Saturday, March 26, 2011

Shallow Analysis Misrepresents Accretive Issuance as "Dilution"

Today I noticed a 3/22 article at Seeking Alpha that discussed AGNC's 27m-share public offering announcement (Seeking Alpha says 27m, but ACAS says 28m plus over-allotments up to 32.2m).

The stupid part of the article isn't getting the share count wrong, of course. The stupid part is this:
While shareholders should never like being diluted, it makes sense for AGNC to keep issuing shares to expand its holdings of securities given that shares trade at a premium to book value, which was last reported being $24.24 on February 8th. The fact that shares continue to march higher, even with the dilution, is a testament to the strength of the company's management American Capital (ACAS), and the 19% yield.
Dilution is when share issuance causes post-issuance shareholders to have less per share than before the issuance. Get it? Dilution. AGNC has been issuing shares above NAV, so that immediately after the issuance the NAV is more than before the issuance. That's not dilution, that's accretion. And no wonder people like it: as long as the same deals are available to AGNC through its ACAS-supplied management at the time of the issuance as was available at the time AGNC entered the deals that led to a NAV premium, the post-transaction NAV premium should make the whole ball of wax even more attractive.

And well it should: AGNC's transactions are in agency-backed securities in which there is no shortage, and increased transaction sizes only allows AGNC's fixed overhead to get leverage on bigger deals. Oh, wait. That's ACAS' overhead. AGNC pays ACAS a management fee based on net assets, so its overhead isn't going to change as a fraction of investment, and I am unaware of any non-ACAS overhead that is material to AGNC's operations. ACAS, on the other hand, makes bigger and bigger deals using the same management team and derives more and more profit from the operation. Its percent ownership of AGNC decreases with each issuance, but as the value of its fixed number of shares continues to swell and its management fees continue to grow, the asset manager does quite well by making the company available to more and more investors.

Fee-based asset management isn't a bad business: ask Ameriprise and Edward Jones about it. ACAS doesn't need to market very hard, though, just run the business while we bid for shares. Assuming AGNC doesn't issue any shares under over-allotments, and raises the net proceeds of $780m it anticipates, ACAS' management fee increases by nearly $10m/yr ($780m x 1.25% = $9.75m) or $813k/mo. That's quite a jump: in 2008, ACAS' entire management fee for running AGNC was $800k per quarter. Currently, with a book value over $24/share and a post-issuance share count of 92.9m (64.9m at the end of 2010 and 28m on offer, disregarding the potential for further issuance under over-allotments), ACAS' fee income for managing AGNC is over $28m/year (over $7m/q). This has grown to dwarf the dividend paid to ACAS on the 2,500,100 shares of AGNC it owned into last quarter, which at the $1.40 quarterly dividend paid $3,500,140 per quarter in dividend income ($14m/y).

ACAS has gone from having a trivial investment management fee as a bonus atop its dividend to having substantial fee income. ACAS' last annual report discloses 353.1m average diluted shares outstanding in the last quarter of 2010 (although only 342.4m outstanding). Assuming that this number remains accurate (I haven't noticed any 2011 issuance of ACAS), ACAS' post-AGNC-issuance income from its AGNC business ($28m/y) leads to per-share receipts of 7.9¢. About a penny a year is attributable to the last issuance, and the shares still trade at a premium, inviting more issuance.

Not too shabby.

ACAS isn't succeeding with AGNC by diluting investors in some share-printing Ponzi scheme, it's attracting additional investment to a strategy the investment in which has been valued by the marketplace above NAV for quite some time. Investors who buy in public offerings of new shares at prices below current market but above NAV aren't getting less than prior investors, and prior investors enjoy an increase in the assets backing each share rather than the dilution described by the article linked above. Sloppy use of language in the article tends to lead readers to believe investors are somehow being fooled by confidence into bidding up shares even as their interests are being devalued by dilutive issuance, which is just wrong, wrong, wrong.

Accretive issuance is good for AGNC owners, which is why ACAS – a former shareholder itself – has been steadily performing this very trick over and over to the delight of capital-profiting dividend investors.

