Re-examining My American Capital Strategies Position

As a value investor, I am used to buying stocks as they go down and averaging into a position. While I believe that markets are not totally efficient, they are fairly efficient and so when Mr. Market marks down 40% a position that I already believed to be heavily discounted, I do not subscribe to the “I’m a long-term value investor so everything’s okay” philosophy that you’ll find propagated all over the Internet. In those situations, I go back and review my research and look for any holes in my reasoning, any details I may have missed, etc. After the recent sell-off in American Capital Strategies (ACAS), I dug back into the company.

I called investor relations and besides the general “What the heck is going on??!!??”, I managed to get answers to the following questions:

• AmCap has a $500M share repurchase authorization. Do they have any restrictions, blackout periods, etc. and if so, what are they?
  • Yes, they have a share repo of which they spent $6M in Q1 2008 in the market on a few days when the share price dropped below book value. They do have some restrictions on the buyback but refuse to disclose these to the market.
• Are there any new accounting standards due to hit their balance sheet in Q2 2008 that may materially impair their NAV?
  • SFAS 157 hit in Q1 2008 but nothing similar is scheduled for Q2 2008.
• Is the company still standing by its guidance, especially regarding the dividend?
  • Yes, as of June 23rd, the company, via Malon Wilkus’ presentation at Wachovia’s Nantucket conference, reiterated the Q2 guidance of $0.68 - $0.75 NOI as well as the previous dividend guidance.

While part of my thesis was a big vote of confidence in CEO Wilkus’ track record, at this point, I felt compelled to dig further into the company’s portfolio. After all, I remember reading that part of Mohnish Pabrai’s investment in Delta Financial was based on the CEO’s long successful track record so caution is warranted. But to the company’s credit, they release a comprehensive listing of all their investments including cost and estimated fair value. Such transparency bolsters their credibility. Some notes on what I found:

• In a previous post, I reviewed an article that highlighted the company’s propensity to leave debt valuations marked up even as they marked down the equity investments of the same company. By my count, the company had $1.8B of fair value related to company investments where the equity had been impaired or wiped out but with debt valuations still marked near full value ($1.1B or 21% of fair value in “Non-Control” and $734M/18% classified as “Control/Affiliate”).
• AmCap noted 27 investments totaling $355.7M at cost as “non-accruing.” The company has cumulatively marked these investments down to 23% of cost ($80.1M), split about 50-50 between non-control & control. Most of these investments have been marked down considerably with the funny exception of ETG, whose fair value is marked up slightly above cost (though below principal).
• They also list $1B fair value ($1.2B cost) of non-income producing assets. This is less worrisome as many of these securities are common stock, warrants, etc. This category probably doesn’t tell us very much about the state of the company’s portfolio.
• AmCap have marked down their securitized portfolio (alphabet soup — CLO, CMBS, CDO, etc) by 62%. This was always a small-ish component of their overall portfolio and they only have $316M fair value exposed to further write-downs. As mentioned in a previous post, some of these assets are throwing off their projected cash flow, even as valuations are marked down.
• ECAS closed out Q1 around 6 GBP per share. While it’s lower now, ECAS closed Q2 up 3% with the pound basically flat so if they don’t change the control premium, I don’t expect to see a write-down in ECAS’ valuation.
• Subsequent to Q1, AmCap launched its mortgage REIT, American Capital Agency Corp (AGNC) which IPO’ed at $20 per share. AmCap purchased 5M shares for a 33% stake valued at $100M at the time of the IPO. By my numbers, AGNC ended Q2 lower 17% than its IPO price which would mean a mark-to-market write-down of $17M on ACAS’ balance sheet. I am not sure if AmCap will factor in a control premium with AGNC. Also keep in mind that AmCap will be collecting 1.25% management fees on a portfolio with roughly $300M in equity levered up 5-10X.

