What is American Capital Strategies Worth?

Jan.13.08 | About: American Capital (ACAS)

I will start by asking a question that every analyst should ask. What is this company worth? Or, what is an appropriate price to pay today for fractional ownership in all the future cash earnings the company will earn?

With American Capital Strategies (NASDAQ:ACAS), I'm really asking what you would be willing to pay for a business that has an economic moat in the form of certain competitive advantages, such that it has been able to consistently outperform peers. The proof that it has this "economic castle" is that management has been able to increase NAV from $15.82 to $29.42 from 2002 to 2006. That is to say, they grew book value over the most recent four years at a 17% cagr. They did this while increasing assets under management from $1,281 million to $9,799 million, representing a 66% growth rate.

Clearly they are becoming an asset manager of choice in deals. With this, they grew NOI on a diluted per share basis from $2.57 to $3.11, and they grew diluted net earnings per share from $0.50 to $6.55. They did this while returning $14.68 cash back to shareholders through dividends in the 5 years 02-06. And, as Malon Wilkus says, dividends cannot be restated.

So what is a company that has economic moats allowing it to attain average return on equity of 15% over long periods (as ACAS seems to) worth? Indeed, since their IPO, ACAS has earned a 17% weighted average annual compounded return.

What are ACAS's moats anyway? Well, first, they have a low cost of capital; second, they operate with low leverage; third, they have an organized, institutional way, utilizing expert teams split by function and by industry or investment type to analyze potential business and then invest in it; fourth, they are well diversified and reap the benefits of fee based income as they have become an asset manager of choice.

How should we value this company? I value this business three ways: price/earnings, price/book, and utilizing a fair dividend yield model.

First, on a price to earnings basis, the company looks extremely cheap given its economics. It earned $6.55 in 06 and as such trades at 5x trailing earnings. I would say 5x earnings for a castle growing at 17% represents a discounted investment. NOI per share in '06 was $3.11 so ACAS trades at 10x trailing NOI. Again, cheap.

I like price to book best and I estimate book value at about $34/share. ACAS is trading 10% under book value. This represents tremendous value, as I believe this equity should trade at 2x book and is valuable at 1.5x book or less.

Finally, on a dividend yield basis, ACAS now yields 13%. The company is typically a buy at a 10% yield and some believe it should trade closer to 5-6%.

Overall this business is a strong buy at this entry point.

Of course, as always, there are questions that one should ask.

Is ACAS understandable? For me, the answer is yes. It is almost like owning a closed end mutual fund that invests in private companies in the middle market. The beauty is that they pay out their income to the investor to provide a cash engine for the shareholder.

Will they be the clear winner in their space 10 years from now? This is not as easy as when analyzing, say, Anheuser-Busch (NYSE:BUD) or Procter & Gamble (NYSE:PG), but they do seem to have a huge castle with moats judging by managements accomplishments over the last 10 years. I would say they are and will be a leader in their industry.

Finally, we should adopt a page from Charlie Munger and invert; that is, ask "what could go wrong?" or "how bad could an investment in ACAS go?" The answer, I think, is that a long, deep recession is a bad scenario for ACAS stakeholders. In this situation, ACAS would presumably have many assets on their books that could not pay interest and defaults would rise. Bankruptcies in portfolio companies would occur and sales of portfolio companies would grind to a slow pace. Depending on the duration and deepness of the recession one could add to their position, averaging down and lowering the cost basis further. Lest we end on a morbid note, I should say Malon Wilkus believes that there is less competition for deals today and he gets better rates in this environment. I'm hardly in a position to dispute him. Also, one assumes some stimulus package would be ready if the economy teeters too far toward slowing. Finally, much of the recession scenario is priced in the stock - that is why we have this one time but solvable problem to capitalize on. Remember - "this too will pass".

Disclosure: Author has a long position in ACAS