UPDATED: American Capital (ACAS) Suspends Dividend
With the conference call is out of the way, first some key numbers, 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 today. 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, this morning’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: Received callback 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.
More thoughts after the conference call.
November 10th, 2008 at 9:00 pm
I don’t think the tax inefficiency is as bad as you suggest. Remember, shareholders get a $0.25/sh tax credit as a result of the deemed dividend, so if the shareholder’s tax rate is better, it’ll clear when the shareholder files the next tax return. The capital gains tax overpayment is, in essence, a dividend that is paid by the government when you file your taxes. (This is better, by the way, than the tax inefficiency of the company Buffett runs, which pays corporate rate on all earnings whether it distributes or not, which leads Buffett not to distribute lest it be taxed twice.)
I posted a while back that in ACAS’ shoes in a panic environment, I’d pay the smallest dividend I could, using any available accounting gimmick, and plow the earnings into the business. This is what ACAS is now doing, albeit under the pressure of debt covenants’ net asset requirements rather than the zeal for good deals. ACAS’ continued deleveraging will help protect the company from panics, and I’m happy to hear management takes a crummy view of the future and is keeping open options like adopting a different tax status as needed to protect shareholder value.
Re-reading your paragraph on VIX … given the history of the company and the history of VIX, do you think management should have modeled for VIX of 90? I’m interested in how NOI is holding up — and that’s apparently good. So long as management can avoid meltdown in a liquidity panic, I think the long-term case is good for the diverse portfolio. Yes, I’d rather have bought it today below $8 than last year over $40, but we can’t rewind the clock.
I don’t expect a dividend (except the late-2009 distribution of 2008′s $1.37/sh required to maintain tax status, if ACAS does maintain tax status) until ACAS has pushed up its cushion over its debt covenant limit. After the 2009 distribution, the next mandatory distribution will be Sept. of 2010. Until further notice, ACAS is a value play (if at all; but look at NAV >$24 and share price $0.70/q. The fact ACAS got slammed with bond-yield-analysis and multiples compression in its FAS-157 valuations when the market collapsed doesn’t tell us anything bad about management; it tells us something frightening about the market in which management operates.
Going from 0.7:1 to 0.9:1 in the course of a collapse like September is frankly a lot better some people’s financial holdings did, and better than I’d have expected a company full of illiquid assets to do. I’m actually impressed they pulled off this quarter without an ugly emergency with most of the liquidity tricks gone (the forward sale agreements, the share-issuance-above-NAV trick, the ability to use credit — all gone gone gone). The fact that the asset valuation covenant has put the kibosh on the ever-growing dividend is certainly a downer, but paying that dividend in cash (rather than issuing new shares, which is what ACAS did under the DRIP while shares were above NAV) results in the company eating the seed corn, paying out the cap gains; unless you can bank on share price above NAV, the only way to play this and be able to raise dividends is to reinvest cap gains, so the corpus grows. The current dividend policy is sustainable in a bad environment, and the old one was sustainable only during share-price-above-NAV, which we’ll likely not see until financials are loved again some time down the road. The downside is that the current policy may result in one annual dividend paid nine months after close of each year, until the economic environment improves. The upside is that this capital is cheaper to the company than borrowing, and may allow some tax deferral for everybody while we get investment off the earnings.
Take care,
–J
November 11th, 2008 at 7:26 am
I cannot tell you enough what an excellent service you have performed in your discovery of what’s behind ACAS’s current numbers and for explaining these current events in explicable vernacular; I have been, and I suspect others too have been, looking for some kind of transparent relation of these events and seeking a contextual framework by which to measure the fate of my long position in ACAS and you have done this. Since the press release of their results and future plans, I have been grim-faced and gulping air like a fish out-of-water.
I wasn’t sure if it was just me not understanding their business risks (and me taking on the risk that they have laid out there like fish bait) or if it was that they were hooked on fiscal malfeasance like some other financial epicenters are…I just did not know. Of course I realize I’m taking on their risk but from all the research I did — including your July piece — they appeared to be one of the strongest operations in the sub-sector. You have dug behind the numbers and I appreciate your efforts and your constructive summary. You said in words what I had only been wishfully thinking was the case for their current decision-making. Understanding this, I still might have bitten off more risk than I can chew.
November 11th, 2008 at 10:25 am
Ricardo,
Thanks for the compliment — sorry I couldn’t help you avoid this flameout but if it helps, I definitely eat my own cooking (yesterday was a bad day in this household!).
I also highly recommend checking out Jaded Consumer’s site for more insight into ACAS
http://jadedconsumer.blogspot.com/search/label/Ticker%3AACAS
Jaded,
Of course you are right on the cap gains tax credit but I was being selfish on my view of it as my exposure was via short a put and the credit is available to shareholders on record 09/30/2008.
I don’t know if anyone should have modeled the VIX @ 90 but if I was worried about the company’s leverage ratio back in July, then I would expect mgmt to either be more worried than I was or to prevent today’s situation from occuring (thus not needing to worry about it). Should management have considered the possibility of a drastic drop in NAV? YES — THE MARKET DID WHEN THEY MARKED THEM DOWN TO $10 earlier in the summer. Instead, in Q3, they made >$400M in new investments and paid another dividend in October (that’s a quick $600M out the door).
The September period was bad but October was much worse. Interesting to note how they wouldn’t really provide any current status on NAV, whining about how hard it is to make these valuations, etc. After Oct and with the Dow fast approaching previous lows, we’re probably brushing up against that NAV limit. Maybe the credit markets thawing a little is a help.
I’ve been mulling over ACAS and its chances going forward. It’s selling at $7 and guaranteed to pay ~$1.37 in dividends by Sept 2009 or else it’s probably going close to zero. So what are the odds of one or the other? I’d feel better if I could handicap the odds.
The biggest danger lurks in the “known unknowns” of market volatility and the resultant mark-to-market issues with NAV. Increased loan defaults and lower realizations are baked into the cake but I don’t think that poses the risk that the previous one does.
I haven’t gauged any increase in the relaxation of mark-to-market accounting requirements but that’s a possiblity and would relieve a lot of pressure on ACAS.
Care to put odds on the likelihood of forced selling or worse?
November 11th, 2008 at 2:31 pm
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