Apple's March Event, Pt. II

The March Event post received one entertaining response:

Seeing as how I'm being referred to as "some", I feel it my duty to revise my earlier statement, given that Apple announced the 2.0 release on Mar 8, 2008.
I now say, for anyone (anyone!) to quote or refute: "this seems late…"
-- yofal via InvestorVillage

I agree: it does seem late :-)

On the other hand, whether it's late or early depends what's in the announcement.

The 2.0 announcement was the announcement of two radical changes: first, a real SDK for native iPhone applications, meaning that in order for the applications to be ready at OS release developers needed large lead time to get cracking on dev and test; second, Apple announced an exclusive delivery apparatus that required Apple to screen potential applications and issue keys to registering developers, meaning that new types of non-dev administrative overhead needed to be understood and digested before applications could be placed in the hands of users.

I expect the 3.0 announcement will be less earth-shattering, even if it does have valuable features and significant bug fixes and performance enhancements. Apple might, for example, push tech intended to make future hardware more easily accommodated: reminding developers about the advantages of vector graphics over bitmaps for handling resolutions dramatically different over time, etc. Apple could play chicken with the Osborne Effect and pre-announce hardware that would take advantage of v. 3.0 features inherited from Snow Leopard, or simply point out that Snow Leopard's refactoring and efficiencies will be enhanced by improved OpenCL capacity to load CPU demand onto DSPs, graphics hardware, and so forth so that everybody will benefit from v. 3.0 -- a reason to announce that since iPhone v.1 purchasers' first two years (and free software rights) have completed, they should be excited and privileged to shell out $24.99 for iPhone OS v. 3.0.

If Apple is really announcing a bunch of new stuff for iPhones -- including hardware -- the marketing folks might prefer the Powers That Be hold off announcement (i.e., announce later) so as not to kill immediate-term sales. On the other hand, iPhone 2.0's early announcement created an opportunity to clear the channel (thus protect vendors) and to build excitement about an anticipated but not-yet-available product.

I think that Apple's investment in the App Store -- to make it a better place to shop, and a more effective place to market applications -- is likely to become increasingly serious as Apple works to improve the value of its plaform, and I expect Apple to spend some time waxing about the range of things one can do as a result of the third-party applications on the iPhone.

If Apple could build a Delicious Monster-like bar-code scanner on the basis of its integrated video hardware, Apple could phase out the WinCE handheld POS systems and simply use store employees' iPhones to conduct POS transactions. Is video imprint of a credit card plausible? Would Apple need to support Universal Dock hardware extensions for card swiping? This kind of thing could be marketed to other shops together with POS back-end systems for additional software revenue. Remember how Apple over time became a power in film by focusing on achieving an integrated suite of software solutions (video editing, audio mixing, video archiving, graphics manipulation, etc.) that ran on its hardware? The field of POS is less specialized but much broader, and as Apple deploys less and less expensive hardware, its ability to sell software becomes more important. Apple could use its in-house solutions, if they are good and don't depend on outrageously costly things like Apple's massive SAP deployment.

But this last bit tends toward rampant speculation :-)

Apple's March Event

There's a rumor that an Apple event next week will introduce iPhone OS v. 3.0.

Although billed by some as "early", I believe this isn't particularly soon for such an announcement. Apple's announcement of its next desktop operating system came last summer, after all, and one of the benefits of Apple's operating system and development environment is the ability to build both from a single code base, and allow developers of either to leverage Cocoa to produce solid and efficient applications. If Snow Leopard nears, it makes sense that the next iPhone OS will also near. I suspect that the effort to make Snow Leopard a leaner, faster cat has also been part of a program to keep the architectures closer together. I view the leaned-down iPhone OS 2.0 as something like Leopard 1.5, with Snow Leopard being "Leopard 2.0" -- like the original in vision, but with refinement. For example, the kludge used in the 10.5-and-earlier kernels to enable greater-than-4GB memory addressing from a 32-bit kernel will apparently disappear as xnu goes 64-bit through-and-through. (The problems of large RAM in x86 machines with 32-bit addressing isn't a Mac problem; Apple has actually delivered a bit better on its promises to consumers than some manufacturers.)

