Thursday, August 25, 2011

Buffett Illustrates Private Deals Can Be Sweeter

Berkshire Hathaway just invested $5,000,000,000 (yes, the zero count is correct) in an investment vehicle that didn't exist last week: 50,000 shares of 6% preferred Bank of America shares with a 6% par value, coupled with a sweetener – warrants totaling some 700,000,000 shares of common stock, exercisable over the next decade at about $7.14. On the news, shares spiked to $8.15, but expect that number to change over the decade.

Given that Bank of America is making me a car loan at less than 4% and a home loan at something close to 5% (I never applied to BoA for a loan, but it bought both notes), I consider Berkshire's 6% coup – coupled, as it is, with a hefty equity upside opportunity – to be pretty slick. Not too long ago, Berkshire Hathaway made a similar deal with Goldman Sachs and General Electric, but with 10% preferred. Capital was tighter in late 2008, so Warren Buffet had more leverage.

Under FAS 157, Berkshire Hathaway must value its warrants using a methodology that will take into account the fact that the warrants are at least hundreds of millions in the money, and that it's got as much as a decade of time premium. It'll also be getting a quarterly dividend at a rate that's fairly respectable. At some point, when it makes sense to exercise the warrants at $7.14, it'll also get whatever the prevailing dividend is on the common shares – but will have a rate of return based on its strike price, not the market price.

Deals like this aren't available directly to small investors. To get involved in a custom-negotiated investment with a counterparty with carefully-examined risks, and a deliberately-engineered upside opportunity, one invests in a firm that makes private deals.

That was my original investment thesis in American Capital: it was (my theory went) Berkshire Hathaway diversification with small-company investment performance. Presently, American Capital is making few new investments, despite the economic climate and its current cash hoard, but instead is paying down a secured debt that it undertook restructuring pre-'08 deals that required it maintain net asset levels that the post-crash value of its illiquid assets didn't make possible. American Capital may be full of these sweet deals, but it's hard to tell because we don't see much deal stream right now. Berkshire Hathaway is clearly making deals, but it's not making them at a high rate and it can't meaningfully invest in anything that isn't enormous.

Anyone else have a line on interesting vehicles for participating in privately-negotiated deals?

UPDATE: ACAS just announced a $50m senior subordinated investment to finance the merger of two opinion survey companies, one of which had previously borrowed from American Capital in 2006. Apparently, the debt pay-down is at levels – or the deals are now at levels – at which it is willing to deploy capital to new investments.

Sunday, August 21, 2011

Lenovo Hasn't Read About iPods

Lenovo's chief executive Yang Yuanquing announced that it will dominate tablets in China because "Apple only covers the top tier." Lenovo, he says, will cover more price points, and reach Chinese customers that can't afford a $500 device.

Remember the Jaded Consumer prediction that Apple was underway with tablets on the same mission it undertook with iPods?

Rewind the clock a few years. Manufacturers of MP3 players were laughing that Apple only sold a $500 player, and that because they could use cheaper (bigger) drives or Flash that they could build things that would reach customers at other price points.

Today? Apple has for years covered every price point from $40 to the top of the market, and with such volume of production and such supply-chain management that nobody else can really make money in the game. No Flash? Now that Flash is big enough to support a player worth printing an Apple on it, Apple is the world's largest buyer of Flash. Trying to build a Flash player to make money in Apple's playground is a tough game.

Hell, Apple's in the process of doing the same things with cell phones, a market in which Apple takes in two thirds of all profit in the entire market. Competitors like Nokia? You can't make it up in volume when you sell at a loss, buddy.

So, what's the difference between tablets and cell phones?
  1. Cheap cell phones don't need a pricey touch screen. Any tablet must, to accommodate the expected UI, include a costly touch-sensitive full-color screen capable of displaying crisp text and viewable movies. This raises the floor on price, except to the extent competitors want to try selling unusably small tablets. Good luck making money in that market, Lenovo.
  2. Cheap cell phones don't need high-end graphics or the horsepower to run all the apps people expect from tablets. What makes tablets so useful are, unfortunately for Lenovo, the apps. That means that unlike phones, in which manufacturers can target customers who won't run apps with a machine whose processor can't run apps, tablet competitors have to ship hardware capable of putting images on the touch-sensitive screens and capable of interpreting touch controls while the apps are running without making the sound skip. These things either involve costly mobile graphics coprocessors, or high-end low-power mobile processors, or terrible battery life that will kill sales. This also puts a floor on parts costs. It also establishes a usability threshold below which the product will suck so badly no-one would want to tarnish their good name selling it. Again: good luck, competitors.
  3. Software. In the phone space, there are market segments in which software is unnoticeable to users. There is of course software on these low-end phones, but all users notice is that it either (a) is unnoticeable (a success) or (b) interferes with making calls (e.g., by introducing a half-second lag between every button-push and every response, so that you can't see the mis-dials caused by the software not picking up keystrokes on cheaply-built buttons, as I "enjoyed" with the phone I owned immediately prior to owning a 1st-gen iPhone). Considering how badly some well-known phone manufacturers are doing at delivering phones that just make calls without irritating users, the ability to deliver quality software and/or adequate hardware is something one can't really take for granted. And since software is a major part of the tablet universe, Apple's edge in software is an extremely serious advantage – especially in markets in which multilingual support is important, or malware makes Apple's curated platform and signed-app system more valuable. Lenovo is launching Android and MS-Windows tablets – both. Just how large are the resources Lenovi is able to put into making both those ecosystems as attractive as Apple's? (In fairness, Google and Microsoft have strong interests in building the value of each of their software platforms, but thus far the "on anybody's hardware" strategy targeted by each hasn't paid off. And in the case of Microsoft, the tablets had better be Intel-compatible unless running in a Microsoft demonstration... and what apps will be running on the non-Intel systems when support becomes official?) So, good luck on the software, which Lenovo won't control.
Given what Apple's achieved in the cell phone market without the above advantages – that is, taken over half the profit in the entire market – it's hard to credit Lenovo as a serious competitor to Apple in a market in which it competes with those advantages. Lenovo may sell units, but units aren't profit. Without profit, who wants to invest in effort to sell units at all?

