Shorts Spike ACAS

American Capital, whose shares' short interest had declined to about 16% of the float, are back to over 19% of the float as of the close of trading yesterday. The assault of the shorts was made easier by the removal of ACAS from the NASDAQ list of securities subject to enhanced delivery requirements under Regulation SHO. With the stock off the list -- and it takes five days of violation to return to the list -- ACAS will be subject to selling with even less delivery requirement than characterized its selling in the last ... oh, half year or so. In July, ACAS had been on the list over a hundred days, and only left the list yesterday.

The increased selling opportunity means that from the standpoint of market mechanics, seller interest will have an easier time placing orders than buyers. The marginal increase in selling pressure will have an outsized impact on per-unit price. There's no ACAS-specific news that would impact the valuation proposition. While everyone is in theory subject to depressed earnings in the event of a protracted recession, ACAS' low leverage and consistent operating earnings suggest ACAS is more a safe haven than a risky buy.

Today I was joking with someone about waiting for shorts to create a buy op at $9. Maybe it's not a joke. The thing that I keep asking -- to no answer -- is why ACAS' hundreds of sound portfolio companies should be on sale so far below their apparent ability to produce earnings. At these prices, ACAS could suffer terribly from a destroyed marketplace and still be a good buy. At half its dividend, it would produce a yield of about 20%. However, ACAS hasn't cut its dividend, but has reiterated more than once that it will pay $1.10 per share in dividends for the next quarter.

The only sign of "backtracking" to be found in ACAS is that ACAS' description of the 4Q2008 dividend has been clarified into $1.05 of ordinary dividend -- the same as the dividend paid Oct. 14 -- plus a "bonus" of $0.05. The designation of 5¢ of the last dividend of the year as including a "bonus" rather than being entirely a regular dividend is likely an effort by management to stick with its prior dividend guidance while not obligating itself to never-ending dividend increases while the economy appears poised on the brink of what may be a protracted recession. ACAS' management has made clear that it views the dividends as an objective performance meter, and stated in its 2Q2007 earnings call that it intended never declaring a regular dividend it would have to lower. By designating only $1.05 of the 4Q2008 dividend as a "regular" dividend, ACAS opens the door for maintaining a $1.05 regular dividend -- the level it paid in 3Q2008 -- without facing the charge that ACAS had been forced to cut its dividend, or that management had been unable to maintain its intended dividend policy.

The November 10 earnings announcement and its associated conference call will definitely offer concerned investors illumination into the company's thinking about the developing economic situation, and its impact on the company.

Although ACAS' "blackout" dates, set by its compliance officer as disclosed in its 2Q2008 earnings conference call, have made share repurchases under the $500,000,000 buyback authorization something of a rare bird, the theoretical prospect raised by the current price depression is interesting. When ACAS announced its share buyback plan, the authorized amount seemed set to enable ACAS to retire "almost 9% of the company's outstanding shares". At $11 a share -- above ACAS' current trading price -- ACAS could buy back quite a bit more of ACAS' outstanding equity. Given that ACAS spent only $6 Million in share buybacks so far (0.2 million shares as described in ACAS' 10-Q from the first quarter, and zero in the second quarter), ACAS could theoretically spend $494,000,000 on buybacks under its existing authorization for as many as 44,909,909 shares -- over 21% of the company's outstanding shares. Retiring 21% of its outstanding shares would boost an operating income per share of 70¢ to over 89¢ a share. This would go a long way toward reducing the impact of a deal slowdown brought on by a protracted economic slump.

Does ACAS actually suffer from such a slump, though? We've seen that ACAS' earnings attributable to deal closings is "lumpy", and we've heard ACAS claim that the problem wasn't yet preventing those operating in its market segment from making deals. If ACAS' deal flow and cash flow are good, but the market as a whole is circling the drain and pressuring ACAS shares downward, perhaps ACAS' best use of its cash is to wait for ACAS shares to get even cheaper. At $7.95, ACAS would be able to retire 30% of the shares oustanding after ACAS issued 8.7 million shares for $36.41 in March, and another four million shares at $35.61 under a forward-sale agreement disclosed in the second-quarter 10-Q.

The fact that the forward-sales agreements are exhausted and that ACAS' trick of raising capital with above-NAV issuance is unavailable, it'll be important to see just what ACAS achieves when it announces its third-quarter results on November 10. The fact that ACAS received in cash 30% of the purchase price, when ACAS sold Contec Holdings Ltd. to Bain Capital, says something about the flow of ACAS' portfolio company exits as a source of cash. The question is how much cash flows directly to ACAS, and how many such deals ACAS works out in the quarter. November 10 should provide some valuable education in the reality of ACAS' ability to create liquidity from deal flow.

In the meantime, ACAS is at record lows. Whether this proves a bargain or not likely turns on the evidence adduced November 10. For my part, I added shares in an IRA at 11 today, so you know how I expect this to turn out. However, market mechanics will continue to rule trading prices until the market participants become less fearful and less illiquid: it'll be much easier to sell than to buy.