I don't see evidence the March 17th event is actually a product release date, so I suspect it's just a feature announcement. The fact that Apple is far enough along with the new kernel that it can discuss upcoming iPhone OS versions (without MSFT-like feature attrition along the way) is a Good Thing™. The fact that Apple is announcing it in advance is perhaps designed to stoke developer interest in the face of competition for developers, and designed to excite people about the future of the platform -- including the free software updates iPhone users can expect.

I think a faster iPhone OS will be good for everyone, and I think the new tech for distributing computation demand to available processing units (I'm looking at you, graphics subsystems and DSPs and additional processors) will be as valuable on handhelds like iPod/Phone as on notebooks and desktops.

In connection with this, I believe that discussion of MacOS X acquiring ULE from FreeBSD should be dismissed. The MacOS X scheduler is not part of its BSD heritage or a historic part of Apple's synchronization of its BSD kernel with the FreeBSD kernel tree; obtaining a new scheduler from FreeBSD thus makes no sense. The objectives of recent FreeBSD updates have already been partially attained in xnu (e.g., the preemptible and re-entrant multithreaded kernel appearing only relatively recently in FreeBSD), and attaining additional benefits may be a matter of further incremental work rather than a matter of wholesale replacement of the scheduler.

The MacOS X thread scheduler is part of xnu's Mach heritage. Considering that xnu (the MacOS X kernel) implements BSD threads atop Mach threads, and that much of how MacOS X achieves its various performance miracles (e.g., copy-on-write, etc., that make some data-intensive transactions nearly free in some cases) requires maintenance of Mach primitives and their behavior, a scheduler designed for a different thread primitive seems an unlikely new feature. All the userland frameworks depend on assumptions about the behavior of Mach threads, for example. Elimination of Mach threads and their scheduler would add a kind of rippling complexity, threatening not only Apple's userland code but that of every developer that ever worked with the old Mach thread behavior.

Given the relative revolution that has occurred since the initial release of MacOS X -- the open-sourcing of the well-known, stable, mature, and widely-deployed Solaris operating system, for example, and the development of real-time performance solutions on open-source operating systems -- it's not entirely implausible that Apple might one day vigorously re-invent the internals of MacOS X. Apple has already paved the road in that direction by providing IOKit (so that many device drivers need not care about operating system internals, so long as they interface with established interfaces) and, more recently, KPIs (to free more drivers from dependence on the implementation details of the kernel such as particular versions of data structures or the like). By allowing third-party code that must run in kernel space to interface with the kernel without leaving the code subject to obsolescence every time the kernel is updated (that is, at every point release) or given a significant performance or feature upgrade (likely at a major release) -- because the third-party kernel code is now capable of using published interfaces that don't change despite radical refactoring of the kernel algorithms and the addition of new features -- Apple has been freed from the shackles of reverse-compatability limitations. Apple has given developers a path to write relatively future-proof code, and gained the power to revise dramatically the details of its kernel implementation. Thus, the day may come that Apple decides its kernel architecture has outlived its usefulness and replaces it -- without users really noticing (other than to reap the benefit).

However, it's not clear that Snow Leopard is that point. FreeBSD seems to have implemented ULE only recently, ULE appears not yet to have achieved things Apple already had obtained, and Apple has been working like a fiend on things like OpenCL and an improved multitasking architecture, all with apparent independence from the FreeBSD updates and release schedules. As an outside observer, I figure that at present, the scheduler is something at which Apple is ahead of the game, but Apple's work on making the implementation details irrelevant to developers will have the effect of leaving Apple free later to adopt superior under-the-hood solutions if and when they appear.

If Apple wanted to create a serious under-the-hood revolution, the switch to a 64-bit kernel (which necessarily requires at least a 64-bit recompile of any prior third-party in-kernel code) would not be a bad time to launch it.

Upshot:
iPhone OS v. 3.0 will be a feature announcement and not a product release, and it will reflect improvements Apple is making in Snow Leopard (while being slowed from release by those issues that would slow Snow Leopard). Improvements in iPhone -- like the ability to use the iPhone as a bluetooth wireless modem for notebooks, or simply the ability to cut and paste -- are not hard to imagine even without considering fundamental issues like better utility of various hardware (digital signal processors, graphics subsystems, multi-core general-purpose processors, etc.) and other performance issues. iPhone OS v. 3.0 will be largely an event to seduce developers, but it will also draw attention to the value Apple has acquired for its naescent platform.

