American Capital (ACAS) reported 4Q12 earnings before the market open on 2/11/2013. It was a good quarter and an outstanding year. Although the rate of improvement has slowed from the extraordinary (but unsustainable) rates we experienced recently there continues to be encouraging signs of further returns. Our investment thesis continues to play out well.
We centered our investment on the company’s balance sheet improvements already underway but yet to be recognized by investors and overly cynical views continuing to punish the company for past issues. The balance sheet improvements continues (see graph below) but at a slower rate discussed below.
After successive quarters of improvement the company’s shares are still selling at a 25% discount to an improving book value of $17.84/share and a 29% to our current estimate of intrinsic value ($18.87/share) although the discount in shrinking.
4Q12 Highlights as Reported [Source]:
NAV per share
For the year 2012: $17.84 NAV per share a $3.97 per share, or 29%, increase over Q4 2011
For 4Q12: $0.45 per share, or 2.6% (10% annualized), increase over Q3 2012 NAV
Net Operating Income (NOI)
- For the year 2012: $1.16 NOI before income taxes per diluted share, or $383 million or $80 million over 2011; $1.20 NOI after income taxes per diluted share, or $397 million
- For 4Q12: $0.36 NOI before income taxes per diluted share, or $115 million or $31 million over Q4 2011; $0.26 NOI after income taxes per diluted share, or $83 million
Earnings Note: includes realized and unrealized appreciation in investment portfolio.
- For the year 2012: $3.44 net earnings per diluted share, or $1,136 million; 22% annual return on average shareholders’ equity; $162 million increase over 2011
- For 4Q12: $0.38 net earnings per diluted share, or $123 million; 9% annualized return on average shareholders’ equity; $471 million decline from Q4 2011
Stock Repurchase Plan
- For the year 2012: 34.8 million shares of ACAS common stock repurchased, totaling $362 million; $10.39 average price per share; $0.77 accretive to NAV per share
- For 4Q12: 8.8 million shares of American Capital common stock repurchased, totaling $103 million; $11.72 average price per share; $0.18 accretive to NAV per share
- S&P credit rating upgraded from B to B+
ACAS remains an attractive investment in my view for the following reasons:
1. Valuation: ACAS share price trades at a discount to the net asset value and intrinsic value implying the potential for a further 42% gain.
2. Return on Equity: Return on equity is a key performance measure for equity owners. At the 2012’s actual average return on equity of 22% when you can purchase the equity at todays discounted price of 29% the implied return to equity holders is actually closer to 31%. These rates of return on equity are being achieved with low leverage.
3. Strong Balance Sheet: The balance sheet is strong and accordingly the rate of improvement must decline simply because there is less room to improve. The S&P credit rating was upgrade from B to B+; the Net Debt to Equity ratio is 0.1 to 1 as of 12/31/12, and John Erickson, Chief Financial Officer commented, “With net debt of $304 million compared to equity of $5,429 million, our balance sheet is outstanding. In fact, our net debt is now about the amount of the liquidity we generate on average in a quarter.” Credit Suisse estimates the industry average Debt to Equity is near 0.49 to 1.
4. Capital Allocation:
Debt Refinance: Faced with historically low interest rates, in 2012 ACAS refinanced $2.4 billion of portfolio company debt. This will increase the value to our interest in these companies by lowering the cost of capital for the portfolio of companies.
Share Repurchases: ACAS’s policy is to repurchase ACAS shares when the price of the shares 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 will be paid. This strategy is being executed to the benefit of existing shareholders. Shares continue to sell at a discount to book and intrinsic value keeping this attractive option open for the use of capital.
5. Management Discipline: During the conference call management commented they were “bidding on companies quite a bit for several years now in terms of our One Stop Buyouts. And we have just not won those bids. The market is very competitive and so for the few companies that do come to — the few good companies that do come to market there is a lot of competition for them.” Later commenting, “So, it is very competitive and we’re maintaining our discipline.”
When markets get competitive and prices get dear it takes discipline to wait for a better pitch. ACAS’s management is in a sweet spot. As Warren Buffet likes to say they can wait for better pitches and never get called out on pitches. But in this case if they want to swing they have a good pitche whenever they want it, their own company selling a a discount. We argued before; “ACAS is doing due diligence to invest in other companies, how many potential 100% 42% 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?”
With the debt to equity ratio at 0.1 to 1 the opportunity exists to increase leverage to improve return on equity when the investment climate becomes more favorable for new investment in higher return opportunities.
Disclosure: Long ACAS