Apple's Competitors' Marketers Lie To Compete

Samsung has been caught not only using paid actors in its supposedly "real-world" interviews with seemingly ecstatic users purportedly found in the wild (as Microsoft was caught doing), but even lying about the thickness of the hardware it has positioned against the iPad 2.

Amazing, isn't it? How, exactly, did they suppose this would go unnoticed? Did they think nobody else had a set of calipers?

Tuesday, March 22, 2011

MSFT To Kill Zune?

When I read that MSFT was "to Kill Off Development of New Zune Hardware" my first reaction was: someone is still selling Zune hardware?

I thought the killing-off of the Zune had been done already, by the marketplace's long yawn at the product. Decisions about the product in Redmond in 2011 smack more of coup de gras than of execution. I declared the Zune dead here in late '08, when it was clear its share came mostly at the expense of Microsoft's "partners" in its PlaysForSure DRM strategy (remember that?). Heck, just to illustrate what a lousy deal MSFT "on sale" was in 2008, I've prepared this little chart to compare it to the Dow (which I believe it's lagged since joining) and to two stocks that have the Jaded Consumer Seal of Approval (Apple and American Capital):

+25% isn't bad in two years, but it's peanuts compared to some not-too-hard-to-find alternatives.

In 2008 Microsoft's web browser share had just dipped below 90%. Now, Microsoft faces the same fate not just in browsers but on the whole operating system. Microsoft faces not just a raft of Unix and Linux distributions in various high-end-server and ultra-low-budget markets, but even one single competitor with double-digit OS share in an increasing number of markets. (MSFT's "share" in Asia and Africa, where it certainly doesn't garner retail or even US-standard OEM licensing revenues, might not be something to brag about.)

More interesting than desktop os share (c'mon, some of those are Internet-unaware point-of-sale systems whose idea of a peripheral is a cash drawer; I've seen an iPod Touch do better, wirelessly, with a cash drawer built into an Apple Store table) is the OS share as seen by online vendors. NetMarketShare offers this view of Microsoft's share of operating systems used by those who browse the web (this ignores, for example, most of the installed Unix and Linux – those are largely deployed in servers, not desktops that would run a browser). Microsoft's share of web-facing consumer machines has, according to that survey, crossed below the 90% threshold that Microsoft crossed in web browsers a couple of years ago.

This doesn't mean Microsoft is irrelevant – there are definitely areas in which neither Apple nor Google have any hope of competing at present – but the Zune isn't part of MSFT's best case for future upside. Identifying the next success story isn't necessarily obvious, and every Goliath must fear a David behind every little pile of rocks (or fall accordingly). Apple can't sleep on the music market or the phone market, and Microsoft sleeps on the desktop operating system market at its significant peril.

The death of the Zune isn't the death of MSFT, but it's a sign that the company is capable and willing to put a lot of resources into things that don't produce returns. Is that a management you want on your side? MSFT's significant cash cows (MS-Windows OS licensing and MS-Office licensing) will keep filling the milk trucks for years to come, but what is the expected upside in a world increasingly based on standards and not on locked-in proprietary formats of the sort that keep people using MS-Office?

UPDATE: despite claims that Zume is not dead, Zune has gone out of stock and the Zune podcast series terminated.

Sunday, March 20, 2011

Bon Jovi: Real Men Don't Know What Music They're Buying

This latest piece from Bon Jovi isn't a musical number, it's a screed against the tide.

Let's back up a few centuries. Let's say you want to hear world-class music from artists you've read about in the papers. Unless you're in Berlin, London, Paris, Vienna, Rome, or maybe Moscow, you're kinda out of luck: that's where the top acts play. There is no recording. If there's a carriage collision on the way to the venue and you are delayed, there's no way (other than by asking patrons how good it was) to know, or re-hear, what you missed. Homebound invalids get to daydream about music, unless someone can carry them to a pub where a traveling act stops – but the traveling act gigging in a local pub won't be the world-class stuff you read about in the papers, it'll be a knockoff by someone who may never have heard it. Or something completely different. And if two acts compete in the same time slot, you may miss one entirely. And there's only so many seats. And the pubs can be noisy – a poor place to hear music.