The possible future of this handheld platform may feature again in future handheld rumors, but for now it's safe to say that Apple has defied critics not only to succeed in cellular phones but also to establish the dominant platform for vending third-party smartphone applications.

Malon Wilkus' Big Margin Call

Although ACAS itself is not subject to "margin calls" because its most concerning debts (those with a breached net asset covenant) are unsecured, ACAS' various shareholders are not so lucky. Joining those of us with ugly ACAS-related margin calls is ACAS' own founder and CEO Malon Wilkus.

Under a pre-Sarbanes-Oxley loan agreement, Wilkus had borrowed from the company funds secured by ACAS shares. Wilkus stated that he was proud never to have sold a single share of ACAS. As ACAS' price declined, he added to the 208,200 shares securing his loans an additional, then-unencumbered 852,456 shares, to prevent foreclosure. As a result, Wilkus has lost 1,060,656 shares as a result of sticking with the company -- and keeping faith with other shareholders -- as its share price has been hammered by the marketplace.

The fact that ACAS' CEO stuck with the shares as their price plummeted, and multiplied the number of shares at risk of foreclosure in order to protect any shares from risk of loss, illustrates his personal confidence in ACAS. Unfortunately, the market did not share his confidence, hence the stock price decline to less than 1/15 its annonced NAV. Malon Wilkus continues to own 630,000 shares through participation in an ACAS incentive bonus plan, some of which shares have not yet vested.

The reduction in outstanding shares should be reflected in the next quarterly report. Hopefully we will by then also have a report on share issuance associated with the ECAS transaction, and get some indication regarding the associated change in NAV.

Justice and the Judiciary

During the last election cycle, then-senator Obama answered swiftly when asked what Supreme Court justice he would not have confirmed: Clarence Thomas. Instead he argued against judges who would merely apply the law as written, but said -- and this isn't a joke, mind you -- that he wanted judges "with heart". Judges that decide cases on the basis of how a particular case "should come out" -- rather than on the basis of the law -- is a serious departure from the principle of the rule of law and is unlikely to result in genuine protections when unpopular or politically powerless groups seek to have their rights protected.

As African Americans learned while trying to protect their right to free assembly in NAACP v. Alabama (decided in 1958, before the United States Congress regularly had Black members, and before the Supreme Court first had a Justice of color), having a rule of law that applies to everyone is critical to maintaining law that means something when it's your turn to have your rights protected. This lesson isn't easy to learn. The NAACP itself did not learn this lesson from NAAC v. Alamaba. When the exact same right -- to protect membership lists from being compelled from private organizations hated by state officials -- was being protected by Anthony Griffin (who then served as counsel to both the NAACP and the ACLU), the NAACP in 1993 fired Mr. Griffin for working to protect the exact same right from encroachment by an overzealous Texas prosecutor. (Griffin, who in addition to being an outstanding attorney happens to be Black, did not take the case because he thought the aggrieved party -- a Grand Wizard in a Klan organization -- was "morally right", but because he knew the law was paramount and that if the law was itself not protected, the next membership list sought might be the ACLU's or the NAACP's). Griffin stayed on the case despite personal attacks that he was on the "wrong" side and won, to the benefit of all Americans and even to the benefit of a small church I saw hit with a membership list subpoena last year during a law suit over an insurance claim. Evil can come from any quarter and our rights must be enforced everywhere, all the time, or they are meaningless.

The rule of law is much more important than "heart" because -- if enforced as written -- it means something over time. This cannot be said about "heart".

The irony in Obama preferring "heart" to careful reading of the actual law is that Justice Thomas is perhaps the voice most likely to support genuine rights of individuals. Just this month, in an opinion on whether federal drug regulations should prevent consumer litigation for product safety, Clarence Thomas went far past even the so-called "liberal" Justices in saying individuals' right to historic safety protection under state law should be protected from federal encroachment by expansion of preemption doctrine. Thomas' interest in protecting individual rights from overreaching by federal authorities dates back to the middle of the last decade, and he has the fearlessness to write what the law requires even when it places him at odds with "conservative" justices -- or any of the Justices sitting with him on the Court.

