American Capital (ACAS) reported 3Q12 earnings after the market close 10/29/12. It was another solid quarter: our investment thesis is playing out well and as a bonus we can anticipate continued gains as intrinsic value increases.
You will recall in our thesis ACAS after many years of successful performance was severely punished during the financial crises. The valuation of its equity holdings declined precipitously and the company found itself in violation of loan covenants and facing possible bankruptcy. ACAS share price plunged and was further hurt by share dilution through restructuring, dividend suspension, and shattered confidence in
We centered our investment on the company’s balance sheet improvements already
underway but yet not recognized by investors and overly cynical views continuing
to punish the company for past issues. Balance sheet improvements were already
underway at the time of our initial investment (see graph below) and improvement
Even with many successive quarters of improvement the company’s stock remains attractively priced in my view with shares selling at a 34% discount to an improving book
value of $17.39/share.
Our original 3-5 year estimate was a book value of $18.87/share and that will likely be achieved in one year or so; much faster than anticipated. So, should we consider selling and take profits? I don’t think so because management’s capital allocation strategy will likely continue to provide additional improvement for some time while we maintain a healthy margin of safety.
Share repurchases vs. dividends:
ACAS is a Business Development Company (BDC) and prior to the crises operated as a
Regulated Investment Company (RIC). RICs do not pay corporate taxes by agreeing
to pass profits directly to shareholders as dividends. To qualify as a RIC the company must derive at least 90% of its profits from investment activities and pay out 90% of its earnings as dividends among other requirements. Prior to the crises ACAS became a favorite of income oriented investors because of the robust dividends paid.
During the crises ACAS incurred substantial losses, suspended the dividend and subsequently made the decision to convert to a Chapter “C” corporation structure so it could utilize the net operating losses (NOL) incurred during the crises. By doing so loss carry forward provisions in the tax code provided more funds for the purchase of its own shares at a large discount to the net asset value of the company on a per share basis.
In our 2/17/12 post on 4Q11 results we argued in part for; “…more aggressive share repurchases at the existing 50% discount to company value. ACAS is doing due diligence to invest in other companies, how many potential 100% return investment
opportunities are they looking at that can beat the share repurchases? Doesn’t ACAS’s management know ACAS better than any prospective company out there making this a low risk high return opportunity?”
ACAS board adopted a policy to enable repurchases of shares when the price of ACAS
common stock is at a discount to the book value of the shares. When the price of ACAS shares is at a premium to book value cash dividends are paid. They continue to follow this strategy to our benefit and will likely continue until the remaining $511 million deferred tax assets accumulated during the crises are exhausted.
Typically owned by income investors for the dividends ACAS is being avoided because it is not paying the dividend. This in my view is helping to maintain the gap between
book value and share price allowing continued share repurchases. The share repurchases at these discounts is increasing the book value and share price more per year than the dividend payment would be otherwise.
Management is purchasing for us shareholders $1.50-2.00 of assets for every $1.00 they don’t pay us in dividends. I’ll take that deal all day long because it provides a higher return and book value (and share price) than the dividend we would have received could provide elsewhere. It’s the difference between a short and long term investment orientation. Ironically income investors could sell some of their appreciated shares, use the gains as income, and still come out ahead.
Until the dividend is reinstated we will likely continue to see share price lag behind book value giving management opportunity for more beneficial share purchases. On exhaustion of the deferred tax asset the company could convert back to a RIC and pay an attractive dividend. For example, even at the current book value of $17.39/share and applying the historic price to book value multiple of 1.4X (for the RIC structure when dividends are paid) we can anticipate a share price of approximately $24/share. Even returning to 1.0 X book value and assuming some other corporate structure we can anticipate a further 51% gain assuming no further improvement in book value.
3Q12 Highlights as Reported:
$17.39 Net Asset Value (“NAV”) Per Share:
- $0.77 per share, $96 MM or 5% increase from Q2 2012
- $5.47 per share, $1,360 MM or 46% increase from Q3 2011
- $0.27 net operating income (“NOI”) before income taxes per diluted share, or $90 MM
- $0.60 net earnings per diluted share, or $196 MM
Stock Repurchase Plan:
- 11.4 MM shares repurchased for $125 MM at an average price of $10.99 per share
- $0.23 per share accretive to September 30, 2012 NAV per share
- Per share impact equivalent to $71 MM of additional retained earnings
Refinanced Secured Debt with a $600 MM Four-year Term Facility and obtained a New Four-year $250 MM Senior Secured Revolving Credit Facility
There is nothing not to like here and ACAS remains an attractive investment opportunity even at today’s prices.
I am long ACAS.
The information contained herein is provided for informational purposes only, is not
comprehensive, does not contain important disclosures and risk factors associated with investments, and is subject to change without notice. The author is not responsible for the accuracy, completeness or lack thereof of information, nor has the author verified information from third parties which may be relied upon. The information does not take into account the particular investment objectives or financial circumstances of any specific person or organization which may view it. Nothing contained within may be considered an offer or a solicitation to purchase or sell any particular financial instrument. Any investment can be very risky and is not suitable for everyone. You should never enter into an investment unless you can afford to lose your entire investment. Always complete your own due diligence. Before making any investment, investors are advised to review such investment thoroughly and carefully with their financial, legal and tax advisors to determine whether it is suitable for them.
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