Deep Value in American Capital Strategies

| About: American Capital (ACAS)

American Capital Strategies (NASDAQ:ACAS) was the only Business Development Company (BDC) listed in the S&P 500, until late last year. As a BDC, it holds loans and equity in small, unlisted companies (portfolio companies), providing funding and management expertise until the portfolio companies can be sold to other investors. It values ites portfolio at $8.5 billion. This was funded by a combination of equity capital and loans, of which $4.4 billion remain outstanding.

Naturally, last year it became more difficult to find other investors to sell their portfolio to. But that's not what really hurt. What hurt was the mark-to-market writedowns that reduced the nominal value of the portfolio by $1.2 billion. That, in turn, triggered violations of covenants on ACAS's debts. Its stock price went from $40 in 2007 to $20 last July, $10 in November, to a low of $0.58 on March 6, following the earnings report that revealed a loss of $8.13 per share.

But the loss was based on writedowns of portfolio assets, not operating income. And now we have an equally dramatic recovery in progress; the stock closed at $2.50 on April 9. Yet it is still trading at only 16% of the book value. As a BDC, it is required to distribute a high percentage of its net operating income (NOI) as dividends to investors; in 2008, stockholders earned $3.08 per share. For 2009, it has promised to pay $296 million in dividends, based on 2008 NOI. Given 205M shares currently outstanding, that would be $1.44 per share, for a 60% yield.

There is, however, a wrinkle or two.

The first one is that while IRS rules require BDCs to pay dividends, there's a temporary waiver in place (because so many BDCs and REITs have become too insolvent to pay cash dividends), which allows them to pay 90% of the dividend in stock. Newly-issued stock, that is. I cannot for the life of me figure out why anyone thinks that receiving a dividend in stock does them any good at all, since each shareholder still owns the same proportional value of the company's equity; other than some minor tax adjustments, it's a purely symbolic gesture. The company has made no commitment as to the use of stock vs. cash. An announcement is due June 15th.

The next wrinkle is potentially even more dilutive.

A BDC can only thrive if it can raise capital. ACAS cannot get new loans due to the covenant violations of previous loans. It could issue new equity, but its bylaws require new shares to be sold at no less than book value; not possible, with current shares trading so much lower.

The company has proposed a way out of this dilemma: a reverse stock split, to bring the share price back in line with the book value. Then, if the company needs capital, issuing new shares after a reverse split would help the balance sheet. Additional benefits, according to the proposal, would be to bring the stock price into a more respectable range (e.g., above $10), where it is once again acceptable to institutional investors. This would, the theory goes, provide additional liquidity, thus benefitting existing shareholders.

The worry, of course, is that the issuance of new shares would dilute existing shareholders. The question would be, how much? If done skillfully, attracting capital and making the stock more marketable would be a good counterbalance to the dilution. The ACAS management has a good track record, and it's good odds that they can again bring value to shareholders.

Other than the writedown of assets last year, the company continues to make money; only about 2% of their loans to portfolio companies are non-performing. So future earnings will generate additional dividends, probably before the end of 2009. But even without cash dividends, the stock is attractively valued. And if the markets continue to improve in general, they will be able to profitably exit more portfolio positions, thus raising capital for new investments.

If market forces continue to put pressure on the portfolio, however, I don't think it will make much difference whether the stock is reverse-split or not; having a respectable stock price doesn't make an attractive investment when your business sucks.

Disclosure: Long ACAS since 3/9/09