The tablet market will be interesting for competition, but not for the reasons Lenovo's chief executive identifies. The interesting competition will occur not at the bottom end, but up where the products are highly desirable and capable of running exciting software. This is because the primary competition will ultimately be in software: the hardware will keep getting more affordable until, like the low-end iPod, it's pretty easy to afford. The software will be the primary differentiators, and the question will ultimately be whether the competitors will marry themselves to counterproductive ideas based on ideology, or will make strategically sound decisions that will result in high levels of perceived quality.

That's not where Lenovo is proposing to compete.

Lenovo explained that it had a phone where Apple competed at $500, but also had a $150 phone for lower-budget families, where Apple could not compete. However, Apple presently holds not only the #1 unit sales slot with its 4G iPhone, but also the #2 slot with its 3GS iPhone. The older model with already-paid-for design and manufacturing setup (and RAM limited to 8GB) helps protect Apple's position on at the top of the market by removing a safe place to compete at the tier just below it. (Much as lower-capacity music players protected Apple's top position in the music-player market.) Lenovo's $150 model hasn't apparently been able to out-compete either phone. Also: Apple's better-selling phone is the more-expensive one.

Saturday, August 20, 2011

Windows Phone Optimist Responds to HP's Mobile Device Exit

Microsoft's Brandon Watson responded (via Twitter) to the HP exit from WebOS hardware with an invitation to extablished (and presumably bummed) WebOS developers. The invitation contains an interesting assumption -- can you spot it?
To Any Published WebOS Devs: We'll give you what you need to be successful on #WindowsPhone, phones, dev tools, and training, etc.
On my read, the invitation assumes that something Microsoft is able to deliver can enable third parties' success. In particular, it assumes that some combination of Microsoft phone hardware and development tools are capable of enabling developer success for developers whose products targeted WebOS. But given Microsoft's share of the phone OS market, which since the launch of the euphonic and musical-sounding Windows Phone 7 Series has fallen 38% from 8% to less than 5.8%, mostly within the last quarter (7.5% to 5.8%), one wonders what "success" means for a developer receiving this largesse. And whether the share Microsoft might snag from disgruntled WebOS developers (less than 2%) is really capable of moving the needle for Microsoft.

Of course, Microsoft may expect its arrangement with Nokia to result in big share. But think for a moment: Nokia's huge market share (recently just under a quarter of the market) lies in the lower-end, where margins are slimmer. And Nokia's share (measured by units) is falling. Measured by profits ... well, is a share that results in a loss bigger than a half-billion dollars per quarter really a market worth targeting? Last year, Nokia's share exceeded 40%. No longer. If Microsoft is making any money on this deal, it's making more than Nokia. What's the lifespan of a deal like that?

But Watson promises "what you need to be successful". And when has anyone from Microsoft ever lied?

Friday, August 19, 2011

On HP Quitting Tablets

On The Next Web we learn that HP could not compete with Apple's iPad hardware: WebOS was over twice as fast on Apple's iPad as it was on HP's own tablet. According to Joshua Topolsky, HP claims to have plans for WebOS, even if it doesn't have plans to compete in tablet hardware.

After shelling out one point two billion greenbacks for Palm, HP has a certain amount of motivation to make something of its IP, and to retain the quality engineers it gained with the purchase. How it'll do these things is a question for which it isn't yet offering answers.


[Note: This post was begun 8/3/11 and, due to distractions, not completed until it was noticed in a draft bin weeks later. Sorry about that.]

As previously discussed, ACAS is launching a REIT to invest in mortgage bundles. Unlike American Capital Agency (AGNC), American Capital Mortgage Investment Corp. (MTGE) will invest mortgage-related investments that aren't necessarily backed by the guarantee of a United States agency. Selling fewer shares than initially planned (8m rather than the planned 17.5m) on the first day of the recent market rout, ACAS maintained pricing at $20. In conjunction with the public offering, ACAS directly purchased a $40m block (2m shares) of MTGE for itself.

Despite a prediction that the investment was doomed to be a loser at issuance prices – based on comparisons with other recent mREITs rather than with ACAS' other mREIT – MTGE shares (which dropped with the whole market over the first two days) have recovered to $19 and above before MTGE even demonstrated any investment performance.

I had hoped to buy under $19, but my plan had been to make the purchase in a new account funded with money I hadn't received yet, and it looks like my window for a steal has closed. I suspect that MTGE will in many ways replay AGNC, with the exception that MTGE will not have access to the derivatives income that aided AGNC during the 2008 panic. This prediction is based on the assumption that non-Agency-backed mortgage securities will be less liquid, and thus will not have a ready derivatives market to use as a hedge.

The investment thesis in MTGE is surely a reflection of ACAS' broader investment thesis: illiquid investments are likely to be underpriced due to the inefficiency of the markets for illiquid hard-to-price investments, so ACAS will buy not to resell but to hold. To counter the risk of being stuck until maturity, I expect ACAS to do things like buy variable-rate mortgages. Without the government guarantee, I expect ACAS to be looking for – and finding – medium-grade mortgage packages at afwul-grade prices, with the intent to hold for the upside of the repayments the sellers are too impatient to bet on. I believe ACAS' experience pricing AGNC's portfolio has given it a good idea where the inefficiency is in the market, and given it a hunger to buy at dirt-cheap prices mortgage bundles that aren't nearly as bad as their pricing would imply.

On the other hand, MTGE isn't barred from investing in the exact same investments as AGNC. MTGE merely has the freedom to invest more flexibly.

