American Capital Q2 2008 Earnings Update

A brief rundown of American Capital's (ACAS) Q2 earnings report (all figures US$ unless noted):

• After last quarter’s negative cash figure (-$10M OCF), Q2 saw several encouraging developments on the cash flow statement. ACAS is once again cash flow positive, generating $141M OCF during the 1st 6 months. This is a 26% decline from last year but with the difficult environment we’re facing, that might be expected. Another possible positive sign is the decline in accrued PIK income in Q2 2008, down to 25% of net operating income — compare that to the 6 month ratio of 32% of NOI. However, collection of PIK income was markedly lower for the quarter and basically flat for the 6 months. So it is unclear to me whether this new trend is a result of better company performance, stronger collection of accrued PIK or possible restructuring in some portfolio companies. Parsing through the 10Q, I saw a handful of companies that seemed to have restructured their capital base and possibly, that could have led to the numbers we’re seeing.
• The company’s balance sheet held up better this quarter than in Q1. Net asset value [NAV] was marked down $264M, mainly due to devaluation in their private equity portfolio as comp multiples compress and lower cash flows. The debt-equity ratio is hovering around 0.8, leaving roughly $1.1B in debt capital available to the company. The company listed $455M of investments at face value as currently non-accruing and have marked these down to $116M fair value (26% of cost). These represent jumps of 28% and 45% from Q1 2008.
• As to be expected, the company’s earnings is suffering as the financial markets enter the 2nd year of this credit crisis. Excluding the unrealized depreciation, net operating income fell 24% to $0.71 per share, which was near the midpoint of previous guidance. The company’s asset management segment is losing money at -$12M operating income for the 1st 6 months of the year. Despite this, the company is still showing good liquidity with total realized earnings coming in at $0.95 per share, which covers 92% of Q2’s declared dividends. The realized earnings number was short of the $1.10 forecast but much of that miss has materialized in the current quarter.

Other items of note:

• A slight uptick in their non-accruing loans, up to 8.6% of face value from 8.2% in Q1.
• Also, the board has brought on another firm, Duff & Phelps, to help with portfolio valuation.
• The company also devoted quite a bit of space in the 10Q to enumerating their valuation methods and the processes at which they arrive at their numbers. In fact, the company seems to be making an effort to help the market better understand the company as they included a financial tables spreadsheet with this quarter’s report (now let’s see about including a spreadsheet of the “Consolidated Schedule of Investments”).
• And as noted previously, the company did not buy back any shares as management claims the window was never open at a time when they were selling below book value (which was 7 days or so before the quarter end, so an entirely plausible explanation, contrary to what I stated in my previous report).

Regular readers know that I have been spending a lot of effort to dig into ACAS during this price drop. After much pondering and analysis, I (almost regrettably) stand by my original analysis. While the share price drop has been dramatic, I have found nothing to change the original thesis. Readers can click here to search my previous updates on ACAS (which is getting quite voluminous) while the original thesis is linked below:

• Part 1 - Overview
• Part 2 - Risk Detail
• Part 3 - Possible Upside
• Part 4 - Competitor Review
• Part 5 - Valuation and Assessment
• Part 6 - Management & Performance Targets

In short, ACAS may be a victim of the negative sentiment surrounding everything financial. A reader asked about possible issues affecting some of the banks like the auction-rate securities [ARS] mess. But while AmCap does provide financing, they are not a bank or brokerage — as far as I can tell, they have nothing to do with ARS, subprime or even residential mortgages, for the most part. Perhaps the biggest risk to the company lays in the future of the US economy but that is nothing Malon Wilkus and his team can control. But management insists that their portfolio is much better positioned for this recession than the previous one in 2002 and they do have some geographic diversification with ECAS. My thesis is centered around faith in management + the dividend and I still expect them to perform and to fare better than many other financials.

No doubt, we can expect rockier times ahead. The company has a credit line up for renewal in November and is not approved to issue shares below book value so the liquidity and/or leverage situation bears keeping an eye on. Also, if the credit crunch lingers through 2009 and/or a severe recession hits, the dividend may stop growing and possibly even start contracting. 

At this point, the company’s balance sheet is probably not an accurate representation of their financial position (of course, the shorts would say it’s far weaker). While this may be scary for some investors, as long as management is able to maintain their leverage ratio below 1:1 (and thus avoid forced selling), the company should eventually realize some of its current markdowns — an estimated $639M of realizable value in Q2 just from holding investments to maturity and not including any recovery in the markets.

I expect Wilkus and company are up to the task of managing AmCap through this treacherous environment in one piece. Though I may make adjustments to my ACAS position due to tax and portfolio considerations, I anticipate that in 3-5 years, shareholders will come out ahead (and get paid nice dividends for the whole of the duration).

Disclosure: Long

Comments

[alambrose:]

I think the weakness in ACAS share price is primarily attibutable to a few factors: 1) Overall decline in the broader market along with a substantial decline in the financial sector, and a misclassification of ACAS (and BDC's in general) as financial sector companies. 2) Negative sentiment aimed at the BDC sector by short interests; eg David Einhorn and his attempts to bring down ALD. Even Cramer states on national TV to avoid ACAS because it is under 'bear attack' and he is not a fan of mezzanine lending. 3) A broad and deep misunderstanding by the general public of how BDC's operate and make money.

