging from one-of-a-kind interesting gifts to one of various classes of shoes. The growth of Internet sales seems to underscore the basic advantage of outlets without brick-and-mortar overhead: people can shop your wares without having to drive or park, and order them delivered to their doors, and maybe even avoid sales tax into the bargain.

Maybe Orchard doesn't know how to exploit its target niches. Maybe it's on the rocks after a crummy holiday season. It's hard to tell on available information whether this is a company that will come back. Hard to tell exactly what's going on in this one (e.g., why subordinate debt would have lower coupon than a senior class of debt? some conversion feature or the like at work?) though it's understandable it's suffering if it depends on seasonal sales and last holiday season was a worldwide bust. The senior debt is valued at more than half its face value, which suggests it's got some plausible security or is paying to some extent (at the end of 2008, the debt was current). Although the first-listed senior debt is not yet on non-accrual, the subordinate debt and the second class of senior debt are on non-accrual. Without knowing who else Orchard's creditors are and how they are secured, it'd be hard to figure out what ACAS' position is if Orchard fails. Since Orchard is still making payments under one of its senior debt classes, it's evident Orchard still has some business to recover. But 7.3% isn't exactly the return ACAS was angling to get when it went into business, and ACAS' cost of debt has increased since this investment was made.

Orchard is one of the investments whose debt is collateral under one of ACAS' secured debt agreements.

Food
Future Foods Inc. apparently manufactures and sells organic sea vegetables in various forms for use in flavoring and as salt replacements. Leveraging a worldwide supply network, the company offers "soy derived nutriceuticals" and freeze-dried organic herbs. The company seems to have expertise in food areas in which there's cutting-edge demand in the health-food marketplace – omega oil ingredients, new antioxidants, herbal remedies, and so on. The new-age granola crowd isn't dead, as a trip to Whole Foods will demonstrate. Health food producers needing ingredient support seem to offer a promising market for the future. Since the senior debt is valued at par (ACAS' basis in the 5.3% notes is $17m, though the principal and the market value are both $17.2m), it seems the company is paying this debt with some room to spare – or that the paying senior debt is well-secured. The below-par status of the company's subordinated debt ($7.6m basis in $8.m face having $0.5m market value; coupon is 12%) isn't hard to figure: subordinate debt of small, illiquid companies isn't in high demand now, and the subordinate debt has been on non-accrual for at least a few quarters. The equity and warrants are valued at nil, which may be FAS-157-compliant (there's not much market for small illiquid companies that have unpaid debt) but is inaccurate if the company isn't a goner. If the company is a goner, how is the senior debt worth par, and more than basis? It's a puzzle. I suspect that an experienced player in a growth industry like high-end inputs for the health food industry has a solid future even if the illiquid debt of a private company with no banking references (because it gets its financing privately) is considered a poor risk when valued by third parties.

Energy Infrastructure
ACAS owns debt (8% senior, with $44.2m face, $43.8 basis, and $44.2 market value) and equity (apparently 4.6%; ACAS and its affiliate bought 6.8%, and 30% of that investment was through one of ACAS' managed funds, so the 70% remaining is presumably ACAS' and should amount to 4.6%) in EXPL Pipeline Holdings LLC, which is presumably the holding company for Explorer Pipeline Company, which owns and operates the second largest refined petroleum products pipeline in the U.S. It's apparently a significant item of energy infrastructure along the Gulf Coast. Being familiar with growth along the Gulf Coast, I am pretty sure that whatever ills may befall the region in the short term, there is (a) a demand for petroleum products, (b) a certainty that owning energy infractructure in the area will be valuable, and (c) no reason to believe that transmission (this isn't an oil well company, it's a pipeline company) is suddenly going to suffer lack of demand (particularly in light of the long-term contracts that typically support infrastructure of this type). The fact that ACAS' equity in this enterprise is not valued at zero like most of the other equity suggests the company must be doing fantastically well by the standards of illiquid privately-held companies. (Else it's evidence that membership in the LLC is more liquid than ACAS' other investments. Anyone know?). On an equity basis of $44.6m, ACAS is required to value the equity at $12.0m. I'm suspicious that ACAS will keep getting its 8% debt paid by the pipeline company until 2017. Tthe debt is not on non-accrual, though the equity is currently listed as non-income-producing. I have no data that the equity being non-income producing is a special problem at present. (The LLC likely holds the underlying company as a close corporation, electing tax-pass-through status, and allowing ACAS to receive distributions prior to income tax withholding. Presumably ACAS ordinarily does expect income from the equity as well as from the debt.) ACAS' minority holding doesn't appear calculated to place ACAS in a position to flip the company or control a re-organization intended to improve its operational efficiency -- it appears calculated to provide steady income and exposure to a business with long-term contracts in a field that will be necessary longer than you or I live.

