Description

We are recommending a short position in ACAS despite it being recently posted as a long on this site.  Based on our calculations, the equity is likely worthless but may survive as a sub $1 issue (essentially a low value option) as the management team does anything they can to maintain control of the entity.  Our thesis is primarily based upon our findings that the quality of the P&L is extremely low, there exists minimal core recurring cash flow and the balance sheet is in much worse shape than the market seems to appreciate (on both the asset and liability side).  With no cash dividends in sight, an extremely unfriendly shareholder management team, a relatively unattractive asset portfolio and a choking and expensive debt burden with aggressive amortization commitments, the company's current $800 million market cap seems completely unjustified.

Although management has very little incentive to undertake any drastic (and risky) changes that might be required to improve the stock price (since they actually own only a very small number of shares), they are incentivized to try to maintain their positions within the company.  It is our belief that they will do whatever it takes to delever the capital structure to avoid an all-out liquidation so that they can continue their attempts to grow and realize their empire building goals.  Based on the work that we have done and the conversations we have had, we believe that management is likely going to issue stock as often and in any form that they can (stock dividends, equity raises to make amortization payments, etc.).  Given that the intrinsic value of these shares is at or near zero, any such share issuance will actually be accretive to the company as a whole despite the fact that it will be extremely dilutive to existing shareholders (and makes no sense as a de novo investment for new investors).  We also believe that ACAS will ultimately conduct a debt for equity swap, after which they will perform a massive reverse stock split and try to put this nightmare period behind them (obviously leaving all current shareholders out in the cold).  Management will retain their jobs and the generous compensation packages that go with them, the debt holders will own the Company and the current equity holders will be completely wiped out.

P&L Issues

At first glance, the income statement actually looks pretty strong.  Our estimate is that run rate operating income before overhead is approximately $530 million per year (see table below).  However, several significant adjustments are required for a meaningful analysis.  First, you need to back out PIK (non-cash, "paid-in-kind") interest and dividends of approximately $125 million per year.  At best, the company should not be accruing any new PIK income given the underlying health of its portfolio companies in the current economic environment and at worst, much of the PIK income they have recently accrued should be reversed (as was done in the second quarter of this year).  Second, you need to back out approximately $150 million of net interest income from the securitizations since all five securitizations are trapping cash and the interest income currently being recognized on the income statement is once again non-cash.  Next, you need to back out about $85 million of cash dividends earned on the company's structured products portfolio.  These securities are said to have a fair market value of approximately $200 million, which implies that the market does not believe that the $85 million will actually be paid for more than about another 2.4 years (we'll give them credit for this when we look at the balance sheet).  Either way, it's not an annuity by any stretch of the imagination (at least anywhere near the current level).  Then, you have to deduct $220 million for cash SG&A (which is simply a ridiculously high number).  Next, you need to subtract approximately $160 million per year (management's estimate) for current portfolio commitments (revolver commitments, finance growth opportunities, liquidity lifelines to stave off potential bankruptcies, etc).  Finally, you have to add back PIK collections, which are currently occurring at about a $50 million run rate, implying an annual run rate cash flow for the company of negative $160 million.  Cleary, this is not a free cash flow yield story.  Now, let's look at the balance sheet.

Balance Sheet Issues

On the asset side of the balance sheet, a few industry executives have made comments to us indicating that ACAS has a reputation for having overpaid in most of their deals (and in some cases apparently by extreme amounts).  With their control subordinated debt and preferred equity portfolios currently marked at 91% and 74% of cost, respectively, one can't help but question the integrity of those valuations.  These figures become even more suspect when you consider that ACAS has valued their non-control subordinated debt and preferred equity portfolios at 80% and 58% of cost, respectively.  Perhaps they have a harder time justifying aggressive marks when third parties are involved?

We also know that approximately 61% of the company's senior and subordinated debt portfolio is currently pledged as collateral to their securitizations and we have heard that current debt investors are upset because ACAS has been replacing poorly performing collateral with higher quality collateral to try and avoid covenant violations in these securitization facilities.  The total amount of assets not currently pledged and therefore remaining to eventually repay its debt obligations is approximately $3.4 billion.  This appears to be comprised of $1.6 billion of lower quality senior and subordinated debt securities (the value of which we question as mentioned above), $1.4 billion of preferred stock and equity in relatively small private companies and $460 million of various other non-core assets (ECAS; AGNC; American Capital, LLC; structured products, etc).  Considering the fact that the company has already been liquidating assets for nearly a full year now and has sold most of the higher quality companies, we find it difficult to believe that they will be able to liquidate this $3.4 billion in assets for much more than the required obligation they currently have to amortize a minimum of $2 billion of debt by 2013.

Turning to the liabilities for a moment, all of the revolving periods on the $2 billion of securitizations have already ended and all of these facilities are currently trapping cash, so they are essentially in liquidation mode.  Any asset currently pledged to the trust that is sold will get trapped inside the securitization until it is fully paid down.  Furthermore, the recently announced debt restructuring for the remaining $2 billion of obligations is extremely punitive.  It has a very aggressive amortization schedule and the interest rates start out at more than 10% (and drop as they delever).  It is also the case that all of the remaining unsecured assets on the balance sheet have now been pledged as collateral.  At this point, with no assets left to pledge, there is very little chance ACAS will be able to raise any new capital other than potentially tapping the equity markets.

Conclusion

The bottom line is that ACAS's shares appear to be essentially worthless.  They have $5.9 billion of assets that likely cannot be sold for much more than $4 billion considering the company's current distressed situation.  Unfortunately, they also have $4 billion of debt that needs to be paid back on an aggressive schedule and the core business generates no free cash flow, so they don't really have the time (and it appears that it wouldn't much matter even if they did).  The only reason this may survive an all-out liquidation is because management will continue to issue equity in any form they can as long as the market will bear it and ultimately they will most likely end up conducting a debt for equity swap.  Either way, with no cash dividends in sight, an extremely unfriendly shareholder management team, a relatively unattractive asset portfolio and a choking and expensive debt burden with aggressive amortization commitments, the company's current $800 million market cap seems completely unjustified.

Catalyst