Here are a few other points to keep in mind:

• According to Bespoke Investment Group, ACAS is one of the most heavily naked-short-sold stocks as evidenced by their ranking on the “threshold securities list” (i.e. people shorting stocks but failing to deliver the shares they’ve already sold).
• During the last conference call, Wilkus and team mentioned that their divestment pipeline has visibility out about 6 months and the pipeline was still looking good even during the current crisis.
• Every quarter, Houlihan Lokey reviews 25% of AmCap’s investment portfolio. I am unsure if this review includes the non-control/non-affiliate investments (which comprise over half of investment assets) or is limited to only control situations.  I have asked the company for clarification and am still awaiting a response.

It is hard to judge the size of possible write-downs during the upcoming quarter.  The collaterized debt/mortgage securities are a fairly small component of total assets.  FAS 157 has already been implemented and there is no catalyst (other than the failure of companies to make debt payments) to force management to write positions down further. Management clearly feels that Q1’s $1B write-down does not accurately reflect the value of those investments as they expect 2/3rds of that to flow back onto the income statement. At 75% of book value, the market clearly disagrees.

My wild guess (emphasis on guess) is ACAS’ book value at ~$25 per share for Q2 2008. At Q1, ACAS had $23.80 debt per share, down from $25.47 at YE 2007. At current prices, ACAS is selling markedly below its book value and seems a good prospect for buybacks. But the combination of a falling share price and write-downs leading to higher debt-equity ratios (was at 0.7 at Q1 2008) may constrain AmCap’s flexibility to act on buying back shares as it will reduce capital. This is especially important as management has stated that they are running on a “steady-state” basis (no capital raises, no added debt, etc.)

I am reminded of a lesson from Marty Whitman’s seminal book, The Aggressive Conservative Investor. Sometimes, accounting reality is not the same as financial reality. Unfortunately, at this point, it is not clear to me what AmCap’s financial reality is. Additionally, as I mentioned in a previous post, my investment in ACAS is partially premised as a de facto hedge against my heavy weighting in bearish US$ investments. So while I’ve already legged into it several times as it dropped, I am uncomfortable with ACAS developing into too large a position. Long term, I still expect economic troubles in the US and these will provide a headwind for AmCap.

Also, the recent sharp drops in American Capital’s share price has raised a possibility that I had not considered in my original thesis.  If the current share price ($22) represents 1x book value, then AmCap would exceed its 1:1 debt/equity ratio as of last quarter’s numbers (though it is possible they may have reduced debt since then).  This could put them in a forced selling situation which negates one of the key safety points of our investment thesis.  I have asked the company how this scenario would play out, i.e. would they be forced sellers, is there a mandated timeline/schedule they would have to reduce the debt/equity ratio, etc.  Unfortunately, the company has yet to respond to my inquiry.

As such, I am holding until I see what management has to say during Q2 earnings. Judging from pricing, the market is expecting big write-downs and possibly a dividend cut. To me, a declining stock price, in and of itself, is no justification for a dividend cut. If the business is still performing (and CEO Wilkus has very forcefully reiterated this point for a few months now, if not longer), then a dividend cut will damage management’s credibility and undermine investor confidence in a stock with a heavy retail base.  I’d prefer management to buy back shares and pocket the 20% yield for the benefit of the shareholders. This would reduce total dividend payouts as well without reducing the yield but they may not have the resources to do so now.

The key question is how much capital and equity does American Capital have at this point?  The company reports Q2 results on Aug. 5th.

Disclosure: Long ACAS

Comments

[spartanz:]

The naked short selling here was obvious. It has damaged many retirees portfolios who bought this for the dividend, but still do not wish to see the base eroded. I have written the SEC and my congress people on the damaged caused. The SEC still has not provided the rationale that only 19 companies can not be naked short. MMMH? Goldman and Einhorn can short ACAS, but Goldman can not be shorted. Does not seem quite fair. SEC is protecting a few Wall Street firms and is forgetting about main street.
I have urged ACAS to address the SEC directly.

2008 Jul 24 08:48 AM

[you_can_cal...:]

The recent government action against short selling really was very distressing. It's already an illegal activity, and the government action demonstrates clearly that they believe it's a problem.

Why are they only willing to enforce the law for a handful of companies? Outrageous.

