ACAS plummets to new lows!

Earlier this morning, when the ask on shares of Americal Capital (ACAS) stood at $9.00, I realized that illiquidity panics are far from over among traders with exposure to ACAS. People interested in high-yield returns like those historically offered by American Capital are perhaps more likely than other investors to take risks with leverage that tend to place them at risk of margin calls, and yesterday's plunge after removal from the Regulation SHO list creates an excellent opportunity to catch people over-leveraged. Although leverage may create a panic in investors, it does not follow that the underlying company itself is at particular risk of a liquidity crisis.

The question about leverage and liquidity isn't trivial, however. American Capital historically solved liquidity issues -- whether driven by a desire to de-leverage, or a simple hunger to enter good deals -- using techniques that may not be available in the current market environment. The usual trick -- issuing shares above net asset value to create cash and increase average net asset value in one stroke -- is unavailable while shares trade at less than half ACAS' last-published net asset value. Forward sales contracts, that gave American Capital the right to put millions of shares to various counterparties at prices well north of $30, have all been exhausted. American Capital's management has stated that it hasn't got a liquidity problem because it has excellent deal flow and knows the content of its pipeline, but without knowing about ACAS' counterparties in these deals investors can't know the buyers of ACAS' portfolio companies will be in a position to close deals they've struck. American Capital has strong operating earnings from its portfolio companies, but these earnings aren't all free cash flow, and ACAS has for some time paid a dividend that exceeds ACAS' operating earnings.

Liquidity is the main concern raised about American Capital both here and at the Enlightened American blog. The Enlightened American, for example, mentioned liquidity twice in his August discussion of American Capital's balance-sheet trends: in connection with ACAS' dividend coverage, and in connection with its leverage. Bullseye.

The biggest worries I have for American Capital in this market turn on the valuation of its assets. The first problem -- leverage -- stems from the fact that ACAS must maintain very modest leverage in order to avoid liquidity problems caused by its tax status; the debt:leverage ratio is capped by ACAS' tax status at 1:1. As asset valuations fall (and the debt doesn't), ACAS' debt:equity ratio will rise. Although ACAS' assets are illiquid and may be challenging to value with transparency (depspite that ACAS has been routinely able to obtain within a few percent of its claimed prior-quarter valuations on portfolio company exits), the valuations of ACAS' equity holdings are driven by models that look to publicly-traded "comparables" for its various portfolio companies. This is akin to looking at real-estate "comparables" to determine either the tax valuation of one's real estate, or the likely selling price of a home that hasn't been in the market in years. The performance of "comparables" will impact the valuation of ACAS portfolio companies. Over the last six months, we've seen the broad market take a pretty bad hit:
This six-month Chart (warning: Yahoo product) depicts the S&P 500 (of which ACAS has been a component over the whole period), the Dow Jones Industrial Average, and the NASDAQ (the exchange on which ACAS trades) all declining significantly -- between 30% and 35%. Over the last year, ACAS has stated repeatedly how great it is to be levered less than 1:1, and has pointed out that it's levered either 0.8:1 or 0.7:1, as matters then stood. To be levered 0.7:1 after a 33% gain in holdings valuations, one would have to start levered at 1.06:1. Working this backward, one sees that unless the company is shedding debt -- which requires expending assets, which works against de-leverage and against bank net asset covenants -- an asset drop of 33% would push ACAS past its regulatory limit of 1:1 debt:equity ratio. Over the past year, however, ACAS de-levered from 0.8 to 0.7 while paying a fat cash dividend.

However, the worst of the price plummet in the chart above is more recent than ACAS' latest debt:equity pronoucements, or net asset value news. The worst is just recently, in September and October. On November 10, we will see what the state of ACAS' financials was at the end of September. On November 10, we will see what deal flow has brought ACAS in terms of liquidity, and we will see what comparables' pricing has done to ACAS' equity value. We will see on November 10 whether ACAS appears set to maintain the four-plus-billion net asset value it promised its lenders when it renegotiated its unsecured line of credit recently, or whether it looks like ACAS is set to have bust the covenant in October when the collapse continued to crush the share price of equities. Considering the possiblity that comparables' pricing could get hammered another 50% as stocks settle into downturn-era P/E ratios, ACAS hasn't got the luxury of just "hanging on" while the world turns around: it plausibly needs to continue de-levering, and it to renegotiate credit lines around different (lower) net asset levels.

I pointed out that, following the recent market crash and ACAS' updated net tangible asset value covenants, ACAS faced an acid test as its dividend date approached. Having successfully paid its most recent dividend timely -- and driving the share price up significantly through reinvestment purchases by its hamfisted plan administrator, which is not an ACAS affiliate -- ACAS is either going to show the world that it made the money in deals ... or it is going to show the world that it levered back up a few hundred million in order to make sure the checks didn't bounce. The truth -- that ACAS is regularly levered while it holds cash due to delivery requirements in deals and in order to make quarter-end dividend payments -- may be lost on critics.

