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American Capital (ACAS) is one of the oldest publicly-traded Business Development Companies ((BDCs)). It also has the current distinction of being a BDC that has elected to be taxed as a C-Corp as of the tax year ended Q3 2011. This means the company it is not paying out dividends and will pay corporate taxes on its income. The C-Corp classification does not disqualify the company from continuing as a BDC or being delisted, it just means they get to burn through their sizeable tax asset before they have to start making payments. This article will compare Q1 with Q2 and try to identify some areas that ACAS could have provided more detail in their conference call and notifications. Please note that all of the figures below can be found in one of the links above or on the company 10-Q documents.

Quarter Highlights

  • Increased NAV to 16.62, a 91 cents/share increase over the previous quarter.
  • 29 cents/share Net Operating Income
  • 9.1 million share repurchases

NAV Drilldown

The increase in NAV makes it appear that the firm had a great quarter and the stock is on the rebound. The book value jumped 91 cents/share over the previous quarter (15.71 for Q1). If the book value is 16.62 and the stock is currently trading around 11.15, you have the opportunity to buy into the company at about a 35% discount to NAV. This discount is substantially less than last year's 46% discount but still significant. The NAV increase was driven by a few factors:

  1. Stock repurchases. The company used $85 million in cash to repurchase shares at an average price of $9.34; this contributed 20 cents to the book value.
  2. Operating activities. The company realized 4 cents/share which was a $189 million improvement over the last year. Also, the company totaled $230 million in net unrealized appreciation in their investments. For the quarter, this added approximately 25 cents to the NAV.
  3. Tax reclassification. This is the one that concerns me the most. ACAS changed how they account for preferred dividends on their balance sheet. Here is the quote from SVP Rich Konzmann: "The biggest driver of that was a change in our tax accounting method of preferred stock investments that we did for the quarter, which was about $132 million of that, I believe it was $145 million increase in our deferred tax asset." This change added 46 cents to the book value. Keep in mind this was approved by the IRS, but it is a paper gain that was not the result of investing activity.

Investment Activity

Over the quarter, ACAS realized $332m from realizations and made new commitments of $103m. Loans on non-accrual status (meaning they are not paying interest and/or principal) jumped up $65m dollars. Ideally, ACAS would be deploying more capital into companies, but they may have a smaller deal pipeline at the moment. The main activity I can see during the quarter was reworking existing portfolio company borrowings into a longer maturity or a lower interest rate.

New Investments:

  • The company now has 84,043 common equity shares in SPL Acquisition Corp. in addition to their other investments. This appears to be the result of some type of workout as the other loans have had principal amounts and/or cost amounts changed.
  • Warrants for about 6.5 million shares in The Tensar Corporation. Again this appears to be the result of a refinance.
  • About $900,000 in EXPL Pipeline Holdings LLC. The previous month's debt was in one line item and this month there are two line items.
  • $20m in Rebellion Media Group Corp.
  • A move down the capital structure with TestAmerica Environmental Services, LLC. ACAS went from a $20.8m Senior Debt investment into a $26.5m Mezzanine investment (the lower you are in the capital structure, the less likely you are to be repaid in the event of bankruptcy).
  • Money Market balances jumped from $58.1m in Q1 2012 to $108.8m in Q2.

Investments Exited:

  • ACAS substantially trimmed back investments in derivatives, trimming notional exposure from $712.4m in Q1 down to $372.9m in Q2.
  • Algoma Holding Company is no longer a $16.2m investment at a 14.2% interest rate.
  • About 150,000 preferred shares of Avalon Laboratories Holding Corp. is gone ($41m Fair Value)
  • The firm renegotiated/exited about $18.2m in Mezzanine debt of FPI Holding Corporation.
  • $19.4m of Orion Foundry, Inc. ($7.8m Fair Value)
  • $2.4m PaR Systems ($2.1m Fair Value)
  • A $3.9m Senior Debt investment in WRH, Inc.
  • GS Mortgage Securities Trust 2006-GG10 of $7m, $0m of Fair Value
  • Equity shares in FreeConference.com, Inc. (about $15m in Cost)
  • $3.4m notional of Kingway Inca Clymer Holdings, Inc.
  • The entire investment in Medical Billings Holdings, Inc. ($30m in Cost)
  • The entire investment in Small Smiles Holding Company, LLC ($57m in Cost)
  • $143m in SMG Holdings, Inc.

Accounting Fun

The company changed how they recognize dividends on preferred equity to the tune of a nifty tax profit. They also appear to have revalued the cost of a number of investments. From comparing the 10-Q side by side, you can see that 123 investments had a cost basis change in the quarter. This is almost half of the entire portfolio! I am not an accountant, but I know of a few ways that this may happen. The company may be amortization (or accreting) the holding back to a value of par. This will happen if ACAS bought the loan at a non-par price. Another way cost may change is if ACAS issued bonds with a PIK option in them.

  • Total principal outstanding in investments dropped from $3.9 billion in Q1 to $3.3 billion in Q2.
  • Fair value in investments dropped from $5.34 billion to $5.29 billion.
  • 15 investments had maturity dates extended.

Conclusion

ACAS is still trying to heal from the effects of the great recession. The company has taken longer than other peer firms like Ares Capital Corp (ARCC) and Main Street Capital Corporation (MAIN) to recover into their prior glory. I was disappointed that the company's main NAV growth was from share repurchases and accounting changes. Also, as per Malon Wilkus and John Erickson, the company has no plans to issue dividends until the NAV and share price are about equal. One fun note that John Erickson mentioned in the conference call is that the firm will lose the $541m tax asset if it converts from a C-Corp back into a BDC Registered Investment Company (RIC). This means the company will not be paying dividends anytime soon. If you believe the firm will be able to close the gap between the book value and stock price, the stock could be attractive. However, given all of the previous factors, I will still keep them on my watch list but I will not be investing in them at this time.

Source: A Deeper Look At American Capital's Earnings Report