2008 Jul 24 09:44 AM

[shuddacudda:]

If ACAS must pay out 90% of statutory earnings (not GAAP) in order to remain a BDC, what makes you think management has the option of cutting the dividend? -- Unless you are predicting a drop in statutory earnings?

2008 Jul 24 10:11 AM

[Alan Young:]

Thanks, Dave, for doing the heavy lifting on this. I like the dividend but without detailed reports like yours I wouldn't have enough confidence to stay with it.

2008 Jul 24 11:03 AM

[shuddacudda:]

Two things you should know -- If you don't already.
1. Management has little discretion to cut dividends.
2. Income from which dividends must be paid can be very different from GAAP earnings since unrealized gains and losses (among other things) are excluded.

Background--

BDCs (Business Development Company) such as ACAS and ALD are also RICs. RICs (Regulated Investment Company) are eligible under Regulation M of the Internal Revenue Service to pass capital gains, dividends, and interest earned on fund investments directly to its shareholders to be taxed at the personal level. The process, designed to avoid double taxation, is called the conduit theory. To qualify as a regulated investment company, the fund must meet such requirements as 90% minimum distribution of interest and dividends received on investments less expenses and 90% distribution of capital gain net income. To avoid a 4% excise tax, however, a regulated investment company must pay out 98% of its net investment income and capital gains. Shareholders must pay taxes even if they reinvest their distributions.

“Taxable income generally differs from net income for financial reporting purposes due to temporary and permanent differences in the recognition of income and expenses, and generally excludes net unrealized appreciation or depreciation, as gains or losses generally are not included in taxable income until they are realized. In addition, gains realized for financial reporting purposes may differ from gains included in taxable income as a result of our election to recognize gains using installment sale treatment, which generally results in the deferment of gains for tax purposes until notes or other amounts, including amounts held in escrow, received as consideration from the sale of investments are collected in cash. Taxable income includes non-cash income, such as changes in accrued and reinvested interest and dividends, which includes contractual payment-in-kind interest, and the amortization of discounts and fees. Cash collections of income resulting from contractual payment-in-kind interest or the amortization of discounts and fees generally occur upon the repayment of the loans or debt securities that include such items. Non-cash taxable income is reduced by non-cash expenses, such as realized losses and depreciation and amortization expense.” From ALD 10-K.

2008 Jul 24 11:09 AM

[henarl:]

spartanz: Of course the government will protect Wall Street at the expense of Main Street. All of the decision makers, from Paulson and Donaldson on down, are old Wall Street insiders. Fairness has nothing to do with it.

2008 Jul 24 11:10 AM

[.*.:]

Excellent article.

A question for David Bui....why should the stock price have anything to do with the 50%/50% ratio of Debt:Equity. I realize debt can't be >50% of total capital. But this rule refers to the Debt and Equity that are on the books, not Debt and Equity market valuations, right?? The required ratio is based on the book equity and the book debt? Meaning stock price is irrelevant for this consideration....Thank... in advance.

Second, comment to shuddacudda....I think they have occasionally paid out >100% of earnings so they could still cut without dropping below 90% requirement. In fact, with the writedowns, they are running accounting losses, and could cut dividend for a while without breaching the 90%. I personally would not be put off by a dividend cut, but I realize most owners would.

2008 Jul 24 11:14 AM

[.*.:]

Excellent backup from shuddacudda.....I got it. Follow up....so the only way to cut dividends and stay in compliance would be to realize losses to reduce statutory income. I.e., sell some "dogs" to raise cash, and at the same time reduce income to reduce the dividend requirement. Thus the company could retrench a bit, reduce leverage and or buy back shares.

2008 Jul 24 11:21 AM

[najdorf:]

I was also confused by Davy's point about the share price, but I think what he's saying is that the current share price could be an accurate estimation of future write-downs to book value, and if these writedowns come to pass the company would be over their legally-mandated leverage standard. If the share price is just an indication of speculative shorting and the book value stays where it is they should be fine.

I appreciate the level of detail in this article compared to many others I've looked at lately. You actually read the report and provided good numbers with interpretation, when most people just make emotional reactions. My one objection is to:

"FAS 157 has already been implemented and there is no catalyst (other than the failure of companies to make debt payments) to force management to write positions down further."

