Monday, March 1, 2010

ACAS 2009 Results: Some More Detail

At American Capital Ltd.'s investor relations page, one can get the Q42009 presentation PDF and a link to what will eventually be a rebroadcast of the earnings call.

ACAS: Cure Worse Than The Disease?
Slide 14 is interesting, as it offers some balm for the fear that ACAS is liquidating its valuable investments to raise cash to feed hungry creditors. The fear is, in short, that to avoid forced liquidation ACAS has been selling the best of its portfolio just to keep the lights on, and there will be nothing worth owning after. Enter Slide 14. Of ACAS' $1.1B in 2009 realizations, $820M was received in the form of principal payments on debt owed ACAS and the sale of loans made by ACAS. Only $323M of the 2009 realizations reflect the sale of equity. (In Q4, exits of $476M included $57M from equity and $419M from principal/debt.) This has two sides, of course; if the equity is valued low, the exit of equity may not result in much cash even though ACAS does, in fact, liquidate equity. Hence, the $716M in net portfolio realized losses reflected on slide 14. Slide 14 does offer some more balm to fears ACAS is liquidating the crown jewels out of desperation: the exits consisted of $122M in gross realized gains and $838M in gross realized losses. ACAS isn't just selling the winners, it's selling a lot of losers. Considering that these big numbers reflect the post-loss prices, the losers vastly exceed winners.

What's this mean for the future? ACAS' requirement to distribute a dividend is based on ACAS' taxable gains. The reason ACAS doesn't pay taxes itself is that as a BDC, ACAS is required to distribute taxable gains to investors, who are taxed on these amounts. If ACAS realizes losses – by selling investments that won't result in much profit and by letting losers get bought – ACAS can avoid having to pay cash dividends. ACAS may be setting itself up for a couple of years in which it need not pay any dividend at all. As ACAS accrues losses, ACAS' ability to reinvest without worry about liquidity issues brought on by dividend-paying requirements will improve.

The Portfolio
ACAS' portfolio remains diverse by industry (see Slide 45). If ACAS is indeed keeping the best investments for long-term gain, or even positioning itself for the particular economic cycle before it, ACAS could be trying to build a financial position from which to maximize the impact of the eventual economic recovery. An example of the future performance is illustrated by ACAS' investment in European Capital. At the close of 2009, ACAS' equity investment in ECAS had a FAS-157-compliant "Fair value" of $243M, but a NAV of $0.7B. The discount to NAV is based on (a) the status of credit facilities (e.g., ACAS' default of net-asset covenants and at least theoretical risk of fire sale), and (b) the NAV discount of publicly-traded funds thought to be "comparable" to ECAS. Although the short term marketplace is a voting machine, the long-term offers a weighing machine, and if ACAS keeps jewels like ECAS it's in a position to do much better than current NAV would suggest. ECAS, because it is discounted to NAV before entering ACAS' NAV, is available to shareholders at a double-discount. This is because the roughly 50% discount to NAV that ACAS has lately offered has allowed investors to buy for about $125M a portfolio ACAS carries at a $243M "fair value" but has a NAV of $0.7B. To the extent of ACAS' ECAS holdings, shareholders buy it at about 1/6 of NAV. What's crazier? This is after ECAS experienced a $124M Q42009 appreciation in "fair value" (see slide 36).

Given that ACAS' market capitalization has recently been in the range of $1.25,B, the fact that one ACAS holding suggests an undervaluation of nearly $500M should make one think about the remainder of the portfolio. Given that ACAS has historically traded at a premium to NAV, the mispricing of ACAS' holdings suggests good things to the patient investor.

No Big Discount?
A criticism of ACAS has been doubt that ACAS' portfolio investments could be sold for their claimed values. Yet, among my original investment theses in American Capital was that the illiquidity and opacity of small investments made by ACAS created opportunities for mispricing, leading to potentially outsized deals. Slide 16 shows that ACS has averaged almost exactly the claimed "fair value" on investment exits, with quarterly overall exist within a percent or two of "fair value" since the beginning of the economic crisis. Slide 16 makes clear that, at the moment, ACAS isn't able to sell holdings at a better price than recognized by FAS 157, but has not been forced to accept lower values, either. Thus, ACAS isn't a get-rich-quick scheme. It's a wait-for-rational-pricing scheme. It's a value-investing thesis.

