Saturday, August 7, 2010

ACAS: 2Q2010

American Capital recently announced its results for the second quarter of 2010, and those results are encouraging. In reading them, consider that American Capital spent the quarter threatening a bankruptcy filing to encourage creditors to accept a debt refinancing deal, which meant that in addition to suffering ongoing distraction at the top of ACAS as it renegotiated its debt, ACAS also had to spend money hand-over-fist on bankruptcy specialists so that it could, on immediate notice in the event deadlines lapsed, file in a bankruptcy court to prevent creditors from asserting acceleration and other rights held under the old debt agreements, under which ACAS was to have maintained a net asset value that proved implausible as the financial markets imploded in 2008. The expense of these renegotiation tactics was $17m over the quarter (up from $7m in the year-ago quarter). The end of the debt renegotiation battle means (a) less distraction for top management, and (b) decreased expenses.

Expense Reduction = Income Increase
To grasp the significance of the decrease in expenses, one should consider ACAS' net operating income (NOI). This is the income gained from operations either because portfolio companies profit (which profits would flow to ACAS' bottom line in the case of the mostly-owned portfolio investments), or because ACAS receives payments on debt extended to portfolio companies (ACAS profits to the extent of the net of its debt income and its debt expense; much of ACAS' lended funds are themselves borrowed). NOI includes everything but investment performance (that is, the change in market value of what ACAS owns); it's the income ACAS makes standing still and doing no deals. And what was that NOI in Q2 of 2010? ACAS' NOI was $29 million over the quarter. Doing nothing else to ACAS' business and merely dropping the debt renegotiation expense, ACAS' NOI would increase over 58% to $46m. This gives one an illustration how significant the elimination of the debt refinancing problem is to ACAS' ongoing operations.

ACAS' NOI hasn't been standing still, though: the current NOI represents a 45% increase over the NOI it posted in Q2 of 2009. As the economy behaves in a more normal fashion, ACAS' portfolio companies will be able to operate in a more normal fashion, and the results of those normalized operations will flow through to ACAS in the form of resumed debt repayment and improved business operations within portfolio companies. The Jaded Consumer has long advocated looking to NOI for an indication of the success of management in picking winning investments, and it's good to see that number moving up -- and looking to continue moving up.

The downside on the NOI is that at $0.09/sh, it is exactly where it was a year ago – that is, share issuance served to dilute NOI performance per share back to its year-ago levels. But there's an upside: even as NOI has stayed the same, ACAS' performance other than in operating income has moved forward.

NAV As Barometer of Management Performance
Even as ACAS posted $0.09 in NOI, it has grown net asset value more than the $0.09 one would expect in the absence of a dividend. NOI increased $0.17/share to $9.15, a 2% increase from the prior quarter. Compared to the NAV announced at the close of 2Q2009, ACAS is up over 23%. That might sound good, but the truth is better. Most companies grow their assets by posting profits on which they accrue tax liabilities. ACAS has achieved its recent results while making investment exits at a net loss – protecting it from being forced to disgorge assets either to the government as taxes or to shareholders as dividends. (As a BDC, ACAS' dividend payment is statutorily set within a range that is a function of ACAS' taxable profit; since FAS 157 and the SEC-reported "income" isn't taxable profit, those aren't the numbers one looks to either for tax liability or for dividend payment. ACAS will have no need to lose valuable cash to dividends for the near future, and will have no tax liability either directly or as passed to investors.) Since much of ACAS' portfolio is valued on the basis of things like price-to-earnings multiples (that are constrained under current markets, and would be expected to expand over the long term as macroeconomic conditions make investors more excited about equities as compared to fixed income investments) and earnings themselves (that are adversely impacted by things like unemployment and spending reductions that accompany the current economic cycle, but are cyclical and absent business failure would be expected to recover), the re-inflation of ACAS' NAV is likely only just begun. As ACAS begins turning in taxable profits, ACAS' loss carryforward will stave off tax liability for maybe another year or so.