With a Thomas-style enforcement of the law as written, States would already be achieving universal coverage in health insurance, just as they did in auto insurance. Under federal encroachment under doctrines that developed far after the creation of the Constitution, however, and never imagined by its authors, the federal government has used "rules" dreampt up by judges with more "heart" than attention to the letter of the law to prevent local government from regulating health care to prevent health plan cherry-picking and to distribute the cost of care across the population of covered lives. The Supreme Court, bending over backward to make up rules not present in the Constitution to enable federal exercise of a general police power, actually enjoined a Hawai'i tax that funded universal health care (affirming without even bothering to write an opinion at 454 U.S. 801 (1981) the decision of the Ninth Circuit Court of Appeals in Standard Oil Co. v. Agsalud). Although Hawai'i got "grandfathered" under the particular federal law at issue (see 29 U.S.C. §1144(b)(5)) so its scheme could be protected as it existed in 1974 before the federal statute at issue was passed, that wasn't the end of the evil: Oregon was prevented from achieving universal coverage under the same law, and Hawai'i itself has been unable to update its health coverage scheme to address lessons learned in the last thirty-plus years. Moreover, other states' effort to solve health coverage and affordability problems -- and efforts merely to enforce coverage already existing -- have been clobbered by the exact same federal law.

Congress may have the right to "define and punish felonies and piracies on the high seas" but this and Congress' other express grants of power do not amount to anything like a general police power other than at sea or in areas of exclusive federal ownership, like stockades and occupied foreign territories. Only brave souls like Justice Thomas stand between individuals who expect the law of their communities to protect them, and a nationwide Washington D.C. in which there is no justice, only crime and oppression and corruption and failed public education. But for the personal action Justice Thomas has taken on the bench, it is difficult to tell how far the federal government could have reached since 1995 in neutering private rights in order to make it easier for federal authorities to control and herd the population it largely ignores (except when running ad campaigns during election season).

Allowing judges to decide cases "with heart" so the broad public is happy with the outcome of the parties' conflict is tantamount to inviting them to rewrite the law to suit every case; it means giving office to judges who do not care about the law they are sworn to uphold, but who prefer instead to legislate it as they go. This kind of excitement to create law where the Constitution offers no support for it is how this nation got stuck with ideas like "field preemption". The runaway preemption of state law protection of individuals is how Americans get saddled with evil decisions like that in Hall v. DeCuir, which should stand as a beacon to the necessity of Justice Thomas' approach -- which if employed in that case could have saved America generations of heartache and placed us nearly a century ahead in racial equality. Unfortunately, the Court ruling on Hall v. DeCuir wanted to show "heart" to the apparently sympathetic Mrs. Hall instead of applying the law as written to the case won at trial and through appeal to the Louisiana Supreme Court by Ms. DeCuir. It's too bad our new President thinks more of "heart" than he does of the law.

The law needs real defenders right now as much as ever.

Justice Thomas and the Texas attorney Griffin carry a proud banner. Let's not have a concept with no consistent meaning over time -- like "heart" -- replace the real rights and legal limits set in writing by the people who wrote the Constitution. If we do not like the result, let us have the courage to admit mistake and amend the law, not simply erase it under some limitless doctrine like "heart".

TheStreet: Illogical Apple Analysis

Today TheStreet.com published a dire warning about Apple: at a time that computers' average selling price is about $720, Apple averages $1,400 for every Mac sold. Therefore, TheStreet.com predicts doom and gloom for Apple.

This is a problem Dell, for example, would love to have. Or HP. The reason Apple is selling its computers for more money is that (a) it's selling higher-end gear (b) to a higher-margin segment of the market. TheStreet.com's complaint is akin to lamenting that BMW doesn't offer a $18,000 entry vehicle. Well, duh. BMW is hoping to make more money than is made on $18,000 entry vehicles. For that matter, I understand that GM's average selling price is lower than Toyota's $ 24,395.18. Which auto maker would you rather own?