Note: EXPL Pipeline Holdings LLC is listed among control investments, which works against my minority equity owner thesis. It's possible that ACAS' senior debt has conversion features, or that its class of membership has unusual control features, or that something else interesting is going on there. Theories welcome :-)

FreeConference.com Inc.? [updated]
ACAS holds investments in something called FreeConference.com Inc. If one visits the web site FreeConference.com, one sees an offer for "simple, convenient, and reliable" conference calls for "businesses, organizations, and individuals." Just register. Clicking around, it seems that some features involve per-minute access charges. Since ACAS' debt holdings are trading at face value ($13.2m at 6.8% and $10.2m at 15%), and the preferred stock is valued above zero ($9.2m on a basis of $13.9m), it stands to reason that the interest payments are current and the company's outlook for solvency is good. But ... if the main offering is free, what kind of revenue can really be expected? ACAS' additional holdings of common stock and warrants suggest that it expects to benefit in an eventual exit, though if it's getting (on average) double-digit interest in the meantime, it might not be particularly worried about the timing of that exit.

Presumably, the move toward globalization, telecommuting, and mobile workers is thought to be a driver of this kind of service. The idea must be to make money on volume; 10¢/min for 1-800 access seems a very tight place to try to make margins.

Conclusion
ACAS is an opaque company: its investments aren't easy to evaluate (but then, what is GEICO worth if sold by Berkshire Hathaway? Tons, yes ... but what number is fair?), and the outlook for particular companies is hard to ascertain. Even knowing a company has one or more debt classes on non-accrual, what can one tell about its ability to survive if its lender -- ACAS -- is willing to work with it? Management has made clear that the last downturn offered both a resurgence and good buying opportunities; of course, the last downturn was not so harsh.

ACAS has tremendous diversity, though: its primary risk seems to be leverage, not concentration. As ACAS pays off maturing debt (I assume some of the cash raised in recent sales is destined to pay off bonds maturing this year), its overhead will look better -- but to thrive, ACAS needs more than just to survive, it needs its portfolio companies to enjoy success. With such a diverse portfolio, the best promise of broad success is economic recovery.

Anybody got a can of that lying around?

UPDATE: Some suggestion has been made that ACAS is doomed because it overpaid at high multiples. This has the attractiveness of being half-true. ACAS overpaid for some investments (remember the Internet company that went to zero when Google killed its referral income? Ouch.), and ACAS did buy some investments at higher multiples than at present. However, conference call listeners will recall that ACAS routinely enters investments with the assumption that it will have to exit at worse multiples, and prices purchases accordingly. ACAS works very hard to do effective due diligence, and once it enters a position its performance teams assist portfolio companies to control overhead while growing EBITDA (which drives up value despite multiples contraction). ACAS' price plummet over the last 18 months has been a disaster for shareholders (and management), but it's not obvious that ACAS' management has suddenly been hit with the wand of a wicked faerie. AGNC's value has grown in the same time period while its dividend has increased, under ACAS' management. The primary difference seems to be that AGNC's portfolio is liquid and easily used as collateral. Assuming the economy does turn around, what should we exepct of other ACAS-managed portfolios? What will become of non-accruing debt's value when PIK notes that previously reinvested at double-digit rates begin paying cash? What will become of the fair value of equity now valued at zero?

ACAS has serious chalenges, not the least of which is the possibility that even more portfolio companies default on debt -- or existing defauted debtors default on more classes of debt -- as the economy continues to threaten business. Income is critical to ACAS' survival, whatever the theoretical prospects of portfolio companies. ACAS doesn't have forever.

The question is, does ACAS have long enough? If it's able to make cash with profitable exits to handle debt maturities and can limp along on ordinary income until things turn up, ACAS is cheap at a small fration of its NAV. If ACAS can't keep its bills paid, its goose is cooked. The fact that ACAS has investments with some classes of debt in default is unfortunate, and the fact that this default reaches a fifth of the face value of ACAS-held debt is genuinely alarming. The question is whether ACAS' diversity, and the fact that many of these companies are still current on other classes of debt, give ground for security that things are not as dire as to justify a share price south of half NAV.