When Earnings Aren't Earnings: What to Look For in ACAS
In the year-ago quarter, ACAS' FAS-157-compliant "earnings" were ($2.52) per diluted share (2Q2009), but the newly-announced quarter shows a gain of $0.84/share. Again, this emphasizes the disconnect between FAS 157 and the real world of taxable gains: ACAS is allowed (nay, required) to tell the IRS it lost money (and owes no tax, and has a loss carryforward that is growing so as to prevent near-term dividend issuance), but at the same time must report to the SEC (and to you and me) in accordance with FAS 157 and proclaim it's made 84¢/sh for the quarter, which at recent prices of $5.30 or so a share, suggests a miniscule multiple of price to earnings.

The tax loss means that dividend-paying requirements are pushed further into the future, which is good because ACAS pays good money for all its cash, and should be making a return on that money whenever possible instead of mailing it to speculators. I'd rather see the share price upward, thank you.

What does the 2Q2010 announcement tell us?

(1) NOI is set to rocket. NOI will swell with the decreased debt expense, which is not reflected in 2Q2010 even though the refinancing closed in the quarter. This is because the deal closed so late in the quarter that NOI reflected chiefly the default-rate interest ACAS was paying prior to the refinance. Because NOI includes ACAS' spread between its debt expense and its interest receipts, dropping its debt expense by reducing the principal by over $1B and by lowering the interest rate from the double digits to the single digits has a multiplicative effect on ACAS' NOI. NOI will also just stop being dampened by things like debt refinancing expense. Add in the elimination of the $17m debt refinancing expense, and it's clear NOI is sitting on a rocket for the next quarter.
Well, barring financial catastrophe that would affect portfolio companies' capacity to repay debt.

(2) ACAS won't be paying a dividend soon. This good for investors who want ACAS to get the most return out of its interest payments; why pay interest on money it has to distribute to shareholders and stop getting a return on?

(3) With rocketing NOI and no requirement for a dividend, ACAS will be generating lots of investable cash that (a) will lower ACAS' debt/equity ratio, (b) will have no interest expense, and (c) will multiply ACAS' returns as management seeks out more opportunities that are as mispriced as ACAS' own shares.[1]

And just how mispriced are ACAS' own shares? ACAS now trades at something like $5.30. At the end of the quarter, NAV stood at $9.15 and rising. This implies a NAV discount exceeding 40%. That means that if ACAS stopped working and focused its efforts on conducting an orderly liquidation, ACAS' shareholders would end up with a gain over current prices of over 50% (shares bought at $5.30 would result in a final dividend on dissolution of over $9, nearly $4 gain on a current investment). Since ACAS has positive operating income and is set to grow that operating income, the case for maintaining a NAV discount seems weak. The overhanging bankruptcy scare is long gone, and the future looks bright.

What kinds of opportunities does ACAS have to increase NAV? For an obvious example, let's look at ECAS – the European arm of the business that ACAS took private in early 2009. The NAV of ECAS is $0.7B, but ACAS claims it has a FAS-157-compliant "fair value" of $0.4B, or a $0.3B discount. The $0.4B given under FAS 157 is again discounted in the hands of ACAS buyers, who get their share of ECAS at a 42% (or so) discount, valuing ACAS investors' ECAS ownership at a total of $0.23B (or thereabouts). Would you buy ECAS for $0.23B when its NAV is $0.7B? What if you heard some of its portfolio companies were being given harsh discounts under FAS 157 and were worth a lot more than appeared on the books? Considering that ACAS has spent most of its publicly-traded life trading at a premium to NAV, the prospects for a multiplying effect as NAV discounts evaporate is an exciting and plausible prospect.

With respect to buying mispriced assets, ACAS founder Malon Wilkus said this:
We are now focused on originating high quality investment opportunities while continuing to improve our balance sheet. We have generated a 27% return on equity since the second quarter of 2009 and believe we will continue to generate strong book value growth for our shareholders as we recover from the recession.
The President of ACAS' Specialty Finance and Operations, Gordon O'Brien, spoke more specifically about this:
The quality of the portfolio continues to improve. Our investment and operations teams have made good progress in improving many of our troubled companies and the pace of new troubles developing in the portfolio has slowed significantly. We are pleased to now be able to turn our focus to making new investments. History has shown that the most attractive investment opportunities are made during the recovery from a recession and we believe that will continue to hold true.
ACAS expects to hunt down the most attractive investment opportunities exposed by the economic chaos and the recession, and use cash to pluck illiquid and discounted middle-market companies from the hands of exiting owners for the benefit of shareholders. This is exactly the reason I liked ACAS in the first place: it gets to cherry-pick the best deals in a field thin with buyers and flush with sellers.