Oh, and ACAS is paid by MTGE an advisory fee of 1.5% of MTGE's assets, not the 1.25% it is paid by AGNC. So maybe the MTGE issuance is less exciting than it looks: ACAS gives itself a 0.25% raise while broadening its freedom to invest funds beyond agency-backed securities. The 185m raised in the initial round of funding doesn't all become MTGE assets; the 8m shares actually in the IPO are subject to underwriting fees. Assets were reportedly expected to be something like $199m, meaning that ACAS' monthly advisory fee (1/12 of 1.5% of $199m) is approaching a quarter million dollars a month. By my own math, I expect $242,000 per month to be paid to ACAS, but there may be some assets in MTGE that weren't raised on IPO Day; the expected post-IPO assets are a bit above what I calculated based on the 80¢/sh underwriting fee disclosed here. Based on the greater advisory fee in MTGE, I expect ACAS to try to raise in MTGE funds it previously raised in AGNC. MTGE's performance – and its consequent price relative to NAV – will determine how successful that effort will be.

The other advantage to ACAS? With growing management fee income, ACAS' asset management subsidiary becomes more valuable. As a component of ACAS' NAV, the asset manager is as valuable as any profitable subsidiary.

You heard it here first: MTGE is just like AGNC, but allows ACAS to deploy funds into underpriced mortgage bundles that aren't backed by an agency (which is a factor potentially exacerbating pessimism and thus creating an exciting underpricing opportunity); because ACAS is paid more to hold funds in MTGE than in AGNC, expect ACAS to try to raise future funds in MTGE, where it will also have more investment flexibility.

ACAS: What's The Cash For?

At the end of last quarter, ACAS had repaid its debt to $1.642B (for a Debt:Equity ratio of 0.4:1) and held cash of $186m. Of that, ACAS has spent $40m buying 2m shares of its newly-public managed fund, MTGE. This leaves $146m, plus whatever it's generating from businesses.

Since ACAS hasn't been snapping up new companies – it's made a few add-on investments in existing portfolio companies and invested in its own subsidiary's IPO and paid down debt – one wonders what exactly ACAS is doing with its brainpower and assets. Holding pat shows confidence, but what about the thesis that economic chaos brings opportunity and that careful investment should pay huge rewards? One has to invest to get that, right?

The Jaded Consumer has a few ideas.

Share Buyback (Or Not)
First, there's been a bit of excitement over the fact that immediately following ACAS' announcement of a NAV exceeding $13, ACAS took a plunge with the rest of the market. ACAS could retire more than 10% of its shares – buying below NAV, thus driving up the assets per share dramatically – and still not run out of cash on hand. A no-brainer, right?

Look at the history. When ACAS' share price was slammed following the Panic of '08, ACAS didn't buy underpriced shares, it bought (to retire) its own underpriced debt. Buying shares doesn't lead to realized gains (imagine if it could treat issuance as a short, and close the positions it opened north of $40!), and offers no benefit to the bottom line. On a per-share basis, it is helpful; but it does nothing for the enterprise. In effect, paying people to retire their shares shrinks the company. As a BDC with aspirations to become a larger asset manager, one of the last things ACAS wants to do is to shrink the company. And look at the other side of the coin: if ACAS thought it worthwhile to issue shares to Paulson at $5.06 so recently, how could it pay a premium of over 50% to get those same shares back?

ACAS has faced below-NAV share price opportunities before. Years ago, before ACAS took ECAS private, analysts asked why ACAS would not use share buybacks to increase value. ECAS had traded below NAV from its inception, and anyone with a blank envelope-back could tell that buying ECAS shares below NAV would increase ACAS' stake in a valuable company with a steady dividend (both companies had to that point paid uninterrupted dividends). ACAS' reply was clear: ACAS was looking to grow its business, to grow ECAS, and to broaden ownership of ECAS in support of its plan to grow the whole enterprise. ACAS had no intention of reducing the size of its enterprise or of its assets under management.

But, the astute reader is surely pointing at the Jaded Consumer and laughing: that analysis is surely wrong, or outdated, or else ACAS would not have bought every share of ECAS when it took the firm private. Surely, something is missing, no? Alas, the explanation shows that nothing has changed.

ACAS did buy ECAS, but the ECAS shares were bought with ACAS shares, not with cash. The transaction did nothing to reduce the size of the enterprise. Because ECAS' discount was greater than ACAS' discount, the below-NAV issuance of ACAS to ECAS holders was accretive to ACAS. Yet, when the dust settled, no shareholders had been paid to stop being shareholders. They just held ACAS shares instead of ECAS shares.

Management Plans Massive Recapitalization
ACAS never wanted to have secured lenders. ACAS fought giving lenders a security interest in its portfolio like there was no tomorrow, and even as it was discussing the new debt agreement on quarterly calls, was already discussing plans to restructure debt to avoid having debt that doesn't move with the markets and exposing ACAS to leverage scares. ACAS wants out of its secured loans. If one recalls, ACAS built up cash during the aftermath of the Panic of '08 – eventually holding over a billion smackers while cash was king and hugely profitable mispriced-investment opportunities lay about the land like stranded fish after a receding tsunami. ACAS is once more quite possibly working on a strategy to address its capital structure issues – to obtain more flexibility than permitted under its agreements with its secured creditors – that will require money.

I don't think ACAS will be retiring equity.

What I dearly hope is that, if ACAS is foregoing panic-selling opportunities that offer decent companies at awful-company prices, its strategy for its cash is really slick. What is ACAS' distressed-opportunity team (the special situations group, mentioned here) doing, anyway? My principal thesis in ACAS is that illiquid privately-held companies trade in an inefficient market in which ACAS has opportunities to buy deals that just don't exist in efficient markets. If ACAS doesn't buy something with its money, what's it doing?

Thursday, August 18, 2011

HP Kills Its Tablet, Looks to Exit PCs

Despite beating Dell at the commodity PC game, HP has killed its TouchPad product and is looking to exit the PC business altogether to focus on higher-margin business (enterprise hardware, services, etc.). With WebOS gone from the mobile market, Apple's platform has fewer competitors, though Google is left (and Microsoft; but partnering with Microsoft can work out differently than expected, and even proving MSFT wrong won't lead to any contrition).

