American Capital Strategies: Ride the Recovery

Private equity has literally gone to the dogs this year, and our pick this week is one of the lesser-known, but higher quality names in the industry. It's not the "rock star" type of private equity company that makes headlines on a regular basis, like a Blackstone (BX) or a Fortress Group (FIG), but it's got some very strong internals to it, despite having been pretty much the baby that is being thrown out with the PE bathwater this year.

American Capital Strategies (ACAS) is a principal investment firm specializing in management and employee private equity buyouts, acquisitions, recapitalizations, mergers and acquisitions, add-on acquisitions, securitizations, special situations, growth capital investments in middle market companies, early stage in mature private and public companies, corporate divestitures, acquisitions of portfolio companies of private equity firms, acquisitions of family-owned or closely held businesses, change of control, or the exit of minority shareholders, going private transactions, and ownership transitions.

The Special Situations Group invests in troubled and distressed situations including operational turnarounds, auctions, corporate and orphan carve-outs, portfolio add-ons, complex management buyouts and provides debtor-in-possession [DIP] financing, exit, mezzanine for sponsored buyouts, second lien refinance, and direct lending to distressed companies.

The Second Lien Group offers secured and unsecured junior capital investments to support an array of financing needs across a variety of industries primarily, focusing on syndicated junior capital opportunities sourced through the loan sales desks of the market's growing junior capital arranger community.

ACAS prefers to invest in manufacturing, services, and distribution companies. The firm also makes investments in companies that provide services or products to federal, state, or local governments, focusing on information technology for custom information technology solutions, technology and software enabling headcount reduction, technology and software enabling cost reductions in conducting transactions with or within government.

Techinal Analsyis

The chart above shows ACAS for the last six months. The stock has been battered along with most of the other companies in the finance sector. ACAS is lumped in with the "closed-end fund" group in the S&P 500. The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are both rounding out at low levels, indicating a bounce, at least on a technical basis, could be coming.

ACAS Fundamental Data

• Current Price: $21.70
• Shares Outstanding: 202.9 million
• Market Cap: $4.5 billion
• Forward Price / Earnings (avg. Est): 6.9x
• PE/G Ratio (5 Year Expected): 0..9x
• Price / Book: 0.8x

ACAS' revenues have been stymied lately, as the financing sector of the US economy has slowed. In 2Q07, ACAS saw revenues of $326 million, and this year, in 2Q08, analysts are expecting about $285 million in revenues. This equates to an annual decline when comparing quarterly numbers of about 12.5%. On an annual basis, revenues for the year ending 31 December 2008 will be around $1.15 billion according to the average estimate of the 18 analysts who follow this company. That's down about 8% from 2007's revenue levels which came in at $1.2 billion.

We think that revenue declines will bottom in '08, and next year (2009) we will see a return to high annualized revenue levels of about $1.3 billion. This estimate is in line with the analysts' best guesses as well, although some 2009 revenue estimates range as high as $1.5 billion. We want to be long-term owners of this company as it makes its transition through the trough of the financial crunch, and we want to be riding the recovery with them through the end of '08 and into 2009.

ACAS pays a significant dividend to its shareholders, with the latest distribution being $0.31 per share payed for the most recent quarter. Annualized, that's at least a 5% dividend yield on today's price of $22 per share.

There is also a significant short position in these shares, with 31.8 million shares short as of June 2008, or nearly 16% of the outstanding float of the company. On ACAS normal daily volume, this equates to a short ratio of 14.9 days. There have been arguments posted in news articles and on blog sites on ACAS' valuation strategies for some of the investments they manage. One of these arguments comes from Greenlight Capital's David Einhorn, who is short these shares. The short-side argument is that most of the assets under management by ACAS are classified as "level 3" assets, meaning they are marked to model as far as quarterly or annual valuations. With over 170 portfolio investments, questions arose out of the mid-June investor's meeting about the valuations and the methodology behind them. In early May, ACAS reported an $813 million loss, primarily driven by over $997 million in accounting writedowns on the value of investments in the portfolio. This act raised a number of questions about the value of the private equity portfolio.

The resulting collapse of the company's share price has been fast and furious, as the chart above reflected. Not only have retail investors abandoned the shares, the professional short seller community has attached as well.