This is true as far as it goes, but it doesn't go very far. The failure of companies to make debt payments has always been and will always be the #1 risk of a company like ACAS. The investability and profitability of the company depends almost entirely on their ability to manage this risk. If you're trying to develop a rationale to hold the company, you should spend 90% of your energy here rather than 1%. The accounting stuff and short-term fluctuations don't matter all that much as long as companies keep making the payments. The writedowns are in large part an attempt to assess the default risk - are they accurate? It's hard to say because we're talking about high-yield investments in small, illiquid, private companies. It's probably even harder to predict than the mortgage market, since no individual mortgageholder has a big impact on a bank's finances, but a few of their larger positions could significantly hurt ACAS by defaulting.

Also, on the share repurchase issue, you won't see this company buy back shares unless the price is below book value, because they are a capital-gatherer, not a capital-returner. Look at the increase in shares over the years. They have to pay out earnings rather than reinvest them, so in order to grow (and raise management's compensation) they need to sell new shares, like a mutual fund. However, this practice is only really valuable to the company if they can trick someone into paying over book value for the shares (since selling new shares at .9 book value is a lot like writing down assets). In the past they were able to get investors at a premium price based on the yield before any credit losses manifested - good luck to them in this market. If the share price goes too low they may be able to help out existing investors by buying back shares below their value, but woe to all concerned if this buyback is followed by writedowns and dilutive capital-raising.

2008 Jul 24 01:02 PM

[Davy Bui:]

Thanks for the constructive comments guys.

Asterisk .*. -- I never said that share price had anything to do with debt/equity ratios. My point was that the market is pricing ACAS well below book, implying the book number is coming down. Either the market is wrong or we (longs) are wrong. If the market is right and book value is closer to current share price, then according to last quarter's debt numbers, AmCap's debt/equity would be at or above 1 and I'm not sure what happens at that point.

shudda, Thanks for the additional background. First, to be clear, I did not say that I expect the management to cut their dividend, only that, at near 20% yield, the market is possibly pricing one in. I think that is a reasonable statement.

My feeling is that management has a little more discretion re: the dividend than you give them credit for. For instance, they've already "de facto reduced" the dividend when they announced their new dividend policy of rolling over and paying long-term capital gains in the dividend (less 4% excise tax) rather than retaining the capital gains, paying a 35% tax and treating gains as deemed distributions. I call this a reduction because previously, they were able to grow the dividend without paying out these long-term cap gains so it suggests a weakness in growing their NOI. But if they needed cash, it seems to me that they could reinstate the deemed distribution policy but maybe I'm missing something. I am definitely not an expert in BDC/RIC regulations as evidenced by my questions regarding what happens if ACAS exceed 1:1 debt/equity. By my spreadsheet, AmCap hasn't paid over 90% of net realized earnings since 2004. I realize that isn't necessarily net taxable income but I don't have those numbers. If you have more insight into this aspect of the business, please share.

2008 Jul 24 01:14 PM

[treerollins:]

A lot of questions here and a good debate. Guess there are some things we just don't know for sure and probably won't until after the fact. My compliments to all, however, on an intelligent analysis and productive give and take seeing as how most of the commentary you find on the web about any company is nothing more than pump and dump specualtion. Been reading Einhorn's book and haven't come across anything yet which could be pinned to ACAS unless there is outright fraud going on which is what he indirectly alleges with ALD. Ultimately, it seems to me that it's more a question of how well the investment team has managed risk as far as making bad loans that may not pay off as this is the most dilutive situation of all. It is, in essence, the equivalent of flushing money down the toilet which is exactly where I stand at present on my ACAS investment.

2008 Jul 24 01:39 PM

[Davy Bui:]

najdorf -- I pretty much agree with you on all points.

Hopefully, I won't ever try to develop a rationale to hold a company but rather, let the "facts on the ground" guide me to a good decision. Easier said than done but that's my goal.