Who will be left to make a quality product?

In news from the other side of the globe, Apple has passed Lenovo in share of the China market (in sales; but remember, unit share isn't profit share). In mobile computers, DisplaySearch reckons that iPads are notebook computers and on that basis concluded that Apple became the worldwide leader in notebook unit volume during the second quarter of 2011 and in that quarter sold just more than 1 of every 5 notebooks sold worldwide. To the extent that platform market share reflects its "stickiness" and serves as a competitive advantage, Apple may have a real and growing platform advantage not just from hipness, but from the virtuous cycle of customers and developer resources being attracted to one another.

Monday, August 15, 2011

MSFT Abandons Another Market Niche (eBooks)

After dumping its Zune music player product and its Kin phone hardware, it shouldn't be a surprise to see Microsoft closing down its e-Book reader. Amazon and Apple seem to have sewn up that market, and Microsoft hasn't bothered to invest in any significant competition.

At least with the Zune, MSFT tried to create both a music marketplace and a sense of buzz. The e-Book platform seems to have been launched in an expectation that because Microsoft did it, everyone would accept it as a standard, and it would naturally succeed due to fear of competition. This sort of reasoning certainly can't have much currency after the fading of wma-encrypted DRM music as a "standard" just because MSFT was selling it.

MSFT seems to be concentrating on a smaller number of core platforms and software where it's still competing: operating systems for desktop, notebook, and phone hardware; and software for its platforms (either to run on the platforms, or to support them on the back-end). Microsoft's server products have significant revenue – Exchange and IIS are major back-end products licensed at great expense by major corporations – but Netcraft's current web server graphs show that Microsoft's competition from free competition may be denying it share in the growing market even as Microsoft's revenue continues to be rich. (MSFT had once a share approaching 40% of the web server market, but MSFT's IIS now appears to have less than 20% of the web server market and is losing share. Among the million busiest sites, Microsoft's share has been less volatile but is on a steady decline.) The effect of free software's increasing capability on Microsoft's licensing outlook will turn on things like Microsoft's ability to make use of third-party tools seem burdensome and hostile to users and administrators. Microsoft's ability to do this with impunity will turn in some part on the availability of alternatives to Outlook, which customers typically use to access mail, calendar, and contact information for which Microsoft offers back-end management through its Exchange product.

If anyone has information on email server share that might offer for mailservers what Netcraft offers for web servers, I'd love to see that data.

Sunday, August 14, 2011

Only 0.01% Wrong?

As a computer hobbyist, the Jaded Consumer is interested in software projects and thus particularly fond of high-quality open-source software projects. Consequently, I was very interested to read that Daniel Hartmeier reported his automated spam solution had achieved a 99.5% accuracy rate in identifying spam, while only losing 0.01% of legitimate emails to false-positive assignment of "spam" status. As it happens, I am not currently running a mailserver outside my own LAN, so I have little current need for this sort of solution – but I have clients, and I read explanations like his to understand what sorts of solutions can be offered to people who don't want to spend thousands on commercial solutions.

Honestly, though, email is becoming like phone service: you don't run your own cable and tap out your own Morse any more, you pick one of a field of commodity vendors and use the service (including any offered spam control) until you decide you like another better. You usually get email service bundled with an Internet connection; there's really little purpose for many businesses to bother with their own email back-ends unless the business is large enough that in-house handling makes better economic sense for handling the business' particular security concerns. Not that all these big businesses get it right, mind you, but ....

But I didn't try to email Daniel Hartmeier about his spam solution. Instead, I emailed him about pf. The page that leads with the word "History" was last updated in 2006, and there's been a recent development in the availability of pf. As of the launch of MacOS X v.10.7 ("Lion"), the firewall originated by Daniel Hartmeier following the removal of IPFilter from the OpenBSD code repository in May of 2001. I thought I'd point out that – although the fact hadn't been advertised – the world's highest-volume Unix distribution now contained the firewall Daniel originated began some ten years ago.

So I sent Daniel an email showing that pf-specific virtual devices were present in the default installation of MacOS X "Lion". What I got back wasn't what I expected:
A message that you sent could not be delivered to one or more of its recipients. This is a permanent error. The following address(es) failed:
SMTP error from remote mail server after end of data:
host []: 554 5.7.1 Spam (score 3.5)
I thought the problem might be that I was using a return email address that didn't come from the domain where the mailserver was located. I sent it again from another email address, using the mailserver of the email address' own domain. I got:
Google tried to deliver your message, but it was rejected by the recipient domain. We recommend contacting the other email provider for further information about the cause of this error. The error that the other server returned was: 554 554 5.7.1 Spam (score 3.5) (state 18).
One of my other tries got a totally different failure. I even tried re-writing my email so that its text might be less apt to trigger a Bayesian spam filter set to trigger on something in my prior email; but to no avail. I suppose the lesson is this: Daniel's excellent firewall tool may be everything one might dream (correctly coded, fast, feature-rich, elegant to configure, etc.) but this doesn't mean I can easily accept his claim that he's stopping 99.5% of the spam with a 0.01% false-positive rate. For information about stopping spam successfully, I'll be reading further.

But on that firewall -- congratulations, Daniel Hartmeier, on an excellent product. It's rocked for years, and I'm pleased it's come to my own desktop. Thanks for everything.

Saturday, August 13, 2011

China: Another Debt Bubble?

Although the national government of China is famously a net creditor with substantial sovereign investment assets, the national government in China isn't the only government in China. Closer to where the rubber meets the road, municipal governments stand responsible for building numerous infrastructure and even housing projects. Local government units in China are restricted in their fundraising. As a result, the frauds that are commonplace everywhere else in China (from fake Apple Stores to fake infant formula, nothing appears too sacred to defile) are equally common in government funding schemes.

