Description

American Capital Strategies (ACAS) is under a ‘short attack’ nearly parallel to the short thesis I contradicted against Allied Capital (ALD) in late May. The outcome is likely to be similiar with longs and traders again having an excellent buying opportunity presented.

To review, I recommended buying ALD on weakness, and since my presentation there have been several opportunities to acquire it for $20 or less (11.2% yield). It closed Tuesday at $21.90, after a 6% downward move in sympathy with ACAS. That price represents a 9.5% gain. Before the Tuesday article that prompted ACAS’ precipitous drop, ALD was at $23.30 for a 16.5% gain and a dividend yield of 9.6%. That is a fair measure of how the market was settling on the ALD short case, and the profits longs could make in a small time frame.

The case against ACAS is well written, but as with ALD, rests on drawing global conclusions on a few and contradictory specifics, with a healthy dose of innuendo. Issued Tuesday, the article by Dr. Mark Haefele appeared on Real Money Pro at TheStreet.com.

Haefele sets the tone of his piece in the second paragraph noting David Einhorn’s “unanswered” charges against Allied Capital. Given the very active defense launched by Allied, this incorrect statement can give one pause to the factual accuracy of the remainder of Haefele’s issues with ACAS.

The first charge is that ACAS cannot pay the dividend with out raising cash through stock sales. That is easily refuted. BDCs like ACAS are REQUIRED to pay out at least 90% of their taxable income as dividends or pay tax at the corporate level. Tax law does not make the distinction between cash interest and dividends and non cash “payment in kind” (PIK) interest or OID accruals. So the dividend is determined by law on net taxable income that consists of the cash and non cash interest and dividends, less operating expenses plus REALIZED gains and/or losses. Unrealized gains or losses relate to GAAP earnings, but not the taxable income that drives the dividend.

ACAS has a relatively young portfolio not yet throwing off steady realized gains. Thus dividends must be largely supported out of net operating income (net before realized gains or losses). This matches well with the dividend.

___ 1999 2000 2001 2002(1/2 yr)
NOI 1.79 2.00 2.27 1.27
DIV 1.74 2.17 2.30 1.22

Another verification of distributions close to balancing with NOI (and the relatively small net realized gains to date) comes from the the balance sheet for 6/30/02: in shareholders’ equity, the line item “Distributions in excess of net realized earnings’ is -$3.342MM. If ACAS was using large amounts of stock sale proceeds to fund distributions of around $200MM from 1999 to date, this number would be quite large.

The nuance here of course is the cash principal repayments from the portfolio are fungible for the accrual of OID, PIK, and interest receivables. Haefele would argue they ‘drawdown’ the portfolio. But PIK at the very least is effectively an internal reinvestment and compounds. OID may be truly a back end collection, but it is additive to portfolio value, and interest receivables while growing, are more of a revolving situation. ACAS does not accrue interest if it does not expect to collect it. Thus the charge that ACAS cannot cover the dividend is not correct.

Haefele than tries to muddy the picture by mixing noncash writedowns of the portfolio valuation (and thus a decline in NAV) with the ability to fund the dividend. (Comparing GAAP earnings to the dividend) The irony here is that ALD was damned for NOT sufficiently writing down the portfolio. Now ACAS is damned for doing just that. If Haefele was saying there is no long term indication yet that ACAS can assemble a successful portfolio for realizing extensive gains, I’d agree. ACAS’ portfolio is largely under 3 years of age. A recent article mentioned Calpers desire to look at cash returns on Limited Partnerships in private equity at the 6-10 year frame as a relative measure of performance. We’re not near that window in time yet, so Haefele’s guess on ACAS’ true capabilities is as good as mine. Given that ACAS largely funds manufacturers, and we are in the early stages of recovery from a recession, one would expect writedowns of value in the last year or so. Until we see the performance in the full recovery phase of the economy, I don’t see any aberration in ACAS’ portfolio valuation or NAV. In any event, the net unrealized depreciation on the balance sheet at 6/30/02 is -$60MM. Not too bad a net decline on a $1.1B portfolio.

