ACAS: Re-examining My 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 propogated 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 (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 totalling $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 writedown 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 writedown 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 writedowns 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 writedown 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 writedowns 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 writedowns 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.

More on this topic (What's this?)
ACAS is a Bargain Worth Buying
American Capital Strategies (ACAS) Dividend Analysis
ACAS Dividend News
Read more on American Capital Strategies at Wikinvest

5 Responses to “ACAS: Re-examining My Position”

  1. jasonc Says:

    great post – after about 5 or 6 years of holding acas, i finally closed out my position a few weeks ago. I had read Einhorn’s book, and though ACAS seemed to me like a totally different kind of company, especially because Malon has most of his own money in the company, I found it difficult to remain in the stock. One big concern that I had was the impact of the credit environment.

    That said, the nearly 20% div yield makes it a tempting buy now, and assuming reasonably decent results on 8/5, I could see getting back in.

    Also, I’ve enjoyed reading your posts over the last few months. Thanks for writing!.

  2. Davy Bui Says:

    jason,

    Thanks for the compliment.

    I understand how you feel. If I think about it too long, I get a little queasy holding ACAS these days!

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