American Capital (ACAS): Q2 2008 Update

A brief rundown of Q2′s 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:

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).

More on this topic (What's this?)
ACAS is a Bargain Worth Buying
ACAS Dividend News
Are Drips Worth It?
Read more on American Capital Strategies at Wikinvest

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