Allied Capital Corp.
ALD Earnings

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By First2Fight
July 30, 2003

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Allied Capital Announces Second Quarter 2003 Financial Results

A few things that jump out;

Net investment income per share was $0.39 vs. $0.41 a year ago. Notice that income per share was down even though net investment income was up. That is due to the dilution of increased shares. So the company is investing money at a much lower return. I suspect this is due to the fact that ALD has made many recent investments and has yet to realize any return on them. One quarter or even two like this are of little concern, but one needs to keep an eye on this trend.

Net realized gains per share were $.07 vs. -$.01 a year ago. Add $.07 + $.39 you get $0.46. ALD had $.46 of income and will pay out $0.52 in dividends. [Edited Later] Where does the other $.06 come from? Total net income for the quarter was $0.52 per share, after changes in net unrealized appreciation or depreciation of $6.8 million or $0.06 per share.

So, we get the following:

a) Of the $0.57 dividend, 75% was covered by cash from recurring investment income.
b) Of the $0.57 dividend, 13% was covered by cash from realized gains.

The other 12% was not covered by any form of cash.

This is an important point � the main argument of the short sellers, IIRC, was that the dividend could not be supported by cash alone, but only be issuing more equity or taking on additional debt. In addition, there is a concern that more and more of the dividend is being covered by capital gains vice investment income.

1) ALD paid out more cash than it generated
2) ALD raised money through debt and equity offerings that covered the payout, but simultaneously reduced ROE and diluted overall earnings
3) ALD's investment income, the part stable and predictable part of the business, covered only 75% of the payout.

For those who don't know, ALD pays dividend according to the following policy, "The company's dividend is paid from taxable income. The Board determines the dividend based on annual estimates of taxable income, which differ from book income due to changes in unrealized appreciation and depreciation and due to temporary and permanent differences in income and expense recognition."

In other words, ALD guesses what its income will be, then pays out an average over time, a policy that eliminates wide swings in payout from quarter to quarter. It also carries the risk of using current capital to cover the payout while relying on anticipated future capital gains.

A broader timetable shows us how this plays out. For the six months ended June 03:

Investment income: $0.78 per share
Realized gain: $0.50 per share
Cash flow: $1.28
Unrealized gains: -$0.57
Net income: $0.71
Dividend payout: $1.14

So, for the past six months, cash from operations more than covered the dividend payout. However, ALD recognized a rather large write down in their portfolio value, which just goes to show how unpredictable the capital gains picture can be. The concern here relates to one of the other short sellers' complaints, that ALD overvalues its portfolio. Did ALD only recognize the unrealized loss only because they booked a correspondingly high realized gain? In other words, did they sell their winners only to offset their losers? And does this indicate general erosion in the quality of the company's portfolio? Given the importance future capital gains play in the quality of the payout, this is probably the central question when evaluating ALD as an investment. This is especially important because cash reserves declined from 7.4M from 11.1M YOY.

According to the company, "At June 30, 2003, the portfolio of Grade 1 investments totaled $839.0 million, or 32.9% of the total portfolio at value; Grade 2 investments totaled $1.46 billion, or 57.4% of the total portfolio; Grade 3 investments totaled $124.8 million, or 4.9% of the total portfolio; Grade 4 investments totaled $20.2 million, or 0.8% of the total portfolio; and Grade 5 investments totaled $101.2 million, or 4.0% of the total portfolio. Included in Grade 4 and 5 investments are assets totaling $32.3 million that are secured by commercial real estate.

For the total investment portfolio, loans and debt securities greater than 90 days past due were $119.2 million at value at June 30, 2003, or 4.7% of the total portfolio. Included in this category are loans and debt securities valued at $43.5 million that are secured by commercial real estate. Loans and debt securities not accruing interest totaled $151.1 million at June 30, 2003. At June 30, 2003, 1.2% of the loans in the underlying collateral pool for the CMBS bonds was over 30 days delinquent or was classified as real estate owned.

This looks good and my experience with the company over the past several years has been that their grading system is pretty conservative. I'd have to go back to look at how the current state of ALD's portfolio compare historically, but my initial impression is that the portfolio is sound in terms of quality.

However, I'm a little less sanguine about the quality of the dividend, which I believe is under pressure, at least in the short term. What really concerns me is that the company might be sacrificing superior long-term capital gains to fund a current high payout. This reflects, I think, how ALD is changing from a BDC into something similar to a VC firm or something like Berkshire Hathaway, a company that provides capital to a portfolio of owned or partially owned businesses.


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