American Capital Is Attractive Below $15: Here's Why

| About: American Capital (ACAS)
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American Capital (ACAS) current price of $14.73 offers the investor a discount of 26% to the true value of $19.81.

ACAS management has been shareholder oriented and is currently exploring restructuring alternatives that may unlock substantial latent value.

ACAS has a subsidiary, American Capital Asset Management, which may be the focus of the restructuring and which could generate substantial value for investors.

American Capital (NASDAQ:ACAS) is a business development company which had a near death experience in the Panic of 2008 but has rebounded smartly. It has a very large tax loss carry forward and has elected not to be treated as a RIC (regulated investment company); RIC status would exempt ACAS from corporate taxes (which ACAS doesn't have to pay anyhow because of the tax loss carry forward) but would also require it to pay out 90% of its income as dividends. ACAS has not paid out dividends the last several years.

I have written before about ACAS here, here, here and here and until recently it has had a nice run. I generally look at net asset value (NYSE:NAV) which was increasing rapidly in 2010-12 but slowed down last year. Current stated NAV is $19.29 a share but discounts in the pricing of ECAS (a European subsidiary) and in the valuation of certain bonds total roughly $137 million or 52 cents a share. This produces a fair value of $19.81 so that Friday's closing price of $14.73 provides the investor with a 26% discount from fair value. Until the end of the first quarter of 2014, ACAS was aggressively buying back shares which, with the stock consistently trading below NAV, tended to push NAV up. Management has announced a halt to the share repurchase activity and is analyzing restructuring alternatives.

A very important factor in the trajectory of the NAV and share price of ACAS has been its subsidiary, American Capital Asset Management (ACAM). The table below provides the NAV of ACAS and the fair market value of ACAM (in millions of dollars) at the end of the fourth quarter for the indicated years and at the end of the first quarter for 2014. The data is based on ACAS shareholder presentations provided in connection with quarterly financial reports.

Quarter ACAS NAV ACAM Fair Value
4Q09 $8.29 ------
4Q10 $10.71 $128.5 M
4Q11 $13.87 $396M
4Q12 $17.84 $828M
4Q13 $18.97 $870M
1Q14 $19.29 $805M

The current share count for ACAS is 263 million and it has been declining but we can estimate the amount of the ACAS annual appreciation that was due to increases in ACAM fair value and in 2011 and 2012 it appears that ACAM's appreciation in value was a major factor in the increase in ACAS NAV. It should also be noted that ACAM pays a dividend to ACAS each year; total payments of dividends, interest, and service charges were $103 million and $133 million in 2012 and 2013 respectively.

ACAM is in the business of asset management. I have been reviewing some of the leading asset management stocks including Blackstone (NYSE:BX) and Kohlberg, Kravis & Roberts (NYSE:KKR) and the sector generally did well coming out of the Panic of 2008. Asset managers generally manage mutual funds, private equity funds, hedge funds, pools of collateralized debt instruments, and other assets. They generally charge a fixed percentage fee based on net assets in the fund (the industry sometimes uses the term "earning assets" to denote those assets generating a percentage management fee). Typically, the percentage fee is in the 1-1.5 % range although this varies. Managers also get performance bonuses in the form of "carries" but these are contingent based on the fund's performance. Many managers also invest their own money in funds they manage on a "side by side" basis with investors. Wall Street is sometimes described as having a "heads I win, tails you lose" set of rules; for fund managers, it is really "heads we both win, tails you lose."

ACAM has been heavily, but not exclusively, reliant upon agency mortgage REITS (I have written about the sector here) generating substantial fees in its role as the manager of American Capital Agency (NASDAQ:AGNC) and American Capital Mortgage (NASDAQ:MTGE). The sector was very hot in 2010-2012 because agency mortgage REITs paid double digit dividends and the assets were protected from default risk by federal mortgage agencies. There were numerous secondary offerings in the sector which permitted managers to increase the amount of assets under management and therefore their fees. All of this took a nasty turn about a year ago and the sector took a dive in response to concerns about Federal Reserve "tapering" and the reality of sudden increases in interest rates. The table below provides earning assets under management and total assets under management in billions of dollars for ACAM at the end of the fourth quarter of each year and the end of the first quarter of 2014.

Time Period EAUM AUM
4Q09 $1.9 $7.4
4Q10 $2.9 $16.6
4Q11 $7.6 $62.1
4Q12 $12.4 $110.5
4Q13 $12.7 $87.2
1Q14 $12.8 $77.4

Total assets under management grew enormously because agency mortgage REITs use a tremendous amount of leverage and the levered part of the portfolio generally does not generate fee income to the manager. The decline in total assets under management appears to be due to a reduction in leverage in 2013 as the increase in interest rates negatively affected agency mortgage securities and the agency REITs managed by ACAM reduced leverage. The table shows the earning assets under management increased rapidly in 2011 and 2012 but flattened out in 2013.

ACAM manages other assets in addition to agency mortgage REITs (private equity funds and collateralized pools of debt instruments) and recently has launched a new BDC - American Capital Senior Floating (NASDAQ:ACSF). It appears that the agency mortgage REIT "pothole" is in the rear view mirror and that ACAM should be able to increase earning assets under management going forward although it is not likely to be at the pace of increase experienced in 2011 and 2012.

ACAS has announced that it is "undertaking a process to evaluate its corporate structure" and has more recently announced that it has retained Goldman Sachs (NYSE:GS) to assist in evaluating separating its investment assets from its asset management business. It has also announced a cessation of share repurchases pending the results of this exploration. It should be noted that ACAS has a very large tax loss carryforward and this will likely be a factor in determining the future direction.

ACAM is on the small side for a spin-off and a stand alone public company asset manager. The cessation of repurchases (at a time when the discount to NAV is relatively high) suggest that the future strategy may involve the deployment of cash. I think one possibility is either an acquisition or an aggressive effort to launch new funds and investment vehicles as a strategy to diversify ACAM's activities away from the agency mortgage REIT sector and to scale ACAM up possibly leading to a spin-off.

In any case, we will probably soon have a "catalyst" and, given management's track record of late, it is likely to be shareholder friendly. I think that the bull case here is fundamentally based on the discount to NAV and buttressed by the likelihood of a "catalyst" in the near future as well as the likelihood that NAV growth will accelerate now that the agency mortgage REIT "pothole" is behind us. I am long ACAS. I generally like the asset manager space and this makes me optimistic about ACAM; I am also long KKR and BX.

Disclosure: I am long ACAS, AGNC, BX, KKR, GS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.