Keeping Up With the Jonses
Normally, I don't spend much time worrying about what other people are doing with their investments (except to the extent I think they are creating an opportunity, like overselling ACAS or underestimating AAPL). However, there seem to be quite a few funds betting on the rationalization of ACAS' share price. ACAS maintains a list of major stockholders, and quite a few funds seem to hold a tenth of a percent of ACAS' outstanding shares or more as of their most recent filings. Among them are Paulson & Co. (which bought in a private placement in April), Vanguard Group, Dimensional Fund Advisors, and BlackRock – each of which reportedly holds over 3% of ACAS' outstanding shares. Well, in Paulson's case, over 12% of ACAS' shares outstanding. These are some big, ten-million-plus share bets.

They aren't making these bets because it looks like a crapshoot or because the anticipated return looks lame. I think they're recognizing that buying ACAS under these conditions is shooting fish in a barrel, or fishing with explosives: you can't hardly miss.

[1] Eventually, ACAS will have enough assets that will look to refinance its debt because it wants terms that improve its ability to leverage up when the investment cycle suggests that leveraging up makes sense. That will be a few years off, though. For now, we have lowered interest expense, lowered need to lobby lenders not to exercise acceleration and related default rights, and lowered need to reimburse lenders for legal expenses in connection with debt enforcement under oppressive debt agreements that force borrowers to bear lenders' legal expenses. (You laugh; as the fireman said in Ghostbusters, I have seen shit that would turn you white. I'm betting some of that $17m was reimbursement of lenders' legal expenses.)


Anonymous said...

Thanks, per usual, for the analysis and insight. One question: you write

"Eventually, ACAS will have enough assets that will look to refinance its debt because it wants terms that improve its ability to leverage up when the investment cycle suggests that leveraging up makes sense."

Wasn't this kind of leveraging up a big part of its problem in the first place?

Jaded Consumer said...

Thanks for coming to the Jaded Consumer!

Regardless the level of leverage ACAS management thinks is appropriate, asset growth will eventually reach the point that ACAS wants to borrow to reach the desired level of leverage, and will have to refinance its debt either by paying off its existing lenders or by renegotiating. Hopefully ACAS' financial condition at that time will make this a less painful procedure, and involve less material expense.

I'm not sure that "leveraging up" was really ACAS' problem; as the economy headed toward the edge, ACAS was de-levering in anticipation of debt/equity ratio issues and to keep in compliance with the debt restrictions it faces as a BDC. The problem wasn't that it took on too much debt, as it were, but that its assets took too big a hit. Did any of the financials really foresee that the crash would have the magnitude it had? I think ACAS lacked awareness that the wreck into which it was headed – and for which management was strapping down the cargo load and fastening the passengers' seatbelts – would be the financial equivalent to a head-on collision with a train, but I don't think this lack of appreciation is an especially powerful indictment against ACAS' management.

ACAS' management did enter some countercyclical investments in the expectation of trouble, and its work with AGNC has been absolutely stellar. ACAS just didn't foresee that the financial collapse would be that bad. Well, neither did I. And what do you know, my own portfolio's leverage bit me in the butt, too.

ACAS plans to continue de-levering, probably to its historical level just below 1:1 debt:equity. In the short run, it'll remain highly levered just because it's started off highly levered. Assuming the economy is turning around in the medium term, leverage will be good because it'll allow ACAS to hold investments as they reverse their paper losses and enjoy the increases of the investments that have been doing well. MION, which ACAS' management intends to IPO, will be one that we want ACAS to hold until the world is willing to pay management's demanded price; we don't want ACAS exiting anything prematurely simply to run down debt at a time ACAS is not being killed by the debt.

