I have written before about American Capital (NASDAQ:ACAS) and have followed it closely since 2008. Some investors may be a bit confused about this stock because it used to be named American Capital Strategies (although it has always had the same stock symbol). Another source of confusion grows out of the fact that a subsidiary of ACAS is the management company which manages American Capital Agency (NASDAQ:AGNC) and other agency mortgage assets. AGNC has been afflicted by the interest rate run up and its negative effects on agency mortgage REITs. ACAS has a subsidiary which manages AGNC and is not directly affected by declines in AGNC share valuation, although - in fairness - it must be pointed out that the ACAS subsidiary is paid based on assets under management and AGNC finds it easier to do follow on public offerings (and thereby increase assets under management) when its share price is soaring than when its share price is tanking.
In any event, after briefly breaking through the $15 a share barrier, ACAS has pulled back sharply and closed Thursday at $12.88 a share. I have owned this stock since I bought it below $2 a share in 2009 and I'm always concerned that, after a big run up, I may be holding on out of a misplaced sense of "loyalty" and thereby beginning to treat my stocks as "old friends" rather than vehicles for wealth creation. In this case, I am satisfied that logic overwhelms sentiment.
The case for ACAS is relatively simple. ACAS has one of the most important characteristics I look for in a stock: a massive discount to a quantifiable value. It has also established a powerful positive trend in several areas: share price, book value and debt reduction. Finally, I'm satisfied that the management of the company is shareholder friendly.
The Discount. ACAS includes a calculation of per share net asset value (NAV) at the end of each quarter and at the end of the last quarter (June 30, 2013), NAV was calculated at $19.28 a share. On this basis, ACAS is trading at roughly 67% of NAV. For a variety of reasons, I believe that current NAV - accurately measured - is higher than $19.28. There are two adjustments to NAV that I think are appropriate. First of all, NAV was calculated by estimating the fair value of the ACAS European subsidiary rather than by utilizing the NAV of the European subsidiary. Since the European subsidiary is owned and operated by ACAS, the consolidation of assets is legitimate for valuation purposes and the NAV of the subsidiary's assets should have been used. This results in adding $225 million to the ACAS NAV. Secondly, ACAS has been using its substantial cash flow to repurchase shares on an aggressive and consistent basis. To calculate NAV as of the beginning of September, some conservative assumptions about share repurchases in July and August are appropriate. Consistent with repurchase levels earlier in the year, it is reasonable to assume that repurchases continued at a level of roughly 3 million shares per month reducing share count by some 6 million shares since June 30. For reasons explained below, I believe that this assumption is conservative and that it is very likely that ACAS may have repurchased more than 3 million shares per month in July and August.
I'm sure I will receive comments which argue that various elements of the ACAS NAV are overstated or may face decline. It is true that there are $245 million of non-performing loans on the balance sheets but they have already been heavily discounted to face value (current accounting treatment involves a roughly 30% discount to face value). Even if only half of the $245 million or $122 million is recovered, the NAV hit would be only 43 cents per share. ACAS also carries a "deferred tax asset" of $443 million on its books - this is worth roughly $1.50 a share. ACAS has elected to discontinue status as a registered investment company (RIC). The tax asset allows ACAS to retain earnings without paying taxes. As a result ACAS has been able to maintain a powerful upward trend in its finances. I am not going to argue that there is only one way to look at NAV or that it is impossible for NAV to decline. However, I will argue that a large enough discount to NAV provides investors with a very reassuring "margin of error" in this area.
At any rate, my adjustments lead to an NAV of $20.51 as of the beginning of September. My $13.33 threshold price is 65% of that NAV and I believe provides investors with enormous upside and limited downside.
The Trend. Using its tax asset to shelter income and eschewing dividends, ACAS has been able to use its cash flow and some money generated by selling assets to pay down debt, buy back stock and steadily increase NAV. The table below is based on ACAS SEC filings going back to 2009. It shows NAV and outstanding debt (in millions of dollars) as of June 30 in 2009, 2010, 2011, 2012 and 2013.
ACAS has managed to go from being a highly leveraged company whose survival was in doubt to being a solid credit with very low leverage and a steadily increasing NAV. I believe that a very important turning point was reached this August when, as described here, ACAS was able to renegotiate the terms of its remaining debt. ACAS lowered its interest rate and dramatically revised its schedule for principal repayments to permit a much slower pay off rate. ACAS also received an upgrade in its credit rating from a rating agency. I believe that this is important because, up to June 30 of this year, substantial cash flow was employed in the repayment of principal on outstanding debt and this may now come to an end. With nearly $6 billion in assets and an improving credit rating, ACAS may well stop paying down debt and utilize its cash flow in other ways.
Shareholder Friendly Management. Since the devastation created by the financial crisis, ACAS management has had its eye on the ball and has steadily repaid debt and repurchased stock. Management could have perceived its interest as increasing the size of ACAS to set up an argument that compensation should be increased on that basis. Instead, management seems to have pursued the objective of increasing shareholder value.
To the degree that debt repayment winds down and more cash is available for share repurchases, the trend toward higher NAV should accelerate. If a company is trading at 65% of book value and it uses $1 million to repurchase shares, it increases NAV per share automatically. On the other hand, using $1 million to pay down debt doesn't increase NAV at all because assets go down by the same amount that debt goes up. By way of example, ACAS has spent roughly $1 billion to pay down debt in the past two years if that same amount had been used instead to repurchase stock at an average price of $10 a share (a reasonable assumption considering ACAS share price history), NAV would now be $26.25 a share.
For a variety of reasons, ACAS was well advised to pay down debt. In the early stages of the crisis, it probably didn't have a choice and more recently a reduction in leverage has opened up more reasonable credit terms. But the days of debt reduction are coming to an end and ACAS will be able to repurchase shares more aggressively or redeploy funds if that is more attractive financially.