It's hard to get a useful earnings number from which to calculate a P/E on ACAS, because FAS 157 makes ACAS report unrealized losses not just as decreasing net asset value, but also earnings. Given the results of some FAS 157-compliant pricing -- for example, certain especially illiquid investments in sectors that are hated, but which are performing and are expected to continue performing for years -- it's hard to imagine thinking about the liquidation value rather than the income produced by these investments, and hard to imagine considering as "lost" amounts due under properly-performing debt obligations owed by solvent obligors. Yahoo-published "earnings" doesn't help ACAS investors to understand either what's happening to ACAS' investments, or to understand what ACAS is likely to do with its dividend. Since ACAS' dividend is driven by its taxable income, which is a bit less subject to estimate error -- the IRS enforces rules designed to tax incomes, not accounting principles, though Congress is apt to give comfort to businesspeople in industries Congress loves, like energy and the nonprofit sector -- the Jaded Consumer suggests looking at this taxable income as an alternate window into what is happening financially at ACAS (in the "good case").

Smoothing out the lumps in ACAS' earnings and assuming that ACAS' management is right about its deal flow and liquidity, taxable earnings of about $1 per quarter would, in a P/E environment of 8, result in a price of $32. If ACAS is wrong and deal flow slows materially, and ACAS ends up living largely on operating earnings, then ACAS' taxable profits will result even more predominantly from the operating earnings of portfolio companies. Those operating earnings, which stood at about $0.71 a share per quarter when last I looked, could be battered down a bit in a nasty economic environment. Since ACAS' due diligence has proved effective in avoiding lemons, I won't predict broad failures -- but let's look at what happens if we assume a bad pricing environment and lower earnings. Let's assume lowball market pricing leads to zero deal exits, below-NAV pricing prevents new share issuance, market illiquidity and fear leads to no new funds under management, and nothing goes right for ACAS. Let's imagine a P/E of 8 across the broad market, and within ACAS' own portfolio companies, meaning that ACAS' equity decline forces ACAS to de-lever at the expense of its equity, meaning unreplaced deal exits to reduce debt. If ACAS sold off businesses to raise funds for de-leverage, and ACAS saw operating earnings fall by 50% to $0.35/q (remember, we're modeling business shrinkage and a bad economic environment), and we applied a P/E of 8, we would see this: annual taxable earnings of $1.40, and a share price of $12.80.

As I write, the market is pricing ACAS' shares under $11, a level at which its current dividend is approximately 10% per quarter. The market is pricing a scenario rather worse than a protracted P/E-of-8-depression and the shrinkage of ACAS' operating earnings to half their current levels. It's understandable why investors with a personal liquidity crisis must exit positions in order to raise cash, but shorts taking new positions at this level must be betting on a collapse in ACAS -- not just a bad quarter or a nasty short-term liquidity problem, but something like complete failure. In light of ACAS' historic deal exits, one wonders how a prediction of utter gloom like this would seem rational. In the absence of fraud by the management, a profitable business like ACAS (taxable profits, the kind the IRS cares about and the kind that creates dividends for ACAS shareholders) and its portfolio companies can hardly be thought a candidate for collapse. The current pricing doesn't seem to reflect ACAS' long-term prospects for returns any more than the FAS-157-compliant valuations of some of its assets reflect the long-term prospects of their returns.

Remembering that some of ACAS' assets are priced below the current value of their expected future returns due to FAS 157 and the illiquidity of some of the investments, one might expect that the worst-case scenario is likely to play out only if ACAS is crushed by an unexpected liquidity crisis. However, the writing on the wall has been legible to ACAS managers since last year, when they issued shares above $40 to de-lever. ACAS has continued de-levering -- which hurts earnings, as it reduces invested equity per share -- to avoid a liquidity crisis, and to be prepared to make deals as competitors lost the power to do so. The last couple of months have been nasty -- perhaps nastier than anyone guessed -- and ACAS has managed to cough up huge dividends timely despite outsiders' liquidity concerns. ACAS has entered new deals that presumably enable better understanding of the value of the assets with which they exited the deals -- and presumably involve debt rates based on today's tight credit market and offer high rates of return going forward.

ACAS continues to be able to exit deals, though the rate at which these deals are closed won't have another data point until November 10. The fact that ACAS continues to succeed as it syndicates senior debt to third parties in even recent transactions shows ACAS as a credible seller, and demonstrates ACAS' management both understands how to sell its products, and knows buyers willing to pay for ACAS' deals. Creating new deals -- and acquiring high-yield investment assets as part of the deal exits -- was clearly still possible for ACAS over the course of the quarter. ACAS did a brisk business over the last downturn, and it seems poised to make good deals during this one -- assuming it avoids destruction by a short-term liquidity crisis.

American Capital faced a question in the last conference call that I think elicited an answer relevant to this issue:

As I said, I think we prepared for this environment and delevered specifically for this environment. Now clearly, every day, every month, every quarter, we're managing... we're analyzing the data and one of the options is to delever some more if we feel the need is there. We've certainly put our self in a position where we can do that on a proactive basis as we see things develop rather than have a gun to our heads.

So we are managing that and I think it just depends on our outlook day by day and quarter by quarter in terms of where we think the portfolio company valuations are going anywhere we think the capital markets are going. We have plenty of flexibility given the capital that we have coming back to make a decision on whether to reinvest it or whether to pay debt down, and it's likely we could do both.
ACAS Second Quarter Conference Call Transcript, via Seeking Alpha (p.4)

Either management was correct when it said it was prepared -- or it was not.