In one example, Loudi raised infrastructure development funds with municipal bonds fully secured by numerous tracts of developed land. The problem? To secure the huge bond issue, the land – located in a place you've never heard, with an annual household income less than $2,500 and severe under-occupancy of existing housing – is given a fictitious value commensurate with fully-occupied Chicago suburbs with an average annual household income exceeding $250,000. And based on this Bloomberg report, payment on the bonds requires the claimed land values to go up.

Chinese rating agencies, unsurprisingly, are as easily motivated by politics and favor-trading as by financial reasoning. Ratings on the Loudi bonds range from junk status to one step above U.S. Treasury obligations. According to Moody's, the aggregate local government debt in China is understated by Chinese state auditors by 3.5 trillion yuan – reflecting the murkily unclear status of local debt issuance and whether some of the off-balance-sheet local government fundraising schemes even constitute enforceable obligations. To the extent that Chinese banks are debt holders, the safety of Chinese banks may be in jeopardy. To the extent that official Chinese debt accounting is off by as much as 25%, the reliability of Chinese financial reports is gravely in doubt.

Local Chinese debt may not look very big from the U.S – a mere couple trillion bucks – but they haven't been working to build it up very long, they have no apparent checks in place to prevent issuance scams, and they're working with the central government to issue more. CNBC's John Carney asks an interesting question: if the entire GDP of China has yet to reach $5 trillion when its debt exceeds $2 trillion, what should we conclude about the strength of the economy that's producing China's current output? (For comparison, the U.S. GDP exceeds $14 trillion, and its debt has been accumulating for decades at the local, state, and federal level until it presently exceeds $17 trillion. But the U.S. economy isn't rumored to have been on fire these last few years as the Chinese economy has been reputed.)

Asian study of American business strategies didn't end with the adoption of mass production facilities, did it?

Wednesday, August 10, 2011

"Racehorse" Haynes Was Right About The Old-Woman's Car

Over ten years ago I climbed out from behind a 1982 Mercedes 240-D – a two-ton Diesel sedan with four cylinders, no turbocharger, and acceleration like a snail heading up a wall. But it was reliable.* There, steps from the old Diesel, I met Richard "Racehorse" Haynes. We talked cars for a few minutes while approaching the auditorium that was our destination.

"I used to have a Mercedes," he said. An 8-cylinder S-Class coupe, as it turned out.

But ... used to? Why'd he get rid of it?

The answer was quick and clear: Mercedes makes "an old woman's car."

Fond of my own (admittedly sluggish) Mercedes, and having no firsthand experience with the Porsche with which he currently drove, I didn't have any particular argument to raise. We changed subjects: law. And given I was speaking to "Racehorse" Haynes, that conversation was amusing in its own right – but that's a different story. This tale is about the old woman's car.

The Old Woman's Car
Being a huge fan of my old Diesel, I was excited when Mercedes in 2004 returned to selling a Diesel sedan in the North American market. I bought a 2005 E320CDI the very summer it launched. I won't go into detail how my neighbors thought I had joined a car-of-the-month club (due to the machine being at the dealer's so frequently for unexpected service), or how little plastic parts in the shoulder belt assembly buzzed near my ear when I drove while trying to listen to the huge-priced sound system, or even how the car left me stranded repeatedly due to unexpected complete failure. And I won't go into the oft-imitated abomination that is the headrest, which forces one's head more than an inch forward of one's shoulders so one can't relax in the passenger seat (the E-class luxury seat had such awful ergonomics that L, who has significant anatomical and ergonomic training, preferred to ride in C-class Mercedes seats). I will just talk about the lag and sag of Mercedes' old-woman's car.

First: the lag. The 2005 E320 CDI did not offer 4-Matic. Two-wheel drive was the only option. So, when road conditions require harsh acceleration (e.g., a right angle on a road that winds so you can't see approaching traffic from either direction), great care was needed to obtain the best acceleration one could without pushing the rear wheels to the point of spinning out, then being called into check by the anti-skid system. But this was impossible due to old-woman's car lag.

Mercedes' vehicles are very carefully engineered – I asked high-end Mercedes-only mechanics' shops about solutions and learned that the problem exists all the way up to 12-cylinder sport coupe models, some of whose drivers had actually sold their hot rides in disgust over the issue – to wait a half-second before responding to the accelerator. Now, how long is a half-second? When you are carefully applying the accelerator searching for the most juice you can safely give the car in order to traverse a curved road with mere yards of visibility, and do so without losing control of the car to a rear-wheel spinout, you push until you feel the car is doing everything you need and then you let off so you can stop accelerating on the other side of the road. Unfortunately, the half-second lag means that you get nothing as you push, so you push a bit more, and a bit more, and by the time the car starts responding you have no idea what depth of accelerator push is having what effect on the car but by the time the car starts turning the rear wheels it's not moving at all, because they've leapt past the limits of their traction in a way no car ever behaved, even when driving a 440-cubic-inch engine in a car at least as heavy, and you've lost control of the Mercedes to a computer that is flashing a triangular warning with an exclamation point in it -- warning that the car's traction control system has overtaken the wheels.

And this isn't the scary part. Embarrassing yourself while burning rubber off your tires in public probably is bad enough, but its not the depth of this bad. No. The worst is that you are still at a stop sign, perpendicular to a curved road with mere yards of visibility along a road with a 35mph speed limit, but instead of being safely behind the stop sign waiting until it looks clear both ways you are now well into the southbound lane, moving about 2mph, with a flashing exclamation point to tell you that you're not yet in control of the Mercedes' acceleration.

