Tuesday, November 1, 2011

ACAS: 3Q2011 Results Promise Confusion

At last, after an eternity waiting to understand what impact the recent financial market madness has had on the opaque internal workings of American Capital Ltd., ACAS investors have received the third-quarter results announcement.

As usual, the top items are income and assets: NOI (what ACAS earns outside the deals it makes exiting investments) and NAV (what its holdings are worth).

As this is written (November 1), shares trade for $7.20 in the after-hours market. Against that backdrop, the NAV reported for September 30 – $11.92 per share – represents a discount of about 40% to the assets ACAS is actually investing on behalf of those who buy the shares at this price. Ordinarily, a huge NAV discount would worry one that the company must be losing money hand over fist, or at least not going anywhere. In this case, ACAS' quarterly Net Operating Earnings of $6 million represent a 10% increase to the NOI of 3Q2010. ACAS' taxable income – the income on which ACAS would have to base its dividend if it hadn't dumped its tax-pass-through status in order to preserve its operating loss carryforward for the benefit of shareholders (as a non-taxpayer, ACAS wouldn't particularly be impacted, but it affects shareholders' after-tax return) – is comprised of both its operating income and its realized gains/losses. ACAS' earnings over the quarter were $98 million (an improvement of $107 million compared to 3Q2010), so the company isn't bleeding losses. Much of the $260 million of realized cash proceeds were profits. Nice.

In addition to making $163 million over the quarter, ACAS both repaid $123 million in debt and repurchased $75 million in its own shares (reducing the share count by 9.1 million shares, at the below-NAV price of $8.21).

So, business looks good. Right?

Expect a selloff.

Because ACAS is bound by FAS 157 not only to mark investments at market, but for SEC income-reporting purposes to book unrealized gains and losses in investments' value as if income (which makes its SEC-reported income utterly independent of its taxable income in a given quarter), the decrease in the financial markets' valuation of other companies (i.e., those against which ACAS' portfolio companies are compared for valuation purposes) caused ACAS to report that it lost $1.24 per share over this profitable quarter (at least, as you or I or the IRS would have measured the quarter). This is similar to the wierd bumpiness that exists in Berkshire Hathaway's earnings as a result of the long-term puts BRK wrote against the S&P index; the totally illiquid long-term can't result in a realized gain except on its maturity date years from now – but FAS 157 requires Warren Buffett to report "gains" based on a modeled value of the short put as the markets fluctuate over the life of the option (which, because it can be exercised only on its expiration date, poses no short-term risk). The difference is that unlike BRK's stable of illiquid portfolio companies that are held "forever" and aren't for sale, ACAS is required to use this accounting treatment with substantially all of ACAS' investments.

Due to the rough quarter in the markets – ACAS' NAV declined by $1.24, from $13.16 to $11.92 – ACAS' NAV isn't what it was at the end of the prior-reported quarter. Combined with the FAS 157 "loss" of $1.34, people will be expected to conclude that ACAS is in serious trouble unless they understand that the "loss" of $1.34 is a double-counting of the NAV decrease. In fact, ACAS' NAV decrease would have been worse had it not made as much money as it did. The fact that it was also repurchasing shares is an added boost.

And expect more repurchases. As the CEO explained in the earnings announcement:
In the aggregate, revenues and EBITDA of our portfolio companies continued to show growth. The positive performance of our portfolio companies, the recently released 2.5% U.S. GDP growth rate for the third quarter and the fourth quarter rebound in the capital markets has us cautiously optimistic that our portfolio companies will continue to perform well in the near future and that our earnings will return to their overall positive trend, similar to the previous eight quarters. Based on this confidence and the current price to book, we believe our shares are an excellent bargain and intend to continue the share repurchases we began in the third quarter.
Let's hope ACAS takes advantage of the predictable confusion to buy lots more shares at even greater NAV discounts than were available in the prior quarter. Retiring debt is nice, but retiring shares below NAV really has a prospect of moving the needle in the long run on ACAS' per-share returns.

Here's to the short-term confusion :-)

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