American Capital Strategies: Management Credibility in Question 17 comments
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With American Capital Strategies' (ACAS) conference call out of the way, I will first give some key numbers and major developments, and then my take going forward:
Results
- $0.74 NOI per diluted share, $0.72 realized EPS, -$2.63 loss per share. The realized number includes $54M of taxes on retained capital gains while the loss number includes $698M of unrealized depreciation centered around ECAS market value, multiple compression in the private equity portfolio and continued market price declines in structured products. NAV per share stands at $24.43 per share with debt at $21.83 for debt/equity ratio of 0.9.
- Bad loans now make up 10.7% of all loans at face value. This number peaked at 15.2% during the last recession but the current situation dwarfs the previous period in terms of severity.
Key Developments
- ACAS will not pay its previously announced Q4 2008 dividend.
- The previously announced $500M rollover into 2009 has been reduced by $45M due to inability to exit investments. Additionally, ACAS siphoned off $155M as a deemed distribution, leaving $300M to be declared by June 2009.
- ACAS will now declare dividends on a quarterly basis after financial results are reviewed. Technically, this may make my post heading incorrect as the company must pay 90% of ordinary income under its current structure and its unclear to me how ACAS can simply stop paying a dividend as long as their assets are performing as CEO Wilkus has asserted all year, including yesterday. During the conference call, Wilkus made a distinction of Q4 2008 not being suspended but that the board will review the payout once the numbers are finalized in early 2009.
- The company announced an all-share takeover of its ECAS subsidiary, pending shareholder and regulatory approvals. Management estimates this will add $1.25 to NAV, helping to stabilize their leverage requirements.
I direct readers to the company press release for further details.
As I stated earlier, yesterday’s announcement is a big blow to management’s credibility, despite Wilkus’ assertions of prudence. My sense of the impetus behind these moves is that the company freaked out during the hellish week in mid-October, realizing that the leverage ratio had probably topped 1:1 with a portfolio filled with illiquid and/or deeply discounted assets. While markets have calmed somewhat since then, Wilkus and his team are now strongly focused on deleveraging.
Obviously, if the ship is sinking, then it is only prudent to take action to prevent that. Toward that end, management probably deserves a little slack as the market dislocations recently have been unprecedented. Credit markets were virtually shut down in mid-October. It used to be that market commentators used a VIX reading of 30+ as fearful and 40+ as a sign of impending washout but the VIX nearly hit 90 (!) in October and still sits at 60 today. For a company that is forced to mark-to-market many of its assets, this volatility can put a lot of pressure on the balance sheet.
My disappointment with management stems from a couple of sources: failure to either adequately plan or execute (it’s hard to tell which of these occurred) and failure to fully level with shareholders. ACAS entered the year with the base case of a recession, which would lead one to anticipate some decline in NAV. While I may be a bit harsh in expecting management to have seen this unprecedented market crisis coming, I discussed the possibility of this scenario back in July. I don’t have the decades of experience in this business like the company does so I’d expect them to plan out possibe scenarios better than I do. Or perhaps they didn’t execute well as their debt ratio was 0.7 back in July and now stands at 0.9. As management stated last quarter, “We’ve certainly put our self in a position where we can do that [deleverage] on a proactive basis as we see things develop rather than have a gun to our heads.” Well, this feels like a gun to the head to me.
Finally, management has been pushing its strong realized earnings performance + its capital gains rollover very hard all year. They were asked repeatedly about their leverage ratio and how they could manage it. Management gave the standard assurances with no hint of any worst-case scenarios (i.e. “While we don’t anticipate having to do so, if gun was at our head, we could take back the dividend”, etc). Now when management says that they’re not cherry-picking their private equity portfolio for exits, should we believe them now? How about their $700M+ in unrealized depreciation that they expect to flow back as cash?
Bottom line, it strikes me that retaining $155M of long-term capital gains and paying 35% tax is highly inefficient. Wouldn’t shareholders only have to pay 15% on that if it was paid out? Very expensive source of capital from a shareholder perspective (someone correct me if I’m wrong and I have a call into IR so I’ll post in the comments with an update if I’m wrong). The irony is that operations-wise, nothing has really changed with the underlying assets — NOI is still good, exits seem tighter than last quarter but still $520M in cashouts for Q3, over $700M of writedowns that they expect to bring back. The main difference is that shareholders aren’t going to get paid because management can’t adequately manage their accounting risk.
Final Note
I received a call back from IR and some clarifications:
- The $155M deemed distribution was in fact long-term capital gains and the company paid a 20% tax premium above LT cap gain tax rate in order to retain the capital.
- The remaining $300M rollover are not capital gains but ordinary income from TY 2008. By statute, these must be declared by June 2009 and paid by September 2009 or the company will be in violation of its RIC status.
- The company can’t really “suspend” its dividend but technically it is delaying payout for as long as possible to retain the cash on its balance sheet. So Q4 2008 (TY Q1 2009) taxable income will have to be paid out by September 2010 but the company has some flexibility on the timing of that payout. Failure to pay 90% of this income as dividends would force them to pay additional taxes on previous distributions. It would take a business-threatening circumstance for this to come to pass.