I didn't spend much time trying to forecast how their companies are going to perform because, as you pointed out, it is a fruitless exercise. Non-performing loans stands at 8.2% of cost and as I've said before, I expect this number to go up. How high, who knows? Subjectively, I'm hoping it doesn't go past last downturn's 15%. I have spent more time going into management's ability & track record in managing these risks in previous posts:

enlightened-american.c.../

Re: share buybacks -- again, I agree. AmCap raised equity in March 2008, during the credit crisis, at a premium to book and are now in "steady-state mode." Book value at Q1 2008 was $28.16 and today they're selling under $23. Last week, they were around $15-16 per share. Hopefully, they bought back some shares or investors may have some unpleasant surprises in store.

2008 Jul 24 01:40 PM

[treerollins:]

najdorf...not sure I completely follow your train of thought regarding dilutive capital raising. Given the nature of BDCs the only way to grow NAV/book value is to raise capital in the market by selling additional shares as earnings need to be payed out in dividends. Assuming that this capital is invested wisely and that these investments/loans pay off then it is essentially a wash since there is an equivalent increase in earnings to offset the higher (total) dividend payouts. Furthermore, this is, in theory, beneficial to existing shareholders as it would increase the book value and, in turn, the market price value of ACAS shares actually giving shareholders a little in capital gains potential. The potential for dilution only occurs when capital is raised, total shares are increased and loans/investments fail to pay off. Potentially, this is where we are at. Granted, I think we all agree that specualting on where non-performing loan numbers are going is a fruitless exercise, but assuming these numbers increase significantly, then we as shareholders are left with a situation where management needs to pay a larger dividend (in terms of total cost) as share count goes up, but earnings either fall or flatten and what the market is pricing in at this point is not encouraging although here again, we can't know how much this has been exacerbated by the naked shorting. I would like to believe that we'll be okay even if 20% of loans go bust as that would still leave us with a book somewhere around 21-22 and as long as the dividend is covered out through 2009, but it may be wishful thinking on my part.

2008 Jul 24 03:17 PM

[David Allen:]

We sold our common shares of ACAS several weeks ago. Once I am past the 31 day IRS period, I will be looking to possibly establishing a long position again. However, the return on the price is "too good to be true." And if it's "too good to be true" well, it usually is.

Management has stated it's intention of paying $4 in dividends during CY 2008. No mention has been made of changing the dividend, or even continuing it in 2009. If I thought that the dividend would NOT change, I would hold onto ACAS. However, I have found other good dividend payers that are INCREASING in value, and may give me a better return. Not only that, ACAS provides me a dandy tax write-off.

2008 Jul 24 05:49 PM

[Some1KnowsS...:]

Great discussion and kudos to DB for the research. Even though the company isn't suggesting any cause for concern and there are no obvious valuation concerns (eg, ACAS doesnt have mortgage exposure), the shorts know something--or think they do. Aug 6 should be interesting. I've been legging in on the downdraft.

2008 Jul 24 07:46 PM

[NoBoB:]

Pretty good article overall. It's obvious you put some effort into it, as opposed to some of the drivel that gets posted here. I'm going to take exception with one point though.

I'm not sure the buyback does them any good. Reducing the share count does not absolve them of their 90% payout requirement. Since they already anticipate rolling $500MM of 2008 earnings into 2009 -- and they just reiterated that a month ago -- all that buyback does is push more cash into the rollover pile. It doesn't reduce the dividend payout as you suggest, it just alters the timing. They still have to pay out the same amount, albeit to a smaller shareholder base (in theory, good for me, eventually).

At best, it buys time, but at the expense of their debt:equity ratio. I'd rather they keep the liquidity.

2008 Jul 24 08:06 PM

[jjason:]

Thanks for the article Davy....and thanks to all the commentators too.

I am long ACAS. I track ALD,ACAS,MCGC, AINV,etc. and all are down. On my yahoo screen for banks, well you probably know how the bank stocks are doing. I did some research on July 24 on CNBC's website. Here is some data:

Stock last mo. YTD 12 mos ( D is for down, #'s are % )

ALD D 12.9 D35.7 D53.4
ACAS D 22.2 D36.0 D51.6
CNS D18.4 D18.4 D38.5
GLAD D13.6 D12.5 D29.9
MCGC D5.7 D65.5 D74.8
PSEC D13.3 D3.4 D30.6

I do not know much about CNS, GLAD or PSEC. I do own MCGC.