ACAS' balance sheet currently has a cash cushion of just over $37 million. The debt they carry though, amounts to over $4 billion. This is prudent leverage on the assets that the firm has under management, and the annual operation margin (for a trailing 12-month period) is a strong 72%. Despite the accounting write downs, cash flow is still very strong in this company, with over $400 million in operating cash flow on a trailing 12-month basis.

Investment Recommendation

Our recommendation this week is to buy ACAS stock at its present price of $21.70. We would also buy a November 2008 call spread in the $20 / $30 strike prices. We would look to acquire the ACAS Nov $20 call for $3.00, and write the Nov $30 call for $0.40, for a net cost of $2.60 to this spread. We would look to sell this call spread at a level of $8.00 or higher between now and the future expiration, giving us a return of just over triple the money.

We've heard from a few of our readers who just want straight option buy recommendations, rather than spreads. For investors who do not wish to write the higher strike call, a direct purchase of the November $20 call for $3.00 would be an alternative. We would look to sell that call at a level of $9.00 or higher.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in ACAS stock or ACAS options.

Comments

[fxtrader07]

good article, but you dividend number is totally wrong by a facor of almost 4. ACAS paid out 1.03$/share last quarter and similar dividends have already been announced for the rest of 2008 and for 2009 (and the money for these has already been set aside, mainly stemming from earlier realized capital gains). This amounts to an annual dividend yield currently of about 18%!
You might perhaps rethink your options strategy in the light of this.

[fxtrader07]

a question regarding your call-spread. I am a fan of spread-strategies, but your suggestion doesn't make much sense imho. the premium raked in for the Nov 30 calls is rather small and i don't see a huge benefit from it as compared to just buying the $20 call without writinjg the $30 against it?

[jjason]

Wouldn't it be better to just do away with options trading? And short selling too?

I find it amazing that this author says some nice things about ACAS but doesn't own any common shares.

And, he did not get the dividend or current yield correct!

Long ACAS.

[Rocknbob]

Kudos to jjason and fxtrader07 on recognizing the incorrect yield number... cah flow sounds like a positive note...
Long ASAS

[Boing]

Indeed he has confused AGNC"S divy's ( first time dividend is .31) versus ACAS at $1.03 and $4.19 on the year 2008 ( divy is covered already.

Important information to report incorrectly.....the article smells set up....why is that?

[Daniel Jones]

biz.yahoo.com/prnews/0...

The link above is the reference to the $0.31 per share dividend, and yes, the total annual dividend is $4+ on a trailing twelve month basis. Much of that income is characterized as gains though, not a normal cash dividend. 19% dividends don't come along every day.

The option strategy call spread is solid - selling that $30 call is up to you whether or not you do it. Yes, it's a small premium but it is 10% of the purchase price of the lower strike call.

The dividend is important information to report correctly. Thank you for pointing it out and correcting my error. When errors like this come along, I always try to publish either a correction or a link to the correct information. I appreciate the notes.

Daniel Jones - editor, OptionsNotions

[Dbrunt]

ACAS is being painted with the same brush as Allied which seems to be justly accused of cooking the books over the last few years. In fact, ACAS shares have fallen even faster than Allied which is strangely worrisome sense we know those guys can't be trusted.

There is plenty of forensic accounting that has been done on Allied. Anybody out there doing the same work on ACAS. If they are being unjustly beaten up, maybe a nice opportunity. On the other hand article's like the above don't really address concerns one might have about ACAS.

Are they marking their portfolio to market or making judgement calls based on higher wisdom?

Are they generating cash by selling their winners and holding their losers?

Not to mention what is the general health of business ACAS is loaning money to. Mezzanine loans are riskier companies with higher default.

[User 98474]

IT IS APPRECIATED TO READ AN ARTICLE THAT HAS A DEFINITE BUY OR SELL RECOMMENDATION

[TKTK53]

CHARLES - Did you read this article before you posted yours on the other page?
Daniel has a buy on it as I said in my comments on the other page too.
I sure wouldn't want you to be my stock broker.

[Michael42]

You should really correct the dividend number. It's not $.31 it's $1.03 for Q2 and forecasted to be $1.05 in Q3 and $1.10 in Q4.

americancapital.com/in...

[CycleGirl]

Thanks for the article about ACAS. American Capital runs a complex business and explaining the nuts and bolts is helpful.

I personally think that buying Nov 30 calls presents a lot more risk than simply buying shares. After all, the economy and the market may continue to be sluggish for months and options lose value as they approach expiration.

