ACAS: Portfolio Includes Recession-Weathering Brands

American Capital Ltd. (ACAS) has been slammed over the last year or so, with share price losses in the range of 90%. Those of us with options exposure needed cardiac treatment to return to the dinner table. Net Operating Income (NOI) has decreased as the economy has battered ACAS' portfolio companies' ability to service debt owed to ACAS, much less to make the growth targets ACAS bargained for when it invested.

As news outlets chatter about whether the economy has hit bottom, it is worth looking at what ACAS has done to protect itself.

Repair, Not Replace
ACAS owns the nation's largest transmission repair network. AAMCO Transmissions, which under ACAS' leadership acquired Cottman in 2006 (I've seen and know both transmission companies' outlets), has 1,100 retail outlets and grossed something like $600m/y back when people were still buying new cars. Now that drivers are tightening their belts, fixing the old car is a bit more attractive than risking good money on a new auto whose value will plummet measurably as one puts the first mile on the odometer.

A 2007 One-Stop-Buyout also gave ACAS control of vehicle fleet supplier Imperial Supplies LLC. ACAS' subordinated debt holdings have a fair value equal to their face value, $22.3m (on a basis of $22.1m), its redeemable preferred stock holdings have a fair value of $22.1m (on a basis of $15.2m), and its common and convertible preferred have zero and little value, respectively, totaling $1.2m on a combined basis of $31.5m. Equity in illuquid companies is apparently considered valueless, whereas the same companies' current debt is worth the number printed in the corner. ACAS earns 16% on the subordinated debt, and for the debt to be valued at face it would appear that the debt is both current and supported by adequate underlying business metrics for the forseeable future -- giving apparent lie to the zero value assigned to the company's common shares.

Sweet, Sweet Profit
In a 2007 One-Stop-Buyout, ACAS bought the New England Confectionary Company, purveyor of those candy hearts everyone buys around Valentines' Day. NECCO also owns other brands, like the Squirrel Nut Zipper (apparently resurrected after the emergence of the Big Band of the same name) and Clark bars. Buffett noticed the money to be made owning and nurturing the business of Sees Candies and snapped it up for Berkshire Hathaway. Wilkus' team has done the same with NECCO. Candy is both a cheap thrill and a high-margin business, dependable when times are tough.

ACAS' existing investment in NECCO Holdings Inc. includes debt and equity, and has a basis of $4.3 million. Its fair value at the last quarterly filing was $8.1m. ACAS also has an investment in NECCO Realty Investments, which is likely related (despite both subject-matter differentiation and a lack of description of the realty business on ACAS' site) because of the involvement of ACAS' realty business in its Special Situations Group's identification of NECCO as a buy. In deciding NECCO was a buy, ACAS specifically mentioned NECCO was a value-oriented purchase. Despite the apparent collapse in real estate markets, ACAS' investment in NECCO Realty Investments LLC has a last-quarter fair value of $48m, up from ACAS' basis of $42.4m. Both NECCO units pay ACAS double-digit interest on senior debt ACAS continues to hold, and ACAS' investment in both is overwhelmingly comprised of senior debt bearing 12% (NECCO Holdings) and 14% (NECCO Realty) interest rates.

Taking Care of Business
Since a One-Stop-Buyout in 2007, ACAS has owned SMG Holdings, Inc., operator of 98% of the publicly-owned exhibition space operated by private companies in North America. This includes the million-sqare-foot Reliant Park, which since opening has been home to the Houston Livestock Show and Rodeo -- which as the astute reader surely knows is the world's largest rodeo. Now that the Summit has closed, it's one of the best places locally to see ZZ Top (in that the Reliant is an indoor venue). It's also the longtime locus of the biggest chili cookoff I know. (An account here.)

But enough about the Rodeo. Millions of square feet and countless visitors attending seminars, graduations, parties, competitions, concerts, training programs, trade shows (like the Offshore Technology Conference), and every type of gathering you can imagine all support SMG's business and that of its restaurants and accommodations businesses. Major arenas are also a great place for SMG to ply it consulting business, which includes naming rights and sponsorship support. Since its founding in 1977, SMG has grown to operate hundreds of venues and has tens of thousands of employees worldwide.

ACAS' existing positions in SMG's senior (8%) and subordinated (12.5%) debt retains a fair value equal to its face value, $126.6m; ACAS equity positions are carried at $101.2m (from a basis of $147.3m). (ACAS presumably successfully syndicated other debt to banks or other buyers impressed with ACAS' willingness to hold subordinated debt and even equity for the indeterminate future, or invested non-ACAS funds managed on behalf of third parties.) ACAS' investment is likely intended to last through the maturity of the debt, in 2014 and 2015 (management has explained it intends holding most debt through maturity), allowing ACAS to benefit from the broad growth of demand for large public spaces for entertainment, education, and business purposes in the nation's population centers.

Good For Your Health
ACAS owns a health practice manager, Affordable Care Inc., which it has funded to acquire multiple dental practice managers. As health care continues as a major American enterprise and obtains a higher profile as a subject of increased funding initiatives, ACAS demonstrates foresight to be in a position to profit from these trends.

ACAS holds investments in Affordable Care Holding Corp. (15% subordinated debt with face value of $65.1m, valued at $65.1m on basis of $64.3m, convertible preferred fairly valued at ACAS' basis of $85.6m, and common stock valued at $13m from a basis of $17.7m), "Health Care Providers and Services" portfolio company MW Acquisition Corp. ($35.1m on basis of $38.4m, an investment that includes $25.2m in face value of 16.2% subordinated debt and a presumably controlling interest comprising common and convertible preferred shares).

Future Shock
ACAS doubtless holds numerous other companies that are less well positioned for rough weather -- companies having trouble paying their debts, and sporting "fair values" well south of basis. However, ACAS' effort to prepare for economic doldrums may have provided it with some seriously stalwort revenue sources for rough times even if ACAS' effort didn't result in de-leveraging before the combined effect of Fas-157 and a credit panic collapsed share values. As the economy turns around, portfolio companies less prone to blossom in harsh weather may begin turning in their bargained-for results: entertainment companies, sporting goods, luxury items, and so forth. In the meantime, ACAS looks forward to steady payment from high-profile holdings like AGNC, but also from little-known holdings carefully positioned to maintain steady performance as the world tightens its belt but continues to need to drive, buy sweets for its sweethearts, fill the occasional dental cavity, and attend business meetings and the occasional graduation or major conference.

ACAS' power to grow is potentially amplified by the fact that much of the common stock on its books is carried with a "fair value" that is zero. Other than a bankrupt, would a company really trade at zero in an open market? Yet, even where ACAS' preferred stock (the means by which it presumably exerts control in these situations) has a value, its common stock holdings (whose basis is also sometimes zero) is often nil. How good is a valuation like that for estimating ACAS' eventual exit values, or the current value of an investment's future income streams? As ACAS' portfolio responds to the eventual springtime of the economy, I expect fair-value surprises -- perhaps first seen at exit -- to become a regular fixture in ACAS' economics.

In the meantime, let's keep an eye on NOI and the developing debt issues.