On November 10, we will hear what comparables' pricing has done to ACAS' NAV; we will hear what ACAS' leverage was exiting the month of September; we will learn what deal flow was really like in the third quarter; we will see how management's deal flow predictions stacked up against reality; we will find out how operating earnings are holding up as the economy worsens; and we will find out what guidance management gives for the next few quarters. On November 10, we will have another opportunity to see whether the Emperor has clothes or not.

Shorts Spike ACAS

American Capital, whose shares' short interest had declined to about 16% of the float, are back to over 19% of the float as of the close of trading yesterday. The assault of the shorts was made easier by the removal of ACAS from the NASDAQ list of securities subject to enhanced delivery requirements under Regulation SHO. With the stock off the list -- and it takes five days of violation to return to the list -- ACAS will be subject to selling with even less delivery requirement than characterized its selling in the last ... oh, half year or so. In July, ACAS had been on the list over a hundred days, and only left the list yesterday.

The increased selling opportunity means that from the standpoint of market mechanics, seller interest will have an easier time placing orders than buyers. The marginal increase in selling pressure will have an outsized impact on per-unit price. There's no ACAS-specific news that would impact the valuation proposition. While everyone is in theory subject to depressed earnings in the event of a protracted recession, ACAS' low leverage and consistent operating earnings suggest ACAS is more a safe haven than a risky buy.

Today I was joking with someone about waiting for shorts to create a buy op at $9. Maybe it's not a joke. The thing that I keep asking -- to no answer -- is why ACAS' hundreds of sound portfolio companies should be on sale so far below their apparent ability to produce earnings. At these prices, ACAS could suffer terribly from a destroyed marketplace and still be a good buy. At half its dividend, it would produce a yield of about 20%. However, ACAS hasn't cut its dividend, but has reiterated more than once that it will pay $1.10 per share in dividends for the next quarter.

The only sign of "backtracking" to be found in ACAS is that ACAS' description of the 4Q2008 dividend has been clarified into $1.05 of ordinary dividend -- the same as the dividend paid Oct. 14 -- plus a "bonus" of $0.05. The designation of 5¢ of the last dividend of the year as including a "bonus" rather than being entirely a regular dividend is likely an effort by management to stick with its prior dividend guidance while not obligating itself to never-ending dividend increases while the economy appears poised on the brink of what may be a protracted recession. ACAS' management has made clear that it views the dividends as an objective performance meter, and stated in its 2Q2007 earnings call that it intended never declaring a regular dividend it would have to lower. By designating only $1.05 of the 4Q2008 dividend as a "regular" dividend, ACAS opens the door for maintaining a $1.05 regular dividend -- the level it paid in 3Q2008 -- without facing the charge that ACAS had been forced to cut its dividend, or that management had been unable to maintain its intended dividend policy.

The November 10 earnings announcement and its associated conference call will definitely offer concerned investors illumination into the company's thinking about the developing economic situation, and its impact on the company.

Although ACAS' "blackout" dates, set by its compliance officer as disclosed in its 2Q2008 earnings conference call, have made share repurchases under the $500,000,000 buyback authorization something of a rare bird, the theoretical prospect raised by the current price depression is interesting. When ACAS announced its share buyback plan, the authorized amount seemed set to enable ACAS to retire "almost 9% of the company's outstanding shares". At $11 a share -- above ACAS' current trading price -- ACAS could buy back quite a bit more of ACAS' outstanding equity. Given that ACAS spent only $6 Million in share buybacks so far (0.2 million shares as described in ACAS' 10-Q from the first quarter, and zero in the second quarter), ACAS could theoretically spend $494,000,000 on buybacks under its existing authorization for as many as 44,909,909 shares -- over 21% of the company's outstanding shares. Retiring 21% of its outstanding shares would boost an operating income per share of 70¢ to over 89¢ a share. This would go a long way toward reducing the impact of a deal slowdown brought on by a protracted economic slump.

Does ACAS actually suffer from such a slump, though? We've seen that ACAS' earnings attributable to deal closings is "lumpy", and we've heard ACAS claim that the problem wasn't yet preventing those operating in its market segment from making deals. If ACAS' deal flow and cash flow are good, but the market as a whole is circling the drain and pressuring ACAS shares downward, perhaps ACAS' best use of its cash is to wait for ACAS shares to get even cheaper. At $7.95, ACAS would be able to retire 30% of the shares oustanding after ACAS issued 8.7 million shares for $36.41 in March, and another four million shares at $35.61 under a forward-sale agreement disclosed in the second-quarter 10-Q.

The fact that the forward-sales agreements are exhausted and that ACAS' trick of raising capital with above-NAV issuance is unavailable, it'll be important to see just what ACAS achieves when it announces its third-quarter results on November 10. The fact that ACAS received in cash 30% of the purchase price, when ACAS sold Contec Holdings Ltd. to Bain Capital, says something about the flow of ACAS' portfolio company exits as a source of cash. The question is how much cash flows directly to ACAS, and how many such deals ACAS works out in the quarter. November 10 should provide some valuable education in the reality of ACAS' ability to create liquidity from deal flow.