In the short run, however, Investors' best bet is that ACAS can find purchases that are mispriced. Because the exit pricing doesn't seem particularly exciting, the profit has to be made by entering the deals cheaply. Toward this end, ACAS has a "special situations group" whose whole purpose is to find opportunities (like the New England Confectionery Company, whose candy business and real estate holdings appeared much more valuable separated) for below-value investment. In a market characterized by distress, one might expect ACAS to be running around buying underpriced distress opportunities left and right. Unfortunately, this hasn't materialized as I'd hoped before now because ACAS has itself been distressed. However, Slide 41 shows that ACAS has bought a couple of new distressed portfolio companies – the majority of its Q4 investment – while making add-on investment for 4 existing portfolio companies (including funding one portfolio company's acquisition). In 2009, ACAS bought 18 distressed companies for $81M. (Slide 42) If these companies were as mispriced as ECAS before the end of the fourth quarter, investors could be in for a treat.

Rational Pricing?
Once ACAS has a deal with its creditors that alleviates the (misplaced, I believe; see Slide 26 and the continued ~2x interest coverage) fear that ACAS will end up in a forced sale, ACAS' share price and its NAV will likely be quite a bit closer. ACAS should then have the ability to raise capital to enter distress situations and to handle the business that first made me interested in it. Once the creditor crunch is over, ACAS' need to be coughing up penalty payments and other nasty earnings-impacting surprises will be replaced with the ordinary market risks we accept when we consider doing business.

Why hold ECAS to get a double-discount if ACAS hopes to get rational pricing? ACAS clearly expects someone to show up in the eventual future with an appetite for a mature portfolio of international investments. To the extent ACAS has already bundled them, ACAS can offer an interest in ECAS and the deal would be quick. Otherwise, the parties would dicker over which stocks would be in the basket, etc. This way, ACAS can say: "Here are the investments we put together while assembling a diverse portfolio in Europe, do you want a third?" and there's no need to quibble over which stocks are at issue. The deal will be faster when it happens. Since speed is an asset at ACAS, management is sensible to maintain preparedness even though the short-term result is NAV lunacy. So long as management doesn't sell ECAS at this crazy price, nobody is hurt except shareholders who bail from impatience.

With ACAS' NAV on the rise and the credit situation seemingly on the right track, investors who accepted stock-only dividends last year at $3.2199/sh are looking to be in good shape compared to those who were willing to take cash instead of discounted shares. Between my $1.80 purchase and the share dividend, my own basis has declined considerably. From my current position, I expect that as ACAS' NAV improves I'll see black ink again.

Slide 33 gives some color on ACAS' capacity to keep doing business. ACAS' closure of 7 offices and its slashing of headcount doesn't leave ACAS an empty shell waiting for the roof to collapse when creditors knock. ACAS retains 8 offices, 32 investment teams comprising 95 investment professionals, a 20-person operations team (to provide expertise and support to portfolio companies), and an audit and valuation team that reviews investments to do due diligence and portfolio monitoring on an ongoing basis. ACAS has folks whose jobs are to syndicate debt to third-party buyers, folks who perform various legal and human resources functions ... ACAS is a going concern, not an empty box of stock certificates.

ACAS appears entirely prepared for an active future.


Anonymous said...

Thank you for your in depth the sell side is having a hard time making any type of stand until the debt situation is resolved. Any comments regarding the price action today? The large volume dip on the sec release had some holders running scared intraday...

Jaded Consumer said...

At the time the SEC filing was made, a slew of Reuters pieces came out with headlines that quoted from the material-risks section of the filing.

Stuff that has long been priced into the shares became "news" for a number of minutes as panicked holders ran for the doors thinking that the debt wasn't going to be handled in an exchange and that numerous other risks spelled out in the filing would materialize.

It wasn't news, though, and the V-shaped graph shows buyers were happy to step in and collect shares on the dip. I interpreted the action bullishly, but of course I've been bullish on ACAS since it was nearly $50.

The interesting thing was the decision of Reuters to spin the material risks section into a series of headlines seemingly engineered to convince onlookers that the SEC filings had disclosed some kind of "news" that warranted immediate action. While strictly true, the practice certainly confused a few buyers – and the ultimate price action shows the "news" was a non-event.

Anonymous said...

Agreed..and those sellers hitting bids below $4 are not trigger happy campers. The sell side is not covering this name correctly in my opinion. There are no distressed situation sell side firms writing on it. KBW has a 3.50 px target. Macquarie 5.50. The rest are hold hold or MP Im looking forward to some resolution soon so they can all climb aboard (hopefully) and change the ratings. None have it as a buy.

Jaded Consumer said...

I wouldn't hold your breath. Some, like Cramer, have hated it since the 40s and are now surely claiming history has proven their every suspicion right.

The folks who said illiquid assets' stated values were bogus will continue to doubt management and conclude that sales of portfolio companies represent only the tiny fraction that come close to claimed values.