Moving forward toward the modern era, we transited through an era in which a large hand-cranked wheels carefully manufactured at great expense spun fragile graphite slabs beneath a needle connected to an amplifying cone (don't drop the recording media!) and into an era in which mass-produced handheld players let users carry an entire hour-long concert on one's belt while walking. For a few hours' wages and no trip across the ocean, the best tenor on the planet – or a rock act that died before you were born – could be enjoyed for as long as the tape held out (which might be years if not left on the dash in the summer sun). If you couldn't bear to part with that much money, bands' labels marketed as "singles" a favorite song, paired with a lesser-known song the sellers hope will get some notice due to the packaging. The "single" might be on a cheap-to-press plastic disc designed to be spun at 45 revolutions per minute (that wouldn't shatter when dropped – nice!), in which case it'd be hard to carry with you (too big), or you could plug the player's output cables into an available-everywhere tape recorder and make your own mix tape full of singles, album fragments, and everything else you might want to hear. Sometimes, whole albums were aired on the radio ad-free and you could tape the whole thing.

Today, whole songs can be found digitally encoded online, with free evaluation ranging from a 30-second clip to a full-song stream. Instead of having to buy twelve tracks from Golden Earring just to hear Radar Love and Twilight Zone, you can buy the ones you like for a small fraction of the federally-established minimum wage employers must pay employees for an hour of labor. If you fall in love with the cheap music, you can drink straight from the fire hydrant: everything that's for sale electronically is for sale on your computer, and so is everything that's not available digitally, because all record shops and secondhand book venues have become major retailers online.

Against this background, Bon Jovi's kvetch against user-previewed per-track online purchase is a quaint "we walked to school in the snow, uphill both ways"-style joke. He literally argues that the "magic" buyers "enjoyed" involved buying closed albums with no idea what they sounded like – buyers were in effect playing a lottery as to whether the music was worth the money. Bon Jovi argues this was a good thing.

Well, maybe if you are Bon Jovi: people recognize the name and buy it. It's a brand. But let's face it: for the average Joe, who wants to get what he pays for, he benefits from knowing what he's buying – and he benefits from being able to see a selection bigger than can be carried in the inventory of a physical-media-peddling corner store.

I for one never wanted to buy the picture on the album, I wanted to know what it sounded like inside. That's why, when Napster was new and I could gather songs from the libraries of likeminded listeners for review by L, we bought more music in a month than previously we'd bought in an entire year.

Friday, March 18, 2011

ACAS: ECAS Making Money, Too

Recently, the Jaded Consumer posted on ACAS' recent year-end and Q4 results. One recurring feature of ACAS' finances is its undervalued holdings in European Capital (ECAS), its formerly (before early 2009) publicly-traded European investment subsidiary, which occasionally gets news releases of its own. (E.g., consider ACAS' 2Q2010 report, which discusses ECAS' valuation as a feature of ACAS' long-term prospects.)

Now, ECAS has released some 4Q2010 and full-year results of its own.

Just like ACAS, ECAS has raised its NAV over the reporting period. At the close of the fourth quarter of 2010, ECAS' NAV of €629m (for those on the left side of the pond, $890m) was up 8% over the prior quarter and up 19% over its NAV at the close of 2009. Not only have NAV increases resulted in SEC-reportable income (remember, unrealized appreciation in securities is now "income" for SEC purposes but not IRS purposes; in the case of this reporting period, it's €47m (31% ROE) on the quarter and €105m (18% ROE) over the year), but ECAS' consolidated financial statements have been boosted by its operating companies' results to a net operating income (NOI) of €29m ($41m) over the quarter and €48m ($68m) for the full year (a 29% increase over the 2009 result).

So, why is a 29% y/y increase in NOI a result to smile about? For starters, ECAS is ACAS' largest single investment. Returns like that on a large investment are much more interesting than a similar return at a portfolio company too tiny to materially impact ACAS' results. More importantly, ECAS isn't just some portfolio company: it's an application of ACAS' business model to European markets, and thus a signal both of (a) results one should expect from ACAS itself, and (b) how ACAS' management should be expected to perform across larger geographies going forward. In the near term, it shows that ACAS can grow a substantial investment's NAV from €528m to €629m in just a year, even as ACAS continues to report the investment as having a FAS-157-compliant "fair value" of $636m (that's not a typo; it really is about €449).