I figure that I will just wait it out on ACAS. There is a lot of naked short selling in ACAS and this has an affect the share price. Shorts scare people. I do not believe that short sellers know more about ACAS then we shareholders do.

But short sellers and naked short sellers do effect the share price because the average investor follows trends, talking heads and momentum strategies.

I have confidence in Malon Wilkes and his people. I think things will get better in the next two years.

2008 Jul 25 09:43 AM

[shuddacudda:]

I think the notion that generating capital gains which pay part of the dividend is a sign of "weakness" is flawed. Many investment organizations generate both operating income and capital gains. Those who prefer only "operating earnings" should invest in government bond and hold them to maturity.

The ability to build a portfolio from which gains can be harvested is laudable. As a BDC matures, it is natural that some of their earlier investments will begin to payoff.

Also, write-downs are not the same thing as write-offs.

2008 Jul 25 03:39 PM

[swissfinanc...:]

Very interesting debate and information. This is still however difficult to find where the "truth" lies between "confidence in ACAS management track record" and th "too good to be true" numbers of the stock price and dividend.

2008 Jul 29 11:10 AM

[Dabqs:]

Najdorf wrote in his 7-24-08 commentary the following to which I would like to add some thoughts--

"The writedowns are in large part an attempt to assess the default risk - are they accurate? It's hard to say because we're talking about high-yield investments in small, illiquid, private companies. It's probably even harder to predict than the mortgage market, since no individual mortgageholder has a big impact on a bank's finances, but a few of their larger positions could significantly hurt ACAS by defaulting."

Two things of note here--

First, as you know, FASB 157 now requires mark to market accounting adjustments be made, yet, as you mention, ACAS holds largely illiquid private equity positions for which active quotes are largely not available. Importantly, we are seeing writedowns in many financial companies which reflect lower than true valuations due to the credit crunch we are currently in. In a credit crunch, due to lack of liquidity, valuations are often beneath true valuation levels not due to a lack of creditworthiness on the part of the borrower, but due to a lack of liquidity in the trading of those credits. Historically, as credit crunches have resolved themselves, liquidity has returned and credits have traded more in line with the actual creditworthiness of the borrower. Also, important to think about is that AmCap has a history of holding its investments to maturity. So FASB 157 forces AmCap to take writedowns as if they were to seek a buyer for their loans in today's credit crunch effected market, which is not their historical operating manner, and which brings up the likelihood that in future quarters, as the credit crunch subsides, we will see a reversal of these Q1 writedowns. As such, these writedowns are largely of a temporary nature, and investors should focus their attention on net operating income, as this will determine future dividend payments and dividend increases.

Finally, I would also ask that you visit the company's website and take a look at the wide diversification in the portfolio of positions held by ACAS. Not only are the investments widely diversified (small positions by percent and diversified across industry sectors, thus, there is no single large position which could meaningfully tip the boat), and of further importance is that the company has specifically targeted investments in non-cyclical companies, which should considerably help them weather this current economic slowdown/recession.

Last thing to mention--

Great work by Davy Bui! Thanks for the legwork, and thoughtful commentary by all message board posters as well!

Dabqs

2008 Jul 30 02:20 PM

[thoreauvian...:]

With the negativity of market sentiment providing a comfortable environment, naked short sellers of ACAS et. al. have been lulled into a false sense of security that has incited "irrational exuberance" on their part. When that sentiment turns (and sooner or later, for some reason or another, it will) there will be savage repercussions. Naked short sellers of ACAS may be king for now but I say "The Emperor has no clothes."

2008 Aug 01 07:33 PM

[wheretoinvest:]

Davy -- What are your feelings since the Q2 conference call? It seems that NAV is substantially higher that the current share price and guidance on dividends has been reiterated.

2008 Aug 26 11:46 AM