The fact ACAS has positive and powerfully-rising NOI is one reason to be reassured about ACAS' capacity to handle its debt load. The NOI announced after the current quarter will show us what NOI is like with single-digit interest expense and over a billion less debt to service, while eliminating $17m in debt refinance expense. I think the NOI number will be very nicely up.

However, what I'm really looking for in ACAS to support my investment thesis is continued NAV appreciation in excess of NOI. Of course, if the NOI pops enough, that might be hard to do. Then again, as NOI pops, one expects the value of ACAS' underlying portfolio to be improving to explain its ability to generate that kind of NOI for ACAS. The two aren't entirely unrelated. I expect both to be moving in the right direction.

When it's clear both are doing a great job, I'll look for the evaporation of the NAV discount.

Anonymous said...

Yeah, nice detailed work, as usual. Any comment on the implication of the growth in non-accruing loans? That number grew over 20% in Q2.

Jaded Consumer said...

The non-accruing loans are definitely a black mark on ACAS' record. The whole point of management's due diligence is to pick investments that will produce stellar returns. When management pays to borrow funds that are repaid at 0% interest or default, ACAS' investors are not rewarded thereby.

Of particular note is that the non-accruing loans are consistently reported at "fair value". "Fair value" -- that is, the value ACAS could get selling them in the marketplace -- is a lot less after they've defaulted than the face value of those loans. Looking at the face value of those growing non-accruals, one wonders where ACAS would be if management hadn't invested in so many of what turned out to be dogs.

The other question is whether some of those non-accruals are on non-accrual in order to keep the businesses on life support until they can turn around and produce a return. In other words, are they strategically in default with ACAS' consent or encouragement in order to keep those particular businesses from being utterly destroyed by the downturn. If so, ACAS could potentially see some reversal of unrealized diminution in value as those loans begin paying again. Considering the number of businesses that are totally dominated in management by their owner/creditor ACAS, it's probably ACAS' choice not to liquidate or shutter those businesses and write their value to zero.

In other words, I expect some of those investments are still on the books because management sees some prospect of turnaround - or at least some prospect of exit at better than the value of the assets at auction.

This part of ACAS' operation is really hard to evaluate from the outside. Just how bad are things inside some of these entities whose debt to ACAS is in default? How good are the prospects of turnaround?

The fact that ACAS is paying more than I pay on my home note on capital it's lent to defaulted borrowers is something that management has justifiably expressed some shame in the past. Let's hope management's turnaround strategy and operations teams have extremely good ideas about how to derive value from these investments going forward.

Anonymous said...

First I'll start with, I own ACAS and like it for its potential writeups... BUT, some food for thought.

1 - BLT's trapped $114 million in cash in the first 6 months.

2 - Half of ACAS's cash position is restricted that they can't redeploy but must use to pay down the BLT's

3 - The new notes that replaced the bonds have a make whole provision through Aug 2012, so there is no advantage at all to refinancing.

4 - the majority of the writedowns are in equity positions thus any writeups will come in lumpy waves.

5 - The CMBS that were written down will likely never recover.

6 - Cash flows from operations were negate 1 million. ACAS generated its cash flows from exits, which currently means they are locking in their losses.

I just wanted to make sure people understood the risks before taking the plunge. From here out it's probably a 3x in the next 5 years, but it will probably be a bumpy ride.

its_not_my_business_but said...

Anonymous ..

The make-whole payments ONLY pertain to the public-bond refinance portion .. about $500M. ACAS does have the ability and provision to get a line of credit once it pays the other portions of the debt down to ~$300M even with the $500M bond-refi still on the books.


Anonymous said...

With the Innova sale today they have breached the 300mm cash balance by about 50mm. Perhaps with the Narus sale closing, ACAS is in a position to pay down that 300mm well before years end. 100mm is the earmark they have for an operating cash balance.

Jaded Consumer said...

Assuming they don't have some special plan for the cash, lowering their entire debt's interest rate by a full percent, and increasing the spread on all ACAS' debt holdings seems like it'd be a high priority. Announcing early success would sound good on the next conference call, too.

Of course, we don't know what deals ACAS has in the pipeline and whether ACAS thinks it needs to deal with an attractive but fleeting opportunity beforehand.

The next conference call will definitely be one to catch.