- At the same time, the $300M 2009 payout puts another liquidity pressure on the company in addition to its NAV mark-to-market leverage ratio issue.
Ouch.
My thesis was centered on management credibility and the dividend. Both are in serious doubt.
My first instinct is to sell, but after a 30% drop, there’s no rush now. Looking through the results, things don’t seem as dire as the headline would suggest but, like I said before, management credibility at this point is in question.
Disclosure: Author holds a long position in ACAS
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This article has 17 comments:
1. I assume all mark-to-market multiples and bond yield analysis are done with data as of 9/30/08. As we all know the S&P as of 11/10/08 has been down over 20% since 9/30/08 and the bond yield has certainly reflected extreme lack of confidence (which they mentioned the week of Oct 10 served as wake-up call). Does that mean the NAV of the company (although hard to measure) can be roughly assumed at ~$19.54, a 20% discount of $24.43?
2. With assumed $19.54 NAV and 208.1 million outstanding shares, this put their net asset value at $4,066M; this will violate their covenant (MIN $4,500M) should the market stay flat till 12/31/2008. With a solid portfolio and healthy capital, how likely can American Capital overcome this $434M gap, even assuming in Q408 they'll break even in NAV? Good chances in further amending credit facilities by paying down more debt with their enhanced cash base?
Thank you very much for your time in advance.
long ACAS and expecting a fireball finish to zero.
This cancellation of previously announced dividend means previous statements were misrepresentation.
Sold at $9.50 yesteray.
Great site and excellent analysis.
And the attorneys much more than that.
How much of the net income that ACAS intends to rollover into 2009 was generated in 2008? A BDC can postpone distribution of income for one year by paying a 4% excise tax. The 35% tax rate only applies to 2007 income that is carried forward into 2009.
Of course, management can eliminate the tax problem by dumping its worst non performing assets during the 4th Qtr and taking "realized depreciation" (i.e. actual tax losses) to offset the income earned during the first 3 quarters of 2008.
I'm not fond of ACAS' management, but its shares will probably not go to zero as long as its lenders don't pull their credit lines. Shareholders need to determine when ACAS' credit lines are up for renewal and whether ACAS is violating any convenants that would cause the lenders to revoke their credit lines.
PS. I hope Wilkus is also laying off people and eliminating executive bonuses to cut expenses
Although all hell broke lose in October, it shouldn't have been a total surprise that things could get worse. Yet they were confident - too confident in highsight - and the market punishes those who promise and deliver a negative surprise.
In a perfect world, they would have set the dividend at NOI and kept cap gains. And in a perfect world, they would have de-levered early with a slighly dilutive equity sale (like ARCC, like KCAP).
You can't fault them for the impossible to foresee, but you can fault them for failing to take actions other BDCs did.
At that price almost almost all the warrants would be exercised, bringing in a lot of cash. It would dilute existing shares, but not existing shareholders. The cash should of course be used to buy back debt or pay down debt.
It possible, the warrants should be tradeable so that those who don't want the extra shares could sell the warrants.
If the warrants were exercisable in time for the cash, or at least the receivable, to show up on the 12/31 financial statements that would be preferable to having it be later.
It's often diffiicult to force exits in the private equity business. Right now, nobody else has money to buy stuff, either.
further 20-30% and their ability to amend the credit facility should the
covenant is breached (I believe it's ~$1.3B with Wachovia). However,
there is one more concern I have and was raised in the conference
call:
Missing dividend payable- If I'm correct, a company incurs a liability
when the board declares a dividend; so even though the record date of
Q308 dividend is in October, I still expect to see a dividend payable
line in its balance sheet dated 9/30/08. In the conference call when
being asked, they replied that GAAP doesn't require it, but the
analyst can do their on calculation and trade the stock themsevles;
I'm a bit concerned/confused why they choose such response.
This, not the dividend cut, for me posts more concern to their credibility. I look forward to hearing different thoughts on this and
appreciate your time.
as for me, I have rarely seen a financial company's mgmt being that honest. straightforward, quick and shareholder oriented as Wilkus and his team. Sorry, but if you folks like to panic in the face of the stocks staggering collapse, feel free to do so, but don't blame management for your sudden change of perception.
Acas has its risks, no doubt but at current prices is an absolute steal. heck, you can even sell some atm or otm naked puts and get the stock essentially for about $3.
that they slashed the dividend, btw, is absolutely prudent-. and they didn't slash it because they didn't have the cash or the earnings - they absolutely have, but to preserve their capital and keep in compliance with their loan covenants. I would not be suprised to read an amendment these days that brings down the required NAV by a billion or a half. then all of a sudden people will realize that they simply panicked and the stock will explode back up towards $10-$12.
Today is Wednesday, December 17, and the stock is trading at about $3, a mere fraction of what I paid for it. I am stuck. Do you think ACAS is going to be bought out by someone, and if so, would that help stockholder's postions? I assume the answer to that is largely linked to might buy them. I am afraid that, like many of your commentors, we are not being told the truth about ACAS, and hence the little guy will be the last to know that they got took on the way down. The flip side to a buyout is bankruptcy. Any thougts on this happening? Us long, little guys would lose everything, should that happen. Thanks for any comments. Bob
Thats the question!