In the meantime, ACAS is at record lows. Whether this proves a bargain or not likely turns on the evidence adduced November 10. For my part, I added shares in an IRA at 11 today, so you know how I expect this to turn out. However, market mechanics will continue to rule trading prices until the market participants become less fearful and less illiquid: it'll be much easier to sell than to buy.

Modest Marginal Demand/Supply Changes Cause Big Price Changes

The demand for petroleum in the world hasn't dropped over fifty percent in the last several months, but the price has. Once over $150 a barrel, oil recently traded under $70.

The price of a barrel of oil at a given moment isn't determined by some economic calculation predicting its downstream economic impact, but by the demand that exists for the last barrel offered for sale. The marginal demand -- that is, the hunger for that last barrel offered for sale -- is what sets prices. Trucking companies are going to deliver food across America regardless what happens on Wall Street. Commuters will get to work, and children will motor to school. Power plants will keep making power, and home heating units will keep heating homes. Most of the demand continues.

However, when drivers are inclined to make fewer (and fewer) discretionary trips, those unburned gallons of fuel begin to dampen demand for petroleum being pumped worldwide at sellers' best possible speed. The American decrease in driving -- over fifty billion fewer miles driven since last year -- mostly impacts gasoline demand (explaining in part, perhaps, why Diesel remains relatively costly). But it definitely impacts what people will bid on yet another barrel of oil offered for sale at a given moment.

The balance of marginal demand against marginal supply is the reason d'être for market-manipulating schemes like the Organization of Petroleum Exporting Countries (OPEC), which tries to keep prices high by limiting production. (The fact that production is limited because of terrorist attacks on production facilities in the Middle East, and incompetent management in Venezuela, and not in fact orders from OPEC bosses -- and that the producers are largely incapable of producing any faster than they presently produce -- is an entertaining observation about the organization's current utility, but says nothing about the reality of producers' ability to manipulate prices if they did agree to limit production.) Artificially manipulating supply to game pricing in the face of a relatively constant demand is attractive if cooperation is available among suppliers.

The reason that markets for goods "work" in the sense of producing "rational" prices is that, in the absence of manipulation, supply and demand check each other: if demand falls enough, the marginal cost of production will make further production a bad bet, and production will fall. Equillibrium is restored not by economic modeling of the intrinsic value of the goods for sale, or predictions about the goods' utility, but by the simple action of supply and demand "responding" to one another through the self-interested business decisions of market participants.

This doesn't mean that markets "work" all the time, though: where manipulation exists on either side of the equation, prices will move to wherever the market plus the manipulation cause marginal transactions to be priced. The ability of vendors of intangible goods on securities markets to "sell" securities without ever delivering them, with no cost of production, ensures manipulative pricing will continue until the law is enforced. The law, of course, is that securities sold in the marketplace must be delivered to the buyers. This, of course, isn't enforced, or lists like this would be very short and would not have the same securities on them month after month. It's not like the exchanges keep these lists secret.

The fact that a slight depression in demand can cause petroleum prices to drop by over half in the space of a few months offers us some insight into the scale of the value destruction potentially at work in marketplaces in which sellers artifially inflate supply by enjoying freedom from any actual requirement to deliver the things they are selling. By mopping up genuine marketplace demand with bogus sales that never result in the delivery of securities, bad-faith sellers who don't own the securities and make no effort to obtain them even by borrowing them can have a significant impact in the markets for some securities.

Securities like Sears Holdings, which last month was short-sold for over 55% of the stock's entire float, remains vastly manipulated with "only" 40% of its float short-sold. Imagine someone added 56.81% to the world supply of collectible automobiles overnight -- production runs of 100 cars now suddenly have 155 specimens on offer, for example. Exactly what, do you imagine, would happen to the price of the next one offered for sale? It's not like the holders of those extra 56.81% of Sears Holdings will ever get to vote -- the company can't count votes for more than 100% of the outstanding shares -- it's hard to see what a buyer of a non-delivered security gets, other than the possibility of becoming the next seller to fail to deliver. It's a fraud.

In the case of OPEC, where supply is (in theory) constrained by cooperation, the supply manipulation is geniune even if it's not the natural behavior for individual market participants (a fact that explains why historically, OPEC members routinely produced over-quota). In the case of naked shorting, it's illusory supply added to a market whose buyers can't know -- because their intermediaries conceal the sellers from the buyers -- that they are being cheated. In the end, it's the market as a whole that is cheated, by destroying the price on which participants are encouraged to rely as the "correct" price for a particular security on a particular day. In the case of a short-oversold stock, it's a price that makes holding look like a loser's game, and drives out investors in favor of a security that displays a more optimistic price.

Getting Harmed Without Firearms

Korea just suffered an arson-plus-stabbing attack that killed six and injured seven. It's not the first time this sort of homicide has taken place in an industrialized country in Asia. Earlier this year, a Japanese man plowed his truck into a pedestrian-filled intersection and assaulted passersby with a knife. The attack, which killed seven and injured ten, came unusually close to home: my relative had crossed the same intersection with her daughter in the Akihabara electronics district just hours before the killings occurred.

