1Q2010: ACAS Still Making Money

ACAS' streak of increasing NAV continued through the just-announced results of the 1Q2010 quarter, in which it reported a fair-value of net assets totaling $8.98 per share, up from $8.29 at the end of 2009. Net operating income of $49 million (largely the result of portfolio companies' results flowing to ACAS' bottom line due to consolidation of balance sheets) brought ACAS to a NOI of $0.17 per share, while net earnings of $187 million resulted in $0.65 per share in net earnings.

ACAS' net earnings aren't leading it to a dividend any time soon, though – something the Jaded Consumer regards as good news for those who want ACAS to reinvest the money management has on-hand. This is because realized portfolio losses were $107 million, even as ACAS booked $367 million in unrealized gains. Because BDCs' dividend-payment requirements are driven by taxable income, it is the realized income (and not the FAS-157-compliant changes in holdings' values that the SEC requires be reported as "income") that will determine ACAS' future dividends. As ACAS builds a backlog of realized losses (anyone have a number?), it will be able to absorb future income without being forced into coughing up its valuable cash in the form of dividends. When the losses are completely consumed, ACAS will get some attention for suddenly having a big dividend, but that's for down the road.

ACAS closed the quarter with $820 million in unrestricted cash. Because of the April issuance, ACAS will have some dilution; however, the $1.2 billion of unrestricted cash on-hand at the end of April places it in an interesting position to conduct financial engineering and to acquire distressed opportunities available in the marketplace. If, as the Jaded Consumer expects, the issuance frees ACAS to bring ECAS out of default of its debt covenants, ACAS could show a FAS-157-compliant "fair value" of ECAS that's substantially better than its last-reported values, resulting in a net gain to NAV in the same manner that ACAS expected to achieve when it bought ECAS from the public market by issuing ACAS shares below NAV. ACAS will, at the same time, be retiring debt. What's the impact of ECAS' current discount to NAV? ECAS' fair value increased $50m over the quarter (less $15m in currency net depreciation) to $0.3B, which is $0.5B less than its $0.8B NAV. The market environment in which ACAS' NAV improves is a plausible environment in which to expect ECAS' NAV to improve, and we've seen ACAS' NAV on the march for several quarters now. The ECAS valuation upside isn't limited to the $0.5B of NAV discount, but the 5/8 discount applied to future NAV improvement as well.

A hypothetical exercise: a company has NAV of $400 but has a fair value of $150 because it is in technical default of debt covenants on $200 of debt, which causes its "fair value" to be discounted to 3/8 its non-defaulted value. The company contains $600 in assets, but has $200 in debt, which is why its NAV is $400. If the company pays its debt with cash on-hand so that it has $400 in assets and zero debt, it will perforce be free of any breach of a debt covenant, because the debt will be retired and its obligation discharged. The "fair value" would cease having a defaulted-debt discount to NAV, and "fair value" would again approach the $400 NAV. Movement from fair value of $150 to fair value of $400 was achieved simply because the company was sufficiently liquid. An illiquid company might have continued to fail to met debt covenants, and defaulted not only on covenants but payments, and might have ended up in bankruptcy court where its failing businesses could have been sold off to meet the demands of unpaid creditors. Liquidity beats mere value. Because ACAS is liquid – to the tune of $1.2B – ACAS can explore financial engineering unavailable to illiquid competitors.

Cash from realizations – not issuance, but events like debt repayments and equity exits – produced $163 million in cash. ACAS expects more cash realizations in connection with the Mirion IPO later in 2010. ACAS invested $84 million in new investments over the quarter, so the company is clearly not dead in the water and unable to make quality investments.

Moreover, ACAS is working to improve its margins. The debt refinancing agreement ACAS has commenced calls for interest rates of LIBOR+5.5%, plus another 1% until the principal balance falls below $1Bn. This compares quite favorably to ACAS' current debt burden, which has grown from 9.9% to 10.3%. (The one-year LIBOR rate, the highest rate listed in the prior link, is cheap compared to ACAS' current rates even after adding 5.5-6.5%. Refinancing will apparently improve ACAS' spread by hundreds of basis points.) Freeing itself from default rates of interest will improve ACAS' margins by lowering the cost of the money it's lending to portfolio companies. Turning cash into both decreased principal and decreased interest rates will help ACAS' margins in the immediate term by lowering both the principal and the interest rate on conclusion of the refinancing. The press release makes apparent that hold-out lenders will have the deal shoved down their throats by a court if they don't agree out-of-court. Bankruptcy court is good for a solvent debtor in the United States, particularly when the debtor has nearly all his lenders onboard with his refinancing plan.

I think the future looks good for ACAS. NOI will benefit from the refinancing transaction, because it will allow ACAS to realize better spreads. I'm dying to learn about ACAS' new investments, but honestly I think the best returns ACAS will be getting in the immediate term will be from financial engineering designed to restore value to ECAS. Over the long term, however, I think fire-sale acquisitions may be the key to ACAS' upside. Improvement of earnings will continue through spread expansion and the improvement of the overall performance of portfolio companies as the economy improves (portfolio companies' operating income flows to ACAS' bottom line because it is required to consolidate with its own accounting the results of its wholly-owned and mostly-owned subsidiaries, just as Berkshire Hathaway books revenue earned by GEICO and Dairy Queen), and the better ACAS is doing without thinking about exits, the more opportunity ACAS will have to reap the benefits of being a patient investor without pressure to flip holdings.

I'm optimistic about ACAS and don't expect the pullback to last. Succeeding rounds of good news – whether in the form of refinancing press releases or quarterly reports showing improvements in NAV – will eventually drive ACAS back toward its historical NAV premium.