The combination of the above three conditions make it particularly attractive for the 'distort & short' crew to attempt to drive share price lower with a concerted smear campaign. All one has to do is look at the short interest and the days that ACAS been on the REG SHO list to see what is really going on here. There have been some encouraging signs as of late with Cox's statements that broad-based-rules will be enacted to prevent the criminal activity of naked short sellers attempts to bring down companies like ACAS. If this happens any time soon, watch for a strong rebound in ACAS share price. However, there is also the caveat that overall market conditions may continue to deteriorate and ACAS will linger at current price levels for an extended period. But with a fairly solid 20% return almost guaranteed for the forseeable, could you really classify making a long-term investment in ACAS at current price levels 'dead money'??? I don't think so, and I have put my money where my mouth is.

2008 Aug 27 07:48 AM

[Rocknbob:]

One question: how long can they keep on paying that lofty dividend in this economic environment?

2008 Aug 27 11:31 AM

[Jonathan Ch...:]

While this company looks very solid, it appears that many positions are illiquid. Unfortunately the housing economy will not be recovering until late in 2009, since there are two additional shocks to come: the repricing of the Option Arm Mortgages, and the failure of several major banking institutions in the US and Europe.

There will be general market movers and unfortunately the movement will be down. I am unable to tell if there is sufficient liquidity in the company to withstand an additional 10% drop in the market.

Remember that this long term bear market began in 2000, and the price, in constant real value (using Gold, or Silver, or Platinum, or Copper or Oil) has been down, even though the "dollar" value does not look that bad.

Net-net: The 20% dividend really helps reduce the risk, and this is a good business, just expect the rough ride to continue for at least another year. There are few places to hid, an this is one of them

2008 Aug 27 11:38 AM

[Big Al45:]

Rocknbob has asked the right question. If the $1.24 per share "unrealized depreciation" reported in the recent quarter were to actually occur (and it probably won't), ACAS really lost .33 per share during the quarter.

The dividend appears to be safe through the 2nd Quarter of 2009, (rollover of 2008 earnings should be sufficient to pay 2 quarters in 2009) but I suspect they will have to reduce subsequent dividends, if the economy doesn't improve.

Personally, I will continue to buy the dips and sell the rips on this stock.

For full disclosure: I have no current position in ACAS.

2008 Aug 27 02:57 PM

[peachberry_tea:]

Does anyone know whether ACAS discloses their scheduled exits are by each quarter/yr? That should give us a fair idea of what ACAS' liquidity should look like and whether they'll be able to support their dividend

As for the depreciation charges they have been taking. Are these just accounting charges or revaluation charges - i.e. did they mark down beacuse FAS said they had due to lower liquidity or whatever, or are their actually expecting their investments to yield less once its exited?

Thanks

2008 Aug 27 03:42 PM

[fireman Jim:]

I continue to add to my position in ACAS. Even if the dividend were to be slashed in half, an 8 to 10 percent return is still remarkable. I am confident a 5 year time line will be very profitable.

2008 Sep 05 09:49 AM

[Jaded Consumer:]

Some of these questions hit good points.

Rocknob: the dividend is based on taxable income, not adjustments to current valuations of investments ACAS isn't exiting. Big Al45: I made the same mistake, confusing ACAS' SEC-reportable earnings with the taxable income on which ACAS is required to calculate the minimum dividends it must pay to retain its tax status:
jadedconsumer.blogspot...

peachbery_tea: I don't think ACAS discloses IN ADVANCE the specific exits it anticipates; this would give counterparties leverage in negotiation by threatening to hold up predicted results by declining to sign documents. ACAS DOES disclose exits after the fact. ACAS also discloses current holdings.

Johnathan Christopher: yes, ACAS' holdings are illiquid. This isn't reason to hate ACAS, though; it's part of the reason ACAS can expect the returns it produces -- there are few competitors for these deals, and ACAS has no reason to hurry into poor deals or rush out of deals that are paying good money. My overview of ACAS is given here:
jadedconsumer.blogspot...

ACAS' ability to raise new funds without diluting its existing shareholders is a testament both to its cleverness and to its dedication to protecting existing shareholders. The new-in-April AGNC deal adds 4¢/share per quarter to ACAS' earnings while doing three interesting things at once: (a) raising funds non-dilutively, (b) creating a new pool of funds under management, and (c) creating 8x+ leverage in a new investment without impacting the 1:1 debt:equity ratio required by its tax status.
jadedconsumer.blogspot...

As demonstrated by the quarter's cash flow (which was positive despite an expected closing transaction being pushed to 3Q), ACAS' liquidity seems to be adequate, as management promises -- and the exit flow allows ACAS to delever (by slowing redeployment) as conditions continue to worsen, so the 1:1 leverage limit should not push ACAS into regulatorily-mandated liquidations with timing not of ACAS' choosing.
jadedconsumer.blogspot...

I label my ACAS posts with a tag:
jadedconsumer.blogspot...

Best regards,
--J

2008 Sep 05 04:16 PM