These attacks aren't just an Asian phenomenon fueled by lifelong martial arts training. A "wave" of knife crime in the United Kingdom has killed twenty teens this year in London alone. The United States isn't without exposure to knifing fatalities, either. One woman, who stabbed the same husband two hundred times (naturally, he died), is hoping to get a new trial. Seven years ago, a single attacker on a California knifing spree killed five family members before disappearing with his three-year-old son (whom he later also killed, for a total of six knifing homicides; he finally committed suicide in police custody, but that death did not involve a knife). Later that year, nineteen men armed with boxcutters caused the death of over three thousand in New York and the District of Columbia when they added to their on-aircraft boxcutter killings the people trapped in buildings into which they then collided the aircraft.

Americans' disagreements about firearms policy seem to blind them to the larger problem of violence, which is that people who want to cause mayhem are free to select the tools of their choice. While her daughter looked on in horror, one angry Texas woman did doughnuts atop her cheating husband in a hotel parking lot with her SUV. It's not like cars are either hard to come by in this country, or require great strength to use. Mayhem is only one pedal away.

Safety isn't about the lack of tools of mischief. Safety is about a culture whose values don't escalate avoidable conflicts. To the extent we are unhappy with violence -- whether it involves firearms or not, whether it involved strangers or family members, whether it is fueled by religious hatreds or ethnocentric supremacy theories or despair over economic threats and the death of one's life's dreams -- we should be looking to solve the problem of the people. Jurisdictions with radically different laws on weaponry have violence problems at least as bad as exist here.

Jurisdictions with nominally mandatory firearm possession don't seem to be at particular risk of violent crime. Twenty-five years murder-free, Atlanta's neighbor Kennesaw has a high firearm ownership rate that has fallen to 50% as the town has grown, while lowering its overall crime rate -- a rather better result than Morton Grove, Illinois earned after passing a gun ban. The murder risk in Switzerland is not alarmingly high -- though males from 21 to 32 all must keep an M-57 automatic rifle and 24 rounds of ammunition at home. (Older males below retirement age are in the reserves, also able to access military-style weapons.) Something beyond mere convenience drives violent crime.

Long touted as evidence that gun control reduces violent crime, the United Kingdom slowly surpassed the United States in its rate of assaults, robberies, and thefts; Scotland's non-homicide assault rate is now higher than than the 2.4% rate shared by Australia and New Zealand, which is exactly double the rate in the United States. (Unless I misread the numbers, however, the U.S. still leads all three in murders.) Meanwhile, the Vatican seems to have more criminal cases than residents -- though this is surely an artifact of its enormous non-resident tourist population and the petty thieves who prey upon them. There's serious disagreement about the impact of weapons legislation on violent crime, making it an ideal field for serious policy research.

When Scotland announces plans to strengthen knife control legislation, perhaps it's barking up the wrong tree. Perhaps the problem, like vehicular mortality in the United States, has cultural roots that require a national change in attitude and a broader public health intervention than a mere uptick in the mandatory minimum sentence.

ACAS' DRIP Pops Price

On October the 14th, when ACAS issued its dividend, the price of the shares popped past $17 during the day. As ACAS paid a couple hundred million dollars in the form of a cash dividend, shareholders participating in the company-offered dividend reinvestment program (DRIP) had their millions plowed into the shares. Unless the shares trade at such a premium to the net asset value that the reinvestment shares are issued by the company rather than being bought on the open market, the plan administrator has the authority to spend up to thirty days making open-market purchases for DRIP participants. Based on the DRIP reinvestment price of $15.936 and the fact these shares are already in participants' accounts, it's clear the administrator didn't wait long at all to buy the shares -- but immediately rushed out to make purchases, and bid the shares up materially in the process. The $17 price hit Tuesday wasn't seen again since. Over the rest of the week, they slid below $15 again.

Myself, I didn't observe this. My broker TD Ameritrade, which has silently dumped me from the ACAS-run DRIP before, did it again. I only learned about the ACAS reinvestment price from a friend with shares in two accounts -- one in the ACAS-run DRIP, and one in a Schwab-run DRIP. The Schwab-run DRIP systematically purchases shares the day following the dividend, and makes all these purchases at ten o'clock in the morning. You can see the share price flicker up a bit as the buy order hits. This so irritated my friend that he started signing up accounts for the ACAS-run DRIP, having seen that I got a slightly better price.