The trends at Apple will naturally be impacted by economy-wide events like the current global depression. However, this impact need not be absolutely bad. For example, Japanese auto makers were famously observed by Lee Iacocca to gain more market share from entrenched U.S. manufacturers during bad economic times than during good ones. Given that the benefit of the foreign car isn't sticker price (see above) but reliability, this may be the exact sort of trend on which Apple can capitalize during a downturn.

The I.T. administrators who so loved Microsoft products because they made I.T. personnel indispensable within organizations employing the company's products gained ascendancy in the 1990s, but the shine is off. The fact of Microsoft's reliability and security record is well-known. Web standards make the desktop API less critical than was the case a decade and a half ago when all applications ran on the desktop or on a local network. Organizational demand for reliable products has made would-be Microsoft upgraders a cautious lot, willing to wait for software upgrades before attempting new versions of Microsoft products. Others are considering simply jumping ship for a less leaky boat.

Apple's supply-chain success and continued operating system and application software improvements leave it in a position to spend less to provide more than competitors who either don't make operating system software (like Dell), or don't sell hardware (like Microsoft ... unless one considers non-general-purpose computing devices like XBox, which has cost Microsoft more money than it's grossed). In a downturn, that might be golden over the long run.

Given the relatively slight 2009 forecast changes made by Apple-following analysts, the recent price action is fairly certain to be more of the jittery-market overreaction we've seen so often of late. From current levels, Apple is a bull play.

On ACAS in 2009

Some Numbers
ACAS has a debt-to-equity ratio of 1.4:1, and cannot take on new debt other than to repay existing debt. ACAS is permitted to redeploy debt as ACAS is paid, though, according to Malon Wilkus on the latest conference call, and is not obligated to race to retreat its debt-to-equity ratio to 1:1. Although ACAS could theoretically enter new investments with these repayments, ACAS is working to make its creditors happy in the face of its apparent breach of its net asset covenant in its unsecured debt facility.

ACAS holds 4.6B in unencumbered assets, against $2.3B in unsecured debt. Pledged assets are in their own entities and are distinct and separate from the general assets of ACAS.

ACAS has let its lenders see its books, and it does not anticipate acceleration even if it faces interest-rate increases in connection with its debt covenant breach. Default interest ranges from 2% to 3%, which I assume is a spread above non-default interest. ACAS anticipates contesting an acceleration demand, if made, though it didn't elaborate on the legal arguments that might be raised to support non-acceleration (i.e., perhaps that the changes in accounting principles or in the valuation formula inputs were not foreseen by the parties and their subsequent materialization should relieve performance in the same way as would a material mutial mistake).

In 2008, ACAS realized over $2B in exits; the 2009 exits to date were made in the vicinity of prior-quarter valuations. The asset ACAS listed as "worth" $11m under FAS-157 several quarters ago, but which was producing $8m in returns (or 73%) per quarter, was described on the recent call as having continued to produce similar quarterly revenues since ACAS originally described the accounting treatment of the investment. To illustrate this problem in ACAS' investment valuation, ACAS produced a chart on page 11 of its slides accompanying its 4Q2008 conference call. Structured products produced an annualized income of $69m per year for ACAS in 1Q2007 and were valued at $833m; at the close of 4Q2008, ACAS received structured product revenues at an annualized rate of $122m per year, and these were valued at $186m.

In response to a question on the conference call, Malon Wilkus stated ACAS hasn't engaged in discussion of changing to some other form of organization other than the BDC structure. Particularly in light of the IRS ruling that ACAS would be able to issue shares in lieu of cash for a large fraction of its required dividend payments, ACAS may not be in such a cash crunch as previously feared: the amount of cash ACAS will be required to dispense to meet its BDC obligations will not be measured in dollars but in dimes. Assuming ACAS really has adequate interest coverage, ACAS may be able to hold on long enough for the long-term value of ACAS' portfolio to be meaningful.

ACAS has authority to issue about 42m shares below NAV, but management stated that it was very unlikely to issue shares in such a volume simply because at current levels such funding would be too small to bother. ACAS gets much more money than that just collecting interest.