In the ancient Mercury Grand Marquis, this never happened because the accelerator pedal mecahnically pulled a carburator valve, causing immediate power transfer to the rear wheels; you knew precisely what amount of push caused what acceleration because you felt it just as it happened, enabling instantaneous and intuitive adjustment to ensure you got just enough, not too much, and had complete control. But don't blame the computers. Mercedes' brake system makes hundreds of adjustments each second to prevent wheel lock-up during braking (as did the 1991 Lincoln Towncar, with its fuel-injected V-8, even more powerful than the Grand Marquis!), and could in the hands of a competent engineer solve all the same problems with acceleration.

But Mercedes doesn't want you to have controlled acceleration. Mercedes is an old woman's car. Mercedes only cares about stopping. Even when you buy a 4-wheel-drive Mercedes, you don't get 4-wheel acceleration every time you punch it -- you get two wheels until Mercedes thinks traction is failing, then you get a reactive switch into 4-wheel mode, which lasts only so long as Mercedes thinks you need it. I haven't bothered to test whether Mercedes' 4-Matic products are any better about getting across this intersection, but I've found the answer and it's such an elegant, fun answer there's little point to making excuses for Mercedes' broken products.

And a half-second delay in acceleration is broken. It robs drivers of control. It strands them at 2mph half into a lane of traffic that cannot be vetted for safety because the foliage and curving road make a pipe dream out of visibility in any conditions but night, when headlights might warn of traffic by illuminating the opposite side of the road from oncoming traffic. And rush hour is nowhere near nighttime. The half-second isn't required by any computer system, but is a direct result of a computer system that is buggy, sickeningly buggy, and probably drove my stroke risk several-fold before the vehicle finally convinced me it needed replacement.

Mind you, the Mercedes didn't suck from bumper to bumper. The engine was a thing of beauty, pumping out ample power from six cylinders of twin-turbocharged Diesel engine. The power would have been much more appreciated, especially at the low end where Diesels have so much torque, if the accelerator lag didn't make it basically uncontrollable unless you drove like you were on your way to Church on Sunday along roads marked only with high-visibility stoplights as traffic signals, so you could trust that at every intersection it didn't matter when you moved or how quickly because you relied implicitly on the safety created by your legal right-of-way. God forbid that some municipality install a stop-sign that required you to wait until judgment and observation were required to assess safety, or that the stop was anything but an all-way stop.

The power of the engine could be felt not only in the acceleration, control of which was usurped by computers whenever lag made it impossible for a human to assess, but even driving. For example, one day I felt a vibration akin to a rumble-strip while slowing to a stop on a freeway access road. I checked, and I was nowhere near the road edge. But as I slowed, so did the frequency of the rumble, until at idle it was a slow procession of little bumps. The light changed and I touched the accelerator -- and felt the pace of the rumble strips speed.

I've seen cars that had plastic bits hanging into their wheel wells, and I've seen cars dragging parts, and I've seen all kinds of things. And this particular car had been in the shop so often with weird and intractable suspension issues that caused all kinds of clicks, bumps, and other strange noises and feelings that I frankly could imagine just about anything. Within a half mile, I had to stop: the vibration became so heinous, and the noise so awful, that I could not be reassured by the voice on the tele-aid system that there was no problem. There was a serious problem, and it was getting worse. I will save you the troubleshooting nightmare and cut to the chase: two of the engine's three (sophisticated, vibration-isolating, liquid-filled) engine mounts had failed. Basically, the engine was being held up from falling into the street by forces being exerted on the transmission. Without warranty, the repair would have been thousands of dollars. This was at about 50K mi, when factory warranty would have just expired. They say extended warranties are not a good buy, but let me tell you: don't own a recent Mercedes without one.

Undrivability didn't require 50k miles to materialize, though. Before 1K, the thing died within a block of home with no explanation, and I found myself pushing it backward out of the intersection in which it had halted. Mercedez-Benz of Greenway Plaza carefully inspected the car and pronounced it cured, but when I went to pick it up, it died the exact same way on the valet. Apparently, dealer-added security technology didn't play well with at least some of the car's numerous built-in computers, which went on strike at odd and unpredictable intervals. Eventually Greenway Mercedes removed the gear and replaced it with LoJack Early Warning, which I do not recommend unless for the insurance discount; it's a long story, but LoJack won't tell you where the car is, and Houston Police Department (to which LoJack will refer you if you call looking for your car when a tow driver drops it in an unknown location in Houston) will transfer you numerous times before you finally realize nobody at HPD has any way to obtain the location from LoJack, either. See, LoJack won't find it for you, only for the police; and the police expect LoJack to help you because finding your car isn't their problem and they've no idea who to call to get a car located with LoJack. But the insurance discount is real; price it, compare it to the LoJack product, and make a business decision. They will never find your car (the owner of the lot where the car is dumped will help you on the next business day), but the insurance discount will come like clockwork.

The clicking and bumping that occasioned slow turns on smooth pavement was an interesting lesson in maintenance. Either Greenway Mercedes lied about replacing all those suspension parts, or Mercedes' suspension parts are horribly short-lived. But there is a third option: Greenway Mercedes is incompetent, and misdiagnosed the problem repeatedly, replaced a part unrelated to the issue you demonstrated over and over after they said they'd fixed it, and kept charging Mercedes for warranty work. Actually fixing the problem would be to kill the goose that was laying the golden service eggs, no? Much better to run you and Mercedes in circles. But I conjecture. Other Mercedes-certified mechanics were shocked to hear the lengthy story of my suspension woes with the 2005 E320 CDI, completely disbelieved that Mercedes would build a product so frequently failing, and suggested in no uncertain terms that the folks at Greenway Mercedes might not be the biggest crooks in the country, but were probably the biggest crooks west of the Mississippi.