Well, in the past, anyway. When ACAS trades at a 10%+ premium to NAV, ACAS doesn't buy back shares at the market but issues shares to DRIP participants at 2% below the market price (which is above NAV, and is accretive rather than dilutive to existing owners' net asset value). Below this level, ACAS has a plan administrator buy shares for DRIP participants. At market, ACAS can obviously make purchases at better prices than Schwab's 10AM purchase system (as in the past), or worse (as this time; $15.905 < $15.936). This difference seems immaterial, though -- it's less than 1% of the purchase price. Below NAV, where the bet is that returns on higher-than-trading-price NAV will result in outstanding returns, this slight difference doesn't seem likely to move the needle on shareholder returns. Above NAV, the 2% discount to market value seems small but likely to add up over time. I've bought above and below NAV, and when I have to buy above NAV I enjoy getting at least a little discount to market value. With TD Ameritrade having mucked up my DRIP participation, I will be manually entering trades in my regular account and a series of tax-advantaged accounts -- and will be unable (due to whole-share purchases) to invest the exact amount of the dividend. In tax-advantaged accounts (to which I am limited in making at-will capital additions), this means I'll end up with some "extra" money earning a slight fraction of a percent in a money market account. Ugh. The only silver lining is that the current per-share price, being about $2 cheaper per share, may allow me to get a bigger bite for the same invested funds. I will be looking to turn the DRIP back on, but I'm worried that TD Ameritrade has dumped accounts from ACAS' DRIP before. When TD Waterhouse merged with Ameritrade, I was told the problem was due to the switch to the new systems. This current problem can't be attributed to anything so easily understood. Further, getting these accounts all set up on ACAS' company-run DRIP -- the only opportunity for below-market reinvestment -- takes a lot of time on hold with the reorganization department, or folks talking to them. I'm thinking I need to find a broker with more consistent service. The upside here is (a) TD Ameritrade has credited me a trade to cover the manual purchase of shares that should have been bought automatically, and (b) my reinvestment price will be better, so I will get extra shares for the money -- shares that will be paying me a dividend for years to come. Since these dividends are not only growing in per-share amount, but are reinvesting, I take consolation in the discount. Other note: shorts seem to have reduced their ACAS exposure to about 16%; short interest has dropped from 39 million shares to less than 34 million. Maybe actually paying these dividends will start to hurt after a while :-) The money made as ACAS plummeted from $44 to $14 may make a good cushion, but from the perspective of prospective returns, I'd think that folks short now are betting not on mere price erosion but on the complete failure of the firm. The folks short now -- when the dividend amounts to nearly 30%, and not the under-10% yield offered over a year ago -- seem to be playing chicken with a management team with a track record of strong execution and the ability to make deals happen in nasty environments. Indeed, the ability of ACAS to make lucrative deals seems to have been aided by the cash crunch: selling Contec Holdings for 10x EBITDA seems to have been aided by ACAS' ability to both raise senior debt from third parties who trust its due dilegence, and its willingness to hold subordinate (high-yield) debt to show it believes in the company it's selling. ACAS seems, in short, to benefit from good due diligence twice: first, on buying a good growth prospect, and second, on disposing of it to firms relying on ACAS' willingness to hold debt as an indicator of quality.

Baffling Apple Monopoly Suit Filed

Luxpro, which has suffered from competition with Apple in the market for portable music players, has filed suit against Apple. Luxpro's principal claim is that Apple has injured it through illegally creating and maintaining a monopoly, and has used dominance in the music sales business to force customers to buy its music players to the detriment of smaller competitors.

This is so bogus. Anyone claiming Apple has forced people to use its players hasn't been paying attention. The fact that the Luxpro's Original Complaint specifically discusses an Apple effort to dominate the MP3 player market draws attention to the very problem with the claim: anyone's players can play MP3s, and all Apple's players support DRM-free formats like MP3.

• MP3 files have no DRM, and can't be locked to Apple players as Luxpro suggests;

• Apple's music player synching software has always been designed to make playable files of any music customers already own, including at present the non-DRM AAC (aka MP4) and MP3 file formats that can be played without restriction on competitors' players as easily as Apple's own players;
  

• Apple's music store sells non-DRM music for whatever tracks it's been able to obtain on DRM-free terms from music vendors, and thus itself undermines lock-in by offering as broadly as it is able file formats that are supported by competing players;

• Non-Apple stores sell non-DRM music cheaper than Apple sells DRM music for tracks for which Apple offers no non-DRM alternative (say, Dig on Incubus' album Light Grenades, which when I tried to buy it for L was available only for more money and with DRM from Apple, so I bought it from Amazon and have been happy as a clam -- playing the song just fine the whole time on the iPod and on the Mac), meaning that Apple has been unable through its maket position to exercise pricing controls to prevent competition on price -- if Apple is succeeding at selling digital music downloads, it's not because others can't sell songs cheaper or with a non-proprietary interface.
  

The "Apple locks you in" meme isn't new. It's just strange that anyone who's been to school long enough to learn to read can look at the marketplace and its varied offerings and conclude that Apple (a) forces music listeners to use iPods or (b) forces iPod buyers to use Apple's music store. Apple offers a store that has cost-competitive competition and is compatible with the non-DRM offerings of every other vendor. (OK, if you bought something encoded in Ogg Vorbis, you might need to use an MP3 converter; but if you bought Ogg Vorbis, you know that and aren't bothered about it.)

The real story in Apple's music store is that it was a defensive measure to avoid being barred by proprietary file formats from selling music players and content editors without being forced to pay competitors a licensing fee. The fact that Apple's defensive move put it at the top of the digital download heap hasn't exactly caused it to roll in profit, either. The store's margins are slim -- and intentionally so -- to prevent competitors from having much room in which to undercut Apple while establishing a moat with Apple-incompatible DRM.

Unable to prove Apple had an evil motive (it was just trying to protect its backside from Microsoft), or that it wields pricing power in the music business (competitors are able to sell the same thing for less, with less restrictions by suppliers), and unable to prove would-be music buyers get locked into Apple hardware (the numbers on the amount of music Apple sells per iPod make this pretty plainly a bunch of bunk), Luxpro seems up the creek without a paddle proving antitrust wrongdoing. All Apple's done to acquire and maintain a monopoly is to build attractive music players and make them as easy as possible to enjoy with customers' music collections. The fact Luxpro got crushed when the industry faced serious design competition from a solvent competitor able to buy parts in bulk isn't Apple's problem. Maybe Luxpro could have improved its margins by shucking compatibility with Microsoft's DRM scheme ....