Since ECAS' NOI and NAV increases are not based on ACAS' "fair value" of ECAS but on the capital actually available to ECAS and the particular deals in which ECAS has that capital deployed, the NAV-discounted "fair value" of ECAS doesn't impact ACAS except to the extent that it makes it a better deal to buyers while the "fair value" ACAS continues to report trails not only the value one might assign on the basis of future cash flows but also the value ECAS would realize liquidating its holdings, or that ACAS would fairly report if it dissolved ECAS in favor of direct ownership by ACAS.

Another investment that ACAS investors will want to watch is Mirion Technologies (MION), ACAS' company that provides surveillance equipment and services to the nuclear industry. Events in Japan have raised awareness and concern about nuclear power and its safety, potentially making MION's products and services more valuable. Theoretically, Japan's recent experiences may create additional headwind for new nuclear projects, but let's face it: new nuclear projects weren't exactly queuing up to launch, and have long been subject to NIMBY opposition and regulatory hurdles of various sizes all around the globe. Japan's news will tend to prolong this trend against nuclear as a clean power option, by helping depict it as potentially frighteningly unclean. Nothing in the news out of Japan will drive existing nuclear power offline, however, but may make compliance and safety a bigger-profile issue going forward. How this impacts MION's eventual pricing as ACAS seeks to take it public is a definite must-see event for ACAS investors, because MION is ACAS' second-largest holding and – for that reason – has the potential to offer a material impact to ACAS' bottom line.

Much larger than MION, however, and much more reflective of ACAS' broader business and the success of its business model, is ECAS. Good news on ECAS – like that in the recent results – is good news indeed for ACAS.

Sunday, March 6, 2011

Libyan Tyrant Attracts Likeminded Fan Praise

Beleaguered Gaddafi, longstanding strongman of a state sponsor of international terror, is attracting supportive comments from other heads of state equally out of touch with the civilized world. The quotes can't be done justice; read them yourself.

On ACAS' Recent Reporting Period (Q42010 and full-year 2010)

American Capital Ltd. recently posted an improved quarterly result. Net Operating Income was up to $0.19 per share in 4Q2010, and net earnings reached $1.08 per share. Return on equity in the quarter was at an annualized rate of 44%. Not bad. Over the quarter, ACAS increased net asset value (NAV) by $1.12 (12%) to $10.71. Compared to a year ago, ACAS' NAV is up 29%. Remember a couple years ago when ACAS traded under a buck?

At its 25th anniversary, American Capital was able to look back on a pretty good year. ACAS' full-year 2010 result included over a billion in net earnings ($3.02/sh) reportable under the SEC rules. (The SEC-reportable income isn't the same as IRS-reportable income, which is what drives ACAS' dividend-paying obligation. One major difference is that under FAS 157, ACAS is required to call capital appreciation "income" which private investors are not required to do in their own portfolios, because the tax rules call for recognition of income on disposition rather than on change in value. This factor – the difference between earnings based on valuation change and earnings based on recognition at disposition – is likely to make SEC-reported income and taxable income rather different since ACAS' business is investments.)

Slide #10 of the investor presentation shows ACAS has continued to experience consistent (though "lumpy") liquidity. Some of the liquidity results from borrowers making repayments of obligations outside of ACAS' control, and some results from ACAS acting to dispose of a portfolio company. ACAS hasn't been trying to dump portfolio companies, but pursuing opportunities and consummating those that were good deals. The 2010 realizations may total $1.3B, but they don't represent ACAS bailing out of its equity investments: of the billion-plus in principal payments, $874m consists principal prepayments (e.g., principal returned on exit from entire investments in which ACAS held both debt and equity) and $36m resulted from scheduled principal amortization. $40m came back to ACAS from syndications and sales of debt. ACAS' equity sales of $266m aren't trivial, but that's not where ACAS seems to have been reclaiming cash. Slide #11 shows that ACAS has gotten for its investments what ACAS has reported the investments to be worth in its quarterly SEC filings. Slide 14 shows that ACAS' investment portfolio statistics haven't changed much with ACAS' realizations (i.e., ACAS isn't selling off its best investments and collecting dogs that will later bite investors; it's selling a fair cross-section of what it's got left). One thing that's worth noting is that as a percent of the fair value of ACAS' assets, equity has grown from 27% of the portfolio's value in 1Q2009 to 40% in 4Q2010, which may simply reflect that in 1Q2009 there was no market for the equity of illiquid portfolio companies and now there is.