So I started having its many warranty problems handled by the evidently more competent technicians at Alex Rodriguez Mercedes. These gentlemen will bring you your loaner, swap you your car, and bring you yours back fixed – all on a schedule you agree in advance. You never have to sit in a waiting room, fight traffic, suffer scheduling problems and so forth just because you had the bad judgment to believe that because Mercedes could build an outstandingly reliable car in 1982, it would surely be able to build a reliable car in this century. Let me save you some trouble: they've completely forgotten how. But if you live anywhere near the Johnson Space Center – the place Man first tried to reach when it spoke those first words back from the surface of the moon and uttered the word "Houston", but which is too unimportant to be allowed to display any of the Space Shuttles it successfully guided into space and back – I urge you to rely on Alex Rodriguez Mercedes-Benz. They can't make the car more reliable, but they'll make you much happier while it's being maintained.

One fine day I made an appointment for A-Rod Mercedes (as they call themselves) to look into why my stereo had quit working. This was a pain for me; I like music, which is why I paid a fortune for a plussed-up sound system. I wasn't exactly surprised that it had failed; I'd had the "Command" system (which includes the plussed-up sound system controls) crash repeatedly, including while I was depending on it for maps in a strange town while under a deadline, and remain broken and unbooting for days at a time, but this time I was determined to show a competent** technician the problem so that it might finally be diagnosed and fixed. After years of this kind of mistreatment, I was determined to have it solved before the extended warranty ran out. So I explained that I had a non-emergency problem, I wanted a loaner, and I was scores of miles away. A-Rod Mercedes' friendly service advisers set me up with an appointment to have a loaner delivered the very next Monday – less than a week away – so they could sort it out with minimal inconvenience.

A few other things associated with the Command system died over the next couple of days. I assumed it was an expansion of the audio problem; the radio, the auxiliary input I used for an iPod, the mapping system (which has a voice component), all became unresponsive. Still, the Mercedes' broad array of potential text messages available to warn the driver about everything from upcoming maintenance to impending engine calamities lay silent, suggesting that nothing particularly critical was amiss, just another audio-related bug. So on Friday – three days before the Monday loaner dropoff appointment – I don't expect serious trouble when I get the car loaded with people for a little outing. Everybody is in the car, everybody is buckled, the garage door is open, and I move to turn the key.


A red backlight emphasizes the message that there is a malfunction. But since it's not even trying to turn over, I know damned well there's a malfuction. And I call A-Rod, who promptly sends a flatbed to haul off the dead husk of the "powerful" Mercedes. Diagnosis? For over a week the car had been slowly shutting down "non-essential" systems out of concern over a "dying" battery. One would think that if the car were at the point of deliberately killing non-essential systems in anticipation of failure, it might send me a little note that failure was at least foreseeable. But no, I got stuck for the Nth time by the "new" Diesel, which disgusted me mostly because I had come to Mercedes' defense so many times when explaining how the "old" Diesel had withstood so much for so long. (And still does: everything but the crummy A/C system runs like a champ, and the A/C system is just hopeless because it was designed by people who live in a country where A/C is an option and not a necessity in a roadcar. New Mercedes A/C systems were designed by a team Mercedes sent to Arizona not to come back without an A/C that could be sold in the South with a straight face. So the new A/C is very powerful but assumes that it's being used in a dry desert, and so promptly fills with condensation in the swamps of coastal Texas and thereafter, following an incubation period, gives off a persistent and nasty mold smell that dealers pretend is not a systematic problem even as they cycle through a long list of imaginative fixes that plainly reflect substantial post-development engineering resources, but none of which work. Short term, your dealer can kill it with harsh treatments that leave the car smelling like a chemical plant, but long term it all just grows back.)

So I asked about this "battery failure". The Diesel has, after all, two big-assed batteries. Oh, I'm told, they both failed. Ahem. Both? At once? I'm thinking its the recharging system; one of the batteries had just been replaced less than a year before. Haha, that battery will be replaced under warranty, but the other one will be about $400. I search online, certain I can find a better price, but I can't: the online price for a comparable battery is actually worse than I am quoted by A-Rod Mercedes. The thing is huge, uses cutting-edge technology to produce enormous cold cranking amps, and just can't be had for cheap. The alternative is that I can't start my car; so I shell out, dubious about the charging system and about the battery life and about the reliability of a car that knows it's failing but chooses to keep the fact a secret even while shutting down ill-designed electronic subsystems I assumed were falling to crasher bugs I'd previously seen.

So I start looking for a different ride.

Trading Three-Point Stars for Four Rings
And let me tell you what fun that new ride is. With approximately the same engine displacement, the 6-cylinder 2008 Audi A6 Quattro*** has comparable interior room, a trunk that's vastly bigger even than the 2.5-corpse trunk of the Mercedes, and full-time four wheel drive. This is a huge win. You want to cross an intersection, the car doesn't lose traction then claw to get it back: it uses all four wheels to get you across with no perceptible loss of traction.

You are at full speed on the freeway and some nutjob thinks it's a good idea to swerve directly into you? The Mercedes was controllable at speed, to be sure. You turn the biiig leather wheel and, dampened beneath a fortune in ground-insulating suspension, the front wheels turn and lean on Mercedes' peculiar front-end control system and the car – driven against the front tires by the rear tires' answer to the call of the relentless Diesel – is pushed sideways out of harm's way while you rely on anti-skid technology to protect you from the risk of strange traction issues on the freeway. Once in your new lane, the Mercedes settles down from the swaying induced by the little duel between the turned front tires and the pushing, ever-pushing rear wheels. And then you're back in the bank vault, insulated from the world, safe.

The same incident passes quite differently in the Audi Quattro. You pull the wheel with the same force – part fear of the near-wreck, part anger at the risk caused by the idiot coming your way – and there is no swaying left-to-right, no conflict front-to-back, no post-lane-change settling-down period. You turn the wheel and the Audi doesn't grudgingly agree to change lanes only while grumbling about what an imposition it is to be asked.