The Jaded Consumer gives this suit an 'F' and predicts a slow death in federal court, where there will be no way to prove Luxpro's claims of illegal conduct, or to prove Apple's conduct caused antitrust damages to Luxpro.

ACAS: The Liquidity Acid Test

Tomorrow, American Capital Ltd. (ACAS) will have to show the world that, despite a market cap under $3 Billion ($207 million shares outstanding, and a price of about $14 a share today, for a market cap of about $2.9 Billion), it can pay a declared cash dividend exceeding $217 million (based on a $1.05 per-share dividend and 207 million outstanding shares).

The Jaded Consumer is among those following ACAS who have considered liquidity to be a major concern in determining its ability to continue executing successfully. Since ACAS' investments are illiquid and its leverage is circumscribed by both regulatory limits and lender covenants, ACAS could theoretically be forced to de-leverage if asset values fell in line with a dismal market. Last quarter, ACAS reported $0.95 in realized earnings, below forecast due to transactions delayed from the second quarter into the third quarter. Nevertheless, management forecast a deal flow fully adequate to satisfy ACAS' liquidity needs and revenue projections, and went so far as to forecast rolling $500 million in 2008 taxable profits into 2009. (Taxable income is the metric that drives ACAS' dividend policy, which results from the company's tax status as a BDC; this status enables it to pay dividends from pretax income rather than after-tax income.) On the basis of this deal flow, management projected adequate liquidity. ACAS' last-quarter cash flow also offered reason for optimism.

In keeping with ACAS' de-leverage program over the last year or so, in keeping with ACAS' OpEx control (ACAS consolidated its San Francisco office into its Los Angeles office), and reflecting its relatively light debt load, management announced in its last quarterly conference call that it would be reducing the size of its lines of credit. Credit line reductions have some beneficial impact to ACAS: it lowers the amount of credit on which ACAS must pay commitment fees to maintain the line of credit (an operating expense) and it reduces the capital requirements ACAS must maintain as a condition of keeping the line of credit (protecting ACAS from liquidity crisis in the event of equity value declines). ACAS subsequently shrank a $1.3 Billion secured credit facility on renweal by amending it to $500 Million (freeing from encumberance some of the debt instruments securing the line and feeing them for sale, or else reflecting their impaired market value; the unsecured credit line costs 0.50% to keep open and LIBOR+2.50% when in use, and had no borrowings outstanding under it at renewal) and shrank an unsecured $1.565 Billion line of credit to $1.409 Billion (the new cost on the secured line is 0.50% to keep open and LIBOR+3.25% to use; ACAS' tangible net worth covenant under the new agreement has been reduced to $4.5 Billion plus a fraction of new funds raised). The unsecured line of credit, though managed by Wachovia, is actually funded by 31 participating lenders. One might view the renewal as a vote of confidence by the lenders in ACAS' credit, though it's also worth noting that the commitment fee quadrupled and the spread payable on borrowings under the facility grew by nearly 28% (from 0.90% to 3.25% above LIBOR). It's possible that the cost of borrowings increased in part because of the elevated cost to financial institutions of borrowing; perhaps they themselves can't borrow at LIBOR under these financial circumstances, and are passing the cost along.

The Story Behind The Credit Reductions
ACAS surely didn't go on purpose to its banks to renegotiate its cost of borrowing up. Management explained when it shrank its secured credit line that ACAS was operating at a steady state, and could re-invest proceeds of transactions into future transactions without needing the higher prior credit limits. This sounds nice, but the truth of the matter is that (a) ACAS' ability to obtain liquidity from deals is more speculative than from established banking relationships, and (b) in 2Q2008, ACAS was already experiencing unexpected deal closure delays, moving $0.12 in net into 3Q2008. The idea that material 3Q2008 deal flow could be delayed into 4Q2008 raises liquidity concerns.

ACAS announced last quarter a Net Asset Value of $27.01 per share, for a net asset total of $5.59 Billion. Since ACAS' investments are not generally susceptible to exchange on in a liquid market, most of the reported asset values derive from models that look to the values of comparable assets. After last week, one wonders at what price comparable assets might trade, and what this might do to ACAS' debt:equity ratio.

Liquidity Nightmare At ACAS?
American Capital Ltd. uses leverage to invest -- though less than banks -- and this leverage is subject to regulatory limits. Investors might liken this to the margin limit in a brokerage account: if the asset valued dwindle, something must be done to decrease the leverage. The nightmare case is that illiquid assets in a fire sale would be liquidated for a song, leaving ACAS broke in the aftermath of a liquidity crisis.

The way a margin account works is this: the investments and borrowings against them have a certain maintenance requirement, and as the equity in the account plummets during a protracted panic, the investor gets notified that if money isn't forthcoming, the broker will begin liquidating the account's assets to bring the account into line with the maintenance limits. Looking at ACAS' last-quarter net asset values and the size of its commitment fee, one applying this model would conclude ACAS must have been in effect about one billion bucks away from a margin call. Thinking about the movement of the markets since the last quarter, and the illiquidity of ACAS' investments, one might imagine that valuations based on comparables might have dipped over 20% with the rest of the market last week, leaving ACAS well below its promised asset levels. Unable to borrow under its credit facilities, desperate for cash from operations trying to run during a recession, and possibly suffering more deal delays due to a broad-based liquidity crisis, one would conclude that ACAS is probably broke.