ACAS stated it has approximately 8 portfolio companies for sale in the current quarter, and that last quarter it pulled from sale companies whose bidders appeared to be low-balling in order to take advantage of ACAS in the expectation that it was a highly-motivated seller. ACAS views itself even now as a long-term investor able to withhold companies from the market until market prices make suce transactions favorable.

The big mystery is what ACAS will (or won't) be able to achieve in its negotiations with its unsecured creditors. Obviously ACAS would rather have an agreement in which it is not in breach, but management has made it clear that proposals it has received so far for renegotiation have involved security arrangements that would leave ACAS without the power to say "no" to rotten deals, and could in effect convert it into a forced seller. Thus, ACAS hasn't entered into any currently-offered rearrangement. However, ACAS continues to discuss the situation with its lenders, who are (contrary to some reports) well aware of ACAS' financial situation by virtue of reporting arrangements associated with its unsecured credit line agreements.

ACAS is still getting regular income from portfolio companies and from debt it holds in connection with both existing holdings and holdings it's exited under an arrangement financed by ACAS. ACAS holds debt in various tiers, including high-yield subordinate debt tiers. As ACAS exits companies to become a bond holder, ACAS moves up the balance sheet to a more secured position and trades steady income for the prospect of capital appreciation. Due to the existing credit crisis, this ungraded unsecured debt has a paper value that is in the toilet, even if it is performing. Historically, ACAS has experienced debt portfolios that were not performing and subsequently became performing again, so even the nonperforming loans aren't certainly valueless. Nonperforming loans at ACAS at the end of 4Q2008 were $150m of $5.1B total loans at their then-presently-marked values, or 2.9% of loans by value -- an increase from 2.4% at the end of Q32008. Presumably some of the loss in NAV results from write-downs associated with non-performing debt, which means that the denominator and the numerator in the "bad debt" calculation are both moving targets. It might be nice to have a percentage by face value, but it would be hard to match these face value amounts against the assets shown on ACAS' books simply because ACAS isn't allowed (as a bank is) to show performing loans at face value; it's required to value them as if it would be required to sell them immediately, regardless its intent.

AGNC's dividends continue to flow to ACAS' bottom line, and ACAS has a strong incentive to ensure that AGNC continues to declare as large a dividend as AGNC can afford. ACAS can't raise additional debt, and its share price makes raising funds through equity implausible. ACAS essentially gets to recycle its balance sheet until funds become more available, while looking to de-lever.

The Upshot
ACAS was initially interesting to me because I believed management's ability to cherry-pick good deals in a sea of illiquid and hard-to-value offerings would place it in a position to realize sustainably high returns over the long term. Finding good buys where others don't notice them -- that's what we're all after, right? The recipe for bargains!

The illiquidity of ACAS' portfolio and the difficulty of valuing its portfolio investments has, ironically, resulted in a serious liability: ACAS must both report quarterly on its assets' values and must book unrealized gains and losses on that moving target just as if it had conducted a sale. So in a quarter in which ACAS realized a $0.01 per share loss, ACAS reported losing $8.13 per share. According to its SEC filings, ACAS looks like it's hemmoraging money: in the full year of 2008, ACAS realized $2.58 in earnings (the hard number the tax authorities want to know about) while reporting under the accounting rules governing SEC reports that it lost $15.29 (more than two thirds of which was a result of changes in the valuation formulas, and less than two thirds of which was a result of portfolio performance decline).

The applicable accounting standards seek information about changes in value and not just actual income, and in doing so conflate the two measures (assets and income). As valuation multiples contract (ACAS has gone from having income-to-value multiples of over 10:1 for some kinds of investments to less than 2:1, an over-80% decrease in stated valuation even on consistent revenue), ACAS experiences valuation changes that dwarf income in a given period. Because these unrealized paper losses are hypothesized on the basis of valuation models and are often entirely disconnected from any real-world transactions, it's worth asking in which cases the valuation decline is even relavent to actual value in the hands of ACAS, particularly in the case of assets intended to be held until maturity (e.g., structured products and high-yield subordinate debt ACAS does not generally syndicate).