Unless there is a sea-change in thinking on ACAS, ACAS will likely prove a value buy for some time as news of its recovery trails its actual recovery.

The combination of NAV recovery and discount evaporation should present an opportunity for longs. Just don't hold your breath for vindication in the media :-)

Mark said...

One thing is keeping me from going all in. What is your opinion on the possibility of PPBK? Has zero probability been priced in? Finally if it does happen will the common emerge unscathed? Thanks

Jaded Consumer said...

Is PPBK is a "pre-packaged bankruptcy"?

Under Chapter 11 (a reorganization, not a dissolution) management should be able to continue as debtor-in-possession and run the business so long as it makes timely payment of interest at non-default rates. On my read, ACAS would actually REDUCE its interest payments and increase its NOI by entering bankruptcy. ACAS' reorganization plan would require ACAS to show how it would repay its creditors, but ACAS is both net positive and able to show it can exit deals at the values it claims are fair, so its projections of the future should be plausible to a bankruptcy court.

The question is then whether ACAS can be more flexible in entering/exiting deals under bankruptcy protection, or not. The benefit of the bankruptcy is that "Acceleration" stops being a threat. The detriment is oversight by the Court when ACAS needs to be nimble.

Since creditors don't want to get paid non-default rates, and prefer the freedom to negotiate deals without judicial oversight, I'm suspicious that creditors are keen to keep agreeing to postpone acceleration as long as a deal seems plausible. After all, interest is well-covered; what's there to lose with delay?

Worst case, ACAS uses bankruptcy to prevent creditors from placing ACAS in the position of a forced seller. Chapter 11 isn't a liquidation, and there will be no race to the exit. Chapter 11 would simply protect ACAS' ability to shepherd assets for the benefit of all the stakeholders if the creditors fly off the handle.

Given ACAS' discount to NAV and the upward trend in NAV, I'd say that delay works in favor or shareholders and that even slowing the company's deals in bankruptcy would work in shareholders' favor. The NOI improvement from reduction of interest rates to non-default rates would be a plus for ACAS' ability to gather whatever ACAS thinks it needs to handle its foreseeable issues.

Like I wrote before, I'm not sure why anyone fears an ACAS Chapter 11 except the creditors. ACAS is doing fine so long as the creditors are kept in their place, and bankruptcy is good at keeping order among competing creditors while a debtor has a chance to sort out finances. Bankruptcy doesn't frighten me, and if it led to a share price collapse I'd be all over it like white on rice.

Mark said...

me too

like a fat kid on a cupcake

Anonymous said...

Well here we go..they announced another extension....before the march 15th deadline. What des this tell us?

Jaded Consumer said...

What's an extension tell us? For my part, I think it tells us that a multi-party contract negotiation can bog down very easily.

On the other hand, with ACAS' NAV on the rise and its profitability under current circumstances (even with default interest) apparent, I think that ACAS' bargaining position improves with delay so I'm not particularly concerned. The lenders are regulated for solvency differently than ACAS, and some of them may be particularly hungry for cash. Also, some of them may not WANT early repayment of principal -- they may like the interest at default rates and hope to draw it out longer for their financial benefit.

Who knows. I don't see particular disadvantage to ACAS, so I'm not particularly concerned. Chapter 11 reorganization remains an interesting alternative that does not favor ACAS' unsecured creditors, so the biggest creditors have a powerful incentive to play ball with ACAS for the time being.

The agreement holdouts are a subset of secured creditors, right? Maybe some don't have financial distress and prefer not to receive principal prepayments that the proposed agreement would necessitate. Just a thought, but can't really guess.

Multiparty contract negotiation can be a bear.

Anonymous said...

Im with you regarding the secured subset being the holdouts. On a macro basis m&a activity is heated. We even have a PE deal coming tonite (Sensata). As long as this environment is conducive to liquidity events I am comfortable staying in the name. Most of the sell side reports i have read are betting on the "dont" and they illustrate what is going wrong. My feeling is the longer this plays out, the higher the write ups will go and closure of the NAV gap will be commensurate. The shares are moving in the right direction...certainly in the face of all the sell side naysayers. Speculation? Short covering? Probably.

Anonymous said...

What are your thoughts on AGNC - I know it is partially owned and managed by ACAS. I don't understand their business model but the 22% dividend seems almost to good to be true. Repurchase agreements used to buy very safe fed-back agency securities? It also trades ABOVE NAV. I'm not sure if you hold any or know anything about AGNC but you used to have updates on AGNC on this blog. Any thoughts???