We know from the questions and answers in the earnings conference call for the second-quarter of 2008 that one reason ACAS sometimes has both substantial cash and substantial short-term borrowings on its books at quarter-end is that it needs cash to pay its dividend -- and often has just reinvested capital in an attractive deal. If ACAS didn't succeed in achieving its liquidity goals, or lacks the covenant-specified assets to make use of its credit facilities, ACAS won't be able to pay its dividend tomorrow.

ACAS Doesn't Have A Margin Account
American Capital Ltd. doesn't have a broker looking over its shoulder on a daily basis waiting to execute immediate forced liquidations depending how ACAS' holdings seem to be valued on a daily basis. Management has also made clear that liquidating some of ACAS' investments takes something on the order of seven months. There is no emergency liquidation market for ACAS' holdings, and no authority for external forces to cause a liquidation.

Moving $0.12 of realized income from 2Q2008 into 3Q2008 doesn't mean ACAS moved $0.12 in liquidity into 3Q2008. ACAS moved to this quarter realized net in the amount of $0.12, which means ACAS receives not only the net this quarter -- the $0.12 -- but also any of the principal ACAS didn't choose to finance. ACAS made clear that management is not desperate to finance bad deals to get them closed, but that are outbid in financing them half the time. Moreover, ACAS' deal flow is a two-way street: ACAS need not enter deals any faster than makes sense, and can sit on its hands if need be as it waits for deals to come available on terms that are adequately attractive under all known existing circumstances.

ACAS has already announced a several profitable exits this quarter ($37 Million from PaR Systems, $57 Million from Contec, and $36 Million from SSH Acquisition), presumably facilitating substantial gross receipts even after providing financing to buyers in two of the three deals. ACAS' liquidity will depend on ACAS' hunger to reinvest in its currently-available deals, which may be tremendous. On the other hand, there may be a tremendous deal in ACAS' own shares.

ACAS Attractive
If ACAS were to repurchase 15% of its outstanding shares -- at $15, this would cost $465 Million, within the remaining amount in the $500 Million share buyback authorization -- ACAS could increase operating income per share nearly 18% -- for example, from $0.71 to $0.84. The net realizations per share from investments would similarly improve. A 15% reduction in outstanding shares bought below NAV would increase the net asset value for the remaining shares, and offer substantial future magnification in gains in NAV associated with eventual improvements in the economy (and thus improvements in the trading prices by which ACAS' asset values are estimated). Because the shares trade at a discount to NAV at present but traditionally trade at a premium of 1.4x NAV, the share price impact over time should be substantial. Improving NAV from a hypothetical $25 to over $29 would be a substantial boon, given the likelihood within the course of a year or so for ACAS to trade at at or above NAV. At $15, a share buyback seems to offer both excellent medium-term return and a great opportunity to protect ACAS' coverage of the dividend.

In the first quarter of the year, when the $500 Million share buyback authorization was new, ACAS had few trading days in which it was not barred from trading. Management said on the confernce call that they wished they'd been able to buy more shares in the twenties. During the 2Q2008 conference call, ACAS' management said that during the time shares traded at a discount to NAV, there were no days ACAS' compliance officer would authorize management to make share repurchases. There's no way to tell when or if ACAS would be in a position to buy back more shares, even if there were adequate liquidity to do it. However, even a few trading days in the teens should permit meaningful share retirement. With shorts again holding positions exceeding 19% of the float, effectively flooding the market with additional shares and depressing the price at which they are exchanged, management at ACAS has an excellent opportunity to concentrate value in shares. This would improve the value of both shares held by insiders (just over 1%), and the value of the shares held by those whom management wishes to reinforce that it will continue to provide a long-term value -- the very people to whom ACAS intends offering newly-issued shares above NAV in the future.

If ACAS can pay its dividend tomorrow, we'll know ACAS isn't out of money. The people on the DRIP will be buying shares near $15, and looking forward to a quarterly dividend of over 7% next month -- a dividend that, without increase, would yield over 28% a year. If ACAS is free to buy shares near this price, and prefers it to getting over 40% annualized returns on investments that work while risking the occasional dud when it invests in an unsustainable business, investors will see some stability increase in earnings as income from portfolio companies' operations grows on a per-share basis. If ACAS' liquidity is really good, we'll see both solid deals from this quarter and a meaningful share buyback.

American Capital has been lauded by its management as the top of the heap in middle-market buyouts, and a king of private equity deals. Although its track record has been great since inception -- if it went to zero after paying the dividend tomorrow, original investors would still have doubled their money -- this financial crisis offers a situation nobody on the ACAS management has previously weathered. (Buffett is older, and said he finds the market sentiment more fearful at any time in his adult life.) American Capital has come through hard markets before and claimed in the last conference call that it was in a better position to profit from this one than it was when the Internet bubble burst.

Tomorrow, we see whether the Emperor has any clothes.