In short, the very feature of ACAS' investments that made ACAS attractive -- that its investments were hard to value and created an opportunity for a firm specializing in doing due diligence in this segment of the private equity market -- has made ACAS both hard to predict and hard to value. In the absence of a dividend, one can't say "since the money is coming in, it must be working as advertised." We face the fundamental question all over again: does management have expertise enabling it to do better than expected by the market? Is management sound and sober? Those who have been shaken by the dividend cut have left, as have those who view ACAS' performance as reflecting a lack of candor on the part of management.

Who, exactly, is left?

The fact that I can't figure out who's left leaves me with a suspicion that ACAS' share value reflects its loss of its historic owner base rather than a considered view of its future value. In particular, I suspect that it reflects abandonment of ACAS share price to the hands of those who've long assumed ACAS was a house of cards and stands ready to fall at any minute -- and view ACAS' performance over the last several quarters as evidence they are right -- at the very time ACAS' historic owner base has bailed on the ground that ACAS no longer represents a dividend opportunity (especially in light of the IRS ruling enabling equity dividend payments to satisfy REIT/IRC payment obligations) and lacks the high per-share earnings (due to a collapse in asset valuations, not necessarily income) previously associated with ACAS. The bulk of the people in ACAS are just gone -- and so, logically, is the price per share.

The question is simply this: are people missing a deal?

The critics have answered with their feet, and sold -- hence the current share price.

On ACAS' Full-Year 2008

American Capital reported its 4Q2008 results. First the bloody headlines: (a) its asset valuation covenants in its unsecured debt agreements have been blown, (b) its NAV has plummeted to $15.41, and (c) its auditor's opinion, though still unqualified, now bears a going-concern explanatory paragraph; NOI has decreased to $0.21 per share. On the other hand, this 4Q NOI reflects one-time items that lead management to argue that investors consider a $0.41 pro forma quarterly earnings it would have showed but for restructuring charges (e.g., severance packages) and a "deferred tax asset valuation allowance", and ACAS claims a "realizable value" exceeding $20 per share. Which story to believe depends whether ACAS can conduct business as a patient investor or is forced to behave as a panic seller as a result of thinks like blown debt covenants.

Over the quarter, ACAS realized $246m in exit proceeds at exit prices less than 2% different than its prior-quarter valuations. This is good on the one hand -- ACAS isn't acting like a forced seller yet and its valuations are standing up to the test of actual market transactions -- but it calls into question whether ACAS is right that buyers will pay pre-FAS-157 prices for businesses. Conversely, if valuation multiples are collapsing, ACAS' ability to make an exit at last quarter's prices might appear a substantial victory. Hard to read the tea leaves on this. What does puzzle me is why ACAS was willing to exit at a loss, unless it was ejecting dud companies. I'd like to look at this a bit more.

FAS-157 valuations have been hammered by a number of comparables sales that were distress sales, and not arms-length sales by investors agreeing on the value of the sales. Since ACAS values debts owed it at this "market" value (under FAX 157), but must carry debts it owes others at face value (under FAS 159), ACAS shows a value over a billion dollars different than if it'd been able to show both debt held and debt owed under the same accounting treatment.

16% of ACAS' decline in NOI is a result of non-performing loans. This is a problem in which ACAS bears the burden: ACAS entered these loans on purpose to provide income and total return for the benefit of shareholders, and nobody but ACAS is to blame for any inadequate loan performance. ACAS itself underwrote and funded these non-performers. Mind you, this is an especially bad economic time, but I'd like to know if anyone has information about ACAS' eventual performance on non-performing loans during the last downturn (i.e., did ACAS eventually get paid, or did these typically become genuinely worthless on a permanent basis?). ACAS reports a weighted average return on its debt portfolio -- incorporating the nonperforming loans -- at 10.7%. This isn't materially better than Warren Buffet has obtained lately for Berkshire Hathaway by entering transactions with the likes of GE and Goldman Sachs, and Buffett gets potential future equity participation in the bargain; ACAS' debt portfolio is just its debt portfolio.