Haefele’s next charge is the apparent avoidance of loss in the bankruptcies of Biddeford and DSI. ACAS structures its deals very carefully to provide some protection. In fact strategically, bankruptcy can be an option. In the case of Biddeford, ACAS went from a note and warrant holder secured by real estate (most likely not more than 100% loan to value), to owner of the real estate with a guaranteed 5 year lease substantially exceeding the old interest payments. Not a bad outcome. At DSI, Haefele mentions that ACAS bought just one of the two DSI facilities. He neglects to mention it is the new state of the art facility retained, and the old money loser left behind. He also fails to mention ACAS reduced senior debt ahead of them by 19MM, and cut other obligations in the the bankruptcy. 100% ownership of a near new facility, with reduced senior debt ahead of ACAS vs 43% ownership of old and new plus a more junior position and a greater burden for the operation. Looks like a pretty good strategic move. Haefele than comes up with the accusation that these 100% owned companies are carried as assets, while their internal debt is not consolidated to ACAS’ balance sheet. BDC regulations do NOT allow consolidation. There is nothing underhanded here. This is how BDCs are required to operate and account. Over time, the debt is paid down, the equity builds and there will be an exit event with a presumed capital gain.

Haefele’s next concern revolves around Capital.com, a finance portal created by ACAS. First Union paid $15MM for a 15% interest in Capital.com in late 1999, at the height of the internet frenzy. ACAS valued its 85% stake at 72.5MM (over an initial internal 1.5MM investment). As the internet bubble collapsed, ACAS promptly wrote capital.com back down to 1.5MM by late 2000. Today it is on the books at 700K. Haefele faults FU for being a friendly outsider...serving as an investment banker at times, creating a ‘false’ high value. But put this fully in the context of the times. Everyone wanted an opening on the internet. These were legitimate values and ACAS took the hits as well as the gains in a timely fashion. Again the contradiction is ironic. Biddeford and DSI are ‘wrong’ for NOT being written down, and Capital.com is ‘wrong’ for HAVING been written up to market, and then back down.

From here the innuendo level rises. Haefele briefly mentions O2, which was IPO’d for a very nice gain at $12/share. The IPO went out the door just ahead of the rapid collapse of telecom suppliers. Haefele notes ACAS’ remaining holding is now worth 20 cents/share. He fails to mention ACAS sold what legally it could at the IPO but was ‘locked up’ on the remainder as the roof fell in on telecom. He then equates Biddeford and DSI with Enron’s Raptor and Capital.com with Enron’s Braveheart. Quite simply, this is inflammatory at best, and slanderous at worst. But for a propaganda effort in support of Haefele’s EXISTING short position it is a nice touch. He concludes with the admonition that BDCs are ‘under fire from some of the smartest professionals on the street’. The quick response is no one is infallible.

So where do we stand? ACAS closed at $21.00, off $4.40 and near its 52 week low of $20.30 (an intraday gyration in sympathy with ALD earlier). It’s dividend is annuallized at $2.64 for a 12.57% yield. If one uses the ‘unperturbed’ ALD yield from Monday’s close of 9.6% after digesting a similar short attack, this implies ACAS will recover to $27.50 in the months ahead. That represents a 31% gain from Tuesday’s close plus whatever quarterly dividends you collect. The short thesis on ACAS, as with ALD, has been skillfully proclaimed, but close inspection shows it as not the slam dunk it purports to be. Buy on weakness.

Catalyst

As with ALD, the short case assumes the retail base will be stampeded in to unloading. As I asserted with ALD, that will not happen. ACAS will gradually recover from the intial assault. Expect volatility near term, but with a steady ramp up in price, particularly ahead of ex dividend date(s). Ultimately, a short squeeze is possible as well, as the short position undoubtedly hit record levels Tuesday.

For a complete analysis of ACAS please see the writeup on the company by Jim77 from a couple years ago. Some of the ideas in this summary were derived from exchanges with other shareholders.