Following the close of 2010, American Capital continued repaying debt, not satisfied to have hit its debt:equity target ratio of 0.6:1. Over the last 6 quarters, ROE has been 44% (so 4Q2010 wasn't a fluke). From ACAS' book-value nadir at the end of 2Q2009, debt repayments have exceeded $2.1B, book value is up $1.8B.

What's the future hold? ECAS alone offers $234M in further appreciation based on evaporation of internal discounts. Expected performance of debt currently bearing a FAS-157-compliant "fair value" below face value promises a further $237M in increases. Capital loss carryforward stood at $590M at the end of calendar 2010, protecting ACAS from future tax expense while that loss carryforward is eroded by future income. Loss carryforwards protect ACAS from tax expense this year or dividend obligation in 2012, so gross results and after-tax results will be the same and liquidity can be kept rather than drained in mandatory dividends. Management believes the reports that the economy is recovering, and offered Slide #6 to suggest an association between GDP and ACAS' net earnings. ACAS' pickiness in deal selection has paid off: despite the worst recession in decades, ACAS has over the last couple of years exited control companies at higher multiples than at the time of purchase (of course, if EBITDA sucks, a high multiple may not save price; the behavior of the market generally still matters ... still, having multiples go up over this period is quite a feat).

ACAS has continued to pay down debt following the close of the 2010 calendar year (to the tune of another $150M). This doesn't reduce ACAS' interest rate, as it's as low as its current debt facility permits. Debt retirement presently provides ACAS a risk-free 9% return while strengthening ACAS' balance sheet toward the ability to borrow at more favorable rates. ACAS' management made it very clear that it didn't think its existing cost of borrowing was attractive: ACAS prefers to borrow at AAA rates, and will repay debt to get there. Share buyback, by contrast, constitutes a leverage-increasing transaction that impairs liquidity without improving the balance sheet: don't expect share buyback soon. ACAS would rather improve its portfolio and balance sheet than shrink the company with share buybacks. Refinancing would occur following the expiration of the August, 2012, yield maintenance provisions of its current debt agreements. Prepayment is available without fees, however.

The recovery program at ACAS is being conducted in two phases: (1) growing book value, then (2) re-starting the dividend. While book can still be grown tax-free (due to loss carryforwards), current shareholders benefit. Dividend resumption will turn on taxable net income following complete erosion of the loss carryforward, and will when it appears will signify that ACAS has made enough money long enough that the government again wants it paying 90% of its taxable income. It will also put ACAS back on the map for income investors. If the dividend is attractive, income investors can be expected to bid ACAS back out of its discount-to-NAV share prices.

ACAS has gotten out of a few lines of business: (1) Credit opportunities, (2) early-stage technology investment, and (3) second-lien investing and trading. American Capital's financial services business hasn't been active, but management welcomes that business as it becomes available. ACAS continues to seek new investment opportunities.

ACAS has continued to increase its funds under management, reduce its operating expenses, improve its net income, and grow its asset value. The future promises more NAV discount evaporation within ACAS' investments, and when (after 2012) ACAS re-initiates its dividend (which will be required based on taxable income) its own NAV discount will be reduced by income investors seeking regular returns based on ACAS' trailing-year taxable income. Management is focused on near-term book-value-building enterprises based on sound financial theory rather than gimmicks designed to game per-share metrics.

I have only accumulated shares since the liquidity crisis in 2008, and I expect the shares to continue appreciating under the management that's helped ACAS to recover so well since the liquidity-related collapse in 2008-9. By the time ACAS resumes a dividend, I hope to have come up with some scheme to migrate those shares into an account in which the dividend – which I expect to become substantial once more – will be less painful than in a regular account. I don't think I'll manage to move it all, though ... ahh, well.

Paying taxes on a huge dividend isn't the most awful thing that ever happened at the Jaded Consumer :-)