Buying shares gets you a ~19% dividend. Furthermore, if the share price doesn't recover until 2009 or so, you'll be much better off as a shareholder than as an option player.

For my part, I do believe that ACAS is an excellent long-term investment at the current price for both the dividend and the capital gain.

Just my $0.02. Long ACAS.

CycleGirl

[ChiCav13]

ALD is the better play in this space. Mezz loans are not necessarily more risky if the firm making the loan adheres to strict underwriting standards (which ALD does). With traditional bank financing markets completely dried up, there is a much wider gap between senior loans and equity -- exactly where Mezz players like ALD fit in. There will be some great opportunities over the next 12-18 months for ALD to get premium pricing on lower risk loans simply because commercial banks do not have the necessary regulatory capital to make the same loan at a lower rate.

Long ALD.

[vatexas645]

My last qtr dividend was $1.03, not $0.31.

[AJB8]

The last ACAS quarterly dividend was $1.03 ..... not $0.31. Their recent IPO, American Capital Agency (AGNC) had the dividend of $0.31. Also, run your graph titles by Spell Check. Otherwise, a good article.

[SavannaIce]

If you like ACAS AND ALD you may want to look at RAS.

[southshoreinvestor]

ACAS is no different than any other company holding private businesses and loans in their portfolios. With the implimentation of fas157 level 3 assets (those not readily traded) are valued based on recent sales of similar investments. Thus, of course if no one is buying, then the values of these investments must be marked down to ridiculously low levels. As hedge funds and brokerages de-leverage / liquidate, fas157 will require BDC's to further mark down holdings. So what?

The majority of these private businesses and loans will be held long term and provide stable interest or dividends to ACAS. When liquidation by over-leveraged hedge funds ends and the market fear subsides, then there will be a reversal of the valuations. That is when those short will become longs. Design your options strategy around this and make your next article more clever.

Currently ACAS has indicated that it has covered its 2008 dividend of $4.19, and has cap gains coverage for part of 2009. For a "clear" picture of how ACAS has managed its dividend through prior market struggles see www.americancapital.co.... Of course, past performance, etc...


* The actual issue, IMO, is the rising cost of capital.

REITs, BDCs, MLPs, etc., that pay out most of their income rely on secondary offerings, preferreds and convertibles, and sell-downs of mature assets to pension funds for new capital to fund their expansion. Note I said expansion, not daily expenses - BDC's are not ponzi schemes.

For a different view than the shorts, see www.deepcapturethemovi.../ concerning shorting Overstock.com. ACAS will be good money for Einhorn down and then back up the pps ladder.

However, it is important to note that BDCs, REITs, and MLPs have variable ratios of fixed and/or variable rate debt. In the short-term:

1. New fixed rate debt will be harder to obtain and more costly.
2. Secondaries will be less accretive to NAV, OR even dilutive if required to capitalize unfunded commitments.
3. Convertible or preferred share offerings will likely be less attractive.

On the down side, these businesses may face slower growth prospects combined with decreased demand for their underlying assets (REITs = mortgages, leases, etc.; BDCs = private businesses and loan market; MLPs = pipeline volumes) resulting in decreasing earnings growth, decreasing NAVs, and falling dividend/distribution coverage. Dividends for some securities and CEF's, even while "banked" from prior years may reduce NAV in the short term.

On the positive side, those BDCs and REITs with capital can take advantage of the more favorable lending environment and distressed securities/loans. Those MLPs with a greater fixed rate debt ratio, longer terms on debt, lower unfunded commitments, and higher regulated percentage of business will benefit. Buying into the best companies at attractive yields will position one for multiple years of attractive gains. Look for a reversal in NAV when the hedge funds have finally de-leveraged / liquidated. Oh, and pension funds will still have to find diversified assets such as those private companies owned by BDCs in which to invest.

ACAS is buy for the long term, IMO, though you may get it cheaper - who can say. No need to buy until the chart looks better.

Homework should include general BDC reports from Wachovia (AGEdwards) and ACAS-specific reports from Jefferies for comments on ACAS's portfolio vintage 2007.

[Ckbb]

Treat this "analysis" for what it's worth! Not only does Daniel Jones get the dividend for ACAS wrong saying it is $0.31 instead of the real value of $1.03 but when it is pointed out he doubles up by giving the Yahoo source for his error!

What part about AGNC not equal to ACAS does Mr. Jones not understand?