Like ACAS, ECAS halted its dividend -- something that impacts ACAS' revenues, because ECAS dividends generally flowed right to ACAS' cash pile. This won't resolve until the ECAS transaction closes, at which point ECAS' cash will essentially become ACAS' to play with. The loss of the ECAS dividend was also a hit to ACAS' income and cash flow for the quarter.

ACAS claims that each share is backed with $20.63 in "realizable value", rather more than the $15.41 it is required to report under generally accepted accounting principles as its "net asset value". To the extent that shareholders see an opportunity to buy at about $1 and to get a company that's pulling in hundreds of millions per quarter in cash, this seems fairly interesting indeed. The question is whether the horizon on which ACAS anticipates realizing $20.63 is longer than the horizon for ACAS' solvency in the face of its breached debt covenants and the like.

Slide 32 shows ACAS paying $37m for 9 portfolio companies acquired under distressed conditions. This is the kind of interesting opportunity that I think creates a way forward for ACAS, if it can avoid being squashed. The problem with expecting ACAS to avoid being crushed in a liquidity crisis is that ACAS can't make assurances that its lenders will be happy with ACAS' 2x interest coverage, and won't decide that ACAS' net asset covenant violation are grounds to declare default and accelerate payment of principal. Moreover, default-status interest rates are likely to be materially worse even than the up-negotiated interest rates, and could leave ACAS with scarcely any margin on the loans it's funding with the borrowed money.

The fact that ACAS needs to use borrowed money to maintain its operations is really a problem: Berkshire Hathaway can't do this under in current economic environment against competition with federally-guaranteed banks and make a living at it (even if the banks have crummy balance sheets, the federal guarantee associated with bank holding company status means cheaper access to lent funds), and ACAS hasn't got Berkshire's balance sheet. Of course, Berkshire doesn't have to mark to market holdings like GEICO or its portfolio companies that do things like broker real estate or sell manufactured housing or motor homes. Applying FAS-157 to Berkshire Hathaway would create a definite buy opportunity. Sadly, Berkshire is only down to something like $2450 a share (from over $5,000 in '07, if I recall).

The question I'll have to attack with more brainpower is this: what is ACAS' outlook for avoiding destruction? ACAS' slideshow repeatedly addresses ACAS' status as a patient, long-term investor able to wait for adequate buy offers . . . but in the face of accelerated principal repayment demand, what will protect ACAS from forced sale conditions? I suspect the protection is the very illiquidity of ACAS' assets: a trustee in bankruptcy won't be able to dump shares onto an exchange for the simple reason that there is no exchange on which to dump the assets. The trustee will likely be required to rely on ACAS' expertise to assess the quality of offers, and in the meantime would likely see that ACAS' ability to keep its interest expense covered with current revenues is adequate reason not to kill the income-producing assets in a fire sale. (This assumes creditors bring an involuntary bankruptcy in order to cause asset sales to fulfill their demand for accelerated payment. I have some doubts that ACAS would deliberately seek bankruptcy, though I can imagine some advantages in terms of avoiding harassment by unsecured creditors. On the other hand, ACAS pointed out that its unsecured creditors have no power to foreclose on ACAS portfolio assets. Also, a couple billion of ACAS debt is non-recourse debt backed by investment products and cannot result in action against ACAS for payment; only $2.3B form the debt backed by the breached net asset covenants.)

More later.

At present, (a) the interest coverage appears attractive, (b) the fire-sale opportunities are exciting, but (c) the fact that the debt covenants have been breached put ACAS into wild territory where the map no longer shows the roads. The IRS has made a temporary ruling that BDCs can satisfy their dividend-payment obligations in part (up to 90%) with stock dividends, which would enable ACAS if needed to preserve capital. Malon Wilkus stressed that ACAS' intention is not to scour the markets for distress entry opportunities, but to get out of trouble with creditors and thus to preserve capital. Moreover, he pointed out repeatedly that ACAS' employees are all shareholders and that management is strongly aligned with shareholders in having both significant holdings and large and deeply-underwater options rights that motivate them to restore share value to ACAS.

Malon Wilkus stated that ACAS remained committed to creating long-term value. This of course is good news, but leaves open the question whether ACAS has the financial strength to continue acting as a long-term investor able to avoid forced-sale situations.