Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New by David Einhorn (tohfa e dulha read online TXT) 📕

As you know, Allied has performed in exemplary fashion, despite Mr. Einhorn’s continued attacks. Indeed, we have had a 15.6 percent average annual total return to shareholders in the last five years ended September 30, 2006. Upon payment of our fourth-quarter preannounced dividend of $0.62 a share, we have distributed a total of $2.42 per share of regular quarterly dividends to shareholders for 2006. In fact, in the nearly five years from 2002 through September 30, 2006, Allied Capital’s paid about $11 per share in cumulative dividends to its shareholders. We all wish that Mr. Einhorn would give up his quest for a big payday, at the expense of Allied Capital and its shareholders, however we expect he has far too much money to lose to do this.

PART FIVE

Greenlight Was Right . . . Carry On

CHAPTER 28

Charges and Denials

Allied received approval from its shareholders to issue stock as part of its “stock ownership initiative” at their annual meeting in May 2006. But as the year unfolded, Allied did not launch its tender offer to take the insiders out of their stock options. On the second-quarter conference call, management attributed the delay to “volatility” in the stock price. It had fallen from around $31 to $28 per share. Apparently, they would wait until the stock was trading better.

When Allied released its third-quarter results, we saw that the first nine months of 2006 were a lot like the 2005 results, except without the big gains from a couple of the home-run asset sales. For the first three quarters, Allied had net investment income of $0.97 per share and earnings per share of $1.47. It paid $1.80 per share in distributions, with the deficit bridged by the gains from the prior year capital gains. Allied began expensing its employee stock options, and compensation costs grew more than 50 percent over 2005 levels. They grew about 30 percent, excluding the stock option expense. Net investment income improved over 2005 levels, mostly from reduced investigation costs, which fell to about $4 million from about $32 million.

Though Allied temporarily halted stock sales after the investigations were announced, the company resumed issuing new equity in earnest in 2006, selling almost $300 million worth of shares to new investors during the year through Deutsche Bank, Merrill Lynch, and Bank of America.

Allied continued writing down its investment in BLX in dribs and drabs. Allied reduced its carrying value from $353 million at the end of 2005 to $285 million on September 30, 2006. According to Allied’s filings, higher prepayments impacted the portfolio and a more competitive lending environment affected its originations.

Though Allied stopped disclosing BLX’s summary financial results at the beginning of 2005, Allied provided enough evidence to show that BLX’s problems were becoming severe and much more serious than the gradual write-downs indicated. In the nine months, Allied earned $11.9 million in interest and dividends from BLX, compared to $19.5 million the previous year. The cash portion of interest and dividends fell from $14.4 million to only $6.2 million. The dividend on the “Class B” equity interest fell from $9 million to nil. Further, the portion of BLX’s borrowings on the bank line that Allied guaranteed expanded from $135 million to $188 million. This meant BLX’s borrowing expanded from $270 million to $376 million. While it is possible that BLX actually needed to borrow more than $100 million in a single quarter, it is also possible that BLX saw that it was in big trouble and simply drew down as much of its line as possible. This is common practice when companies foresee significant problems with lenders, often immediately prior to filing for bankruptcy. Considering BLX wasn’t paying Allied as much, it raised the question of why BLX needed to borrow at such an accelerated pace.

Given the higher borrowing, we estimated that Allied reduced its calculation of BLX’s enterprise value by only 7 percent. Given the deterioration described above, it would be hard to justify such a modest reduction. Allied did this by yet again changing how it valued BLX. According to its SEC filings, “In addition, for the quarter ended September 30, 2006, we performed a fifth analysis whereby the value of BLX was determined by adding BLX’s net asset value (adjusted for certain discounts) to the value of BLX’s business operations, which was determined by using a discounted cash flow model.” (Emphasis added) Apparently, given BLX’s deterioration, they couldn’t justify the modestly reduced value using the four old methods, which already generated an unreasonable valuation.

Two days after the Times story about pretexting, I spoke to a large gathering at the Value Investing Congress in New York about a couple of stocks we owned long. After I finished, a man approached me in the hall and followed me into the private “speakers only” room. He asked if I was proud of the Times pretexting story. I said I didn’t see what there was to be proud about being the victim of a crime. Then he said, “I hear you’re writing a book. Is it more like the stuff you spoke about today or about Allied Capital?” Alarm bells went off in my head. Rather than answer, I asked him who he was. He identified himself as Seth Faison from Sitrick & Company, a public relations firm. I’d heard of Sitrick. It was known for its aggressive advocacy on behalf of companies that were suing short-sellers, among them Overstock.com, Biovail, and Fairfax Holdings. By reputation, they are even more aggressive than Lanny Davis. I guessed, and later learned, that Allied had hired them. At this point, one of the conference organizers noticed the tension and escorted Faison from the private area.

The following week, I gave a closer reading to Allied’s quarterly SEC filing. Buried on page eighty-two, under the section “Change in Unrealized Appreciation or Depreciation,” in the subsection “Business Loan Express, LLC,” the fourth paragraph read:

Furthermore, in determining the fair-value of our investment in BLX at September 30, 2006, we considered