Instead, the Audi leaps with excitement, thrilled to do your bidding, ecstatic that you've asked it to do something more interesting than keep straight-on between an endless series of dashed lines. The Audi's all-time four-wheel drive pulls you where you want to go, ignoring road oil, rain, debris of other cars' shredded tires and shattered fiberglass, and eagerly awaits your next command – its next fondest wish. Sure, the Diesel in the Mercedes has more torque and feels like it's got more raw power, even though the Audi's gasoline engine has much more listed horsepower, but most of us aren't in a roadrace and are unconcerned with track times. What we want is to know what it feels like.

And in the Audi, I feel in control. Not worried about unexpected equipment failures. Not worried about lag in reacting to emergency commands. Not worried that the maps will quit while I'm in a rush in a strange place. Not worried even that the buzzing of Mercedes' plastic parts signifies other overlooked details with safety and reliability implications that will bite me, hard, in the back when I am most vulnerable. In the Audi, I am not worried at all about the car failing for any reason to perform exactly as I demand. And that security, and that control, represent the kind power I care most about.

* Except the A/C. Well, that was reliable too I suppose – it reliably sucked.
** Competent technician in this circumstance means a technician qualified by the absence of any relationship to Mercedes-Benz of Greenway Plaza.
*** After the value fiasco I had with the new Mercedes, I was gun-shy about buying new. In 2004, the '05 was the only recent-generation Diesel to buy from Mercedes, and my personal history with cars was to keep them longer than a decade so I didn't really have a lot of concern about resale value. Never having owned an Audi, but liking the reliability and performance implications in a firm able to take 1st, 2nd, and 3rd in a grueling long-distance torture event like LeMans (in 2010; in 2011 they took 1st after losing their other cars to crashes while overtaking slower Ferrarris, for the tenth victory in twenve 24-hour races), I thought buying used would give me an opportunity to try one out for a few years to see it if treated me like I expect a car ought.

Tuesday, August 2, 2011

ACAS: NAV Up Again In 2Q2011

American Capital announced its 2Q2011 quarterly result, and the result is more of the same: secured debt decreased ($100m repaid; ACAS has a debt:equity ratio of 0.4:1), and net operating income increased (to $71m, 145% above the year-ago quarter). But this is not the metric that most interests me as ACAS recovers from the liquidity crisis that crushed the valuation of its portfolio assets and share price. The single metric that most impacts my assessment of ACAS' recovery is the increase management is able to achieve in net asset value.

This quarter, management increased NAV to $13.16, up 10% from $11.97 in 1Q2011 and up 44% from $9.15 in 2Q2010. This valuation increase still shows some undervaluation in assets, though: ACAS claims the value of its investment in ECAS is $933m, though the value of ECAS' assets (over which ACAS has complete dominion, just as it has dominion over ECAS itself) is $1.035B. (Note that the gap between asset value and ACAS' claimed "fair value" is decreasing; it's just not yet at parity.)

One might try to draw some conclusion from ACAS' realized losses and compare them to ACAS' unrealized gains. A familiar meme among critics and a repeated question in conference calls is whether ACAS is selling its winners to look good and getting stuck with a portfolio of losers. The fact that ACAS is able to achieve $179m in realizations is nice, but the fact that this resulted in a realized loss of $177m strongly suggests that ACAS is reclaiming unproductive capital from investments whose thesis didn't survive the crash and isn't sticking investors with dogs in the name of making a quarterly number. The realized loss is a decrease from the year-ago quarter, but ACAS realized a gain last quarter. Which brings us to ...

... what games ACAS might be playing with its books. As suggested by management previously, ACAS has just announced that it had, or by the deadline would have, failed a RIC test. Intentionally failing a RIC test was one of management's schemes to roll forward operating losses whose value would otherwise be lost to ACAS and its shareholders. Losses are a tax asset: they offset taxable income. Losing the loss would really suck, and the failed RIC test preserves the perishable asset for next year. Management said at the same time that it expected to meet the RIC test in the future: this is a tax planning stratagem, not some kind of business failure. What does that mean? ACAS may be accelerating losses into this year when they are available so that it will make the most out of its carry-forward opportunity. We usually get an opportunity to see how the quarter's business has affected the portfolio mix, but there's strong reason to doubt that with investments as illiquid as ACAS', there's a lot of power to move the timing of deals in a transaction pipeline. I don't think we'll see that the quarter's business has really changed the overall numbers for the whole ACAS portfolio, even if ACAS management were trying to rush losses and working to bargain up gains in a way that would slow their transactions into a later reporting period.

The quarterly announcement discusses things like unrealized appreciation (can't complain about $587m in unrealized appreciation, can you?) and net earnings ($410m), but these things don't affect its eventual obligation to pay a dividend on resumption of BDC status (that is driven by taxable income, not SEC-reported "earnings"). For the time being, the metrics that have my attention are NAV (what the company is worth) and NOI (what the company earns without swapping assets around). The NOI increase has definitely shown the increases I expected following the debt restructuring, and I look forward to viewing it as a barometer of the success of the company's portfolio companies.

With respect to the NAV and NOI, ACAS has one strategy that has bourne some interesting fruit. Over the last year, ACAS has grown assets under management not only by holding them while value recovered, but by having controlled companies issue equity to new investors. American Capital Agency's issuance has been accretive to shareholders of AGNC (i.e., has raised AGNC's NAV at each issuance), and has boosted ACAS' assets under management – and thus ACAS' management fees, a source of NOI. Whether the public has an appetite for shares of American Capital Mortgage Investment Corp will determine whether ACAS can use MTGE to effect more of the same.

The breadth of the portfolio companies' business across industries and geographies makes it sensitive to broad macro-economic conditions, which is why management's prediction of success bears the qualification "if the economy continues to recover." I think long-term bets are in favor of recovery, and especially as ACAS has 0.4:1 debt:equity and is no longer in debt covenant default, there's very little reason not to regard ACAS as a long-term investment. Indeed, I bought some during the quarter for my niece. This is the niece whose mother sold the AAPL I recommended ten years ago, because her broker told her it had already moved up. This ACAS purchase is an account I won't be handing over to my sister's broker.

See you next quarter :-)