American Capital Ltd. recently posted an improved quarterly result. Net Operating Income was up to $0.19 per share in 4Q2010, and net earnings reached $1.08 per share. Return on equity in the quarter was at an annualized rate of 44%. Not bad. Over the quarter, ACAS increased net asset value (NAV) by $1.12 (12%) to $10.71. Compared to a year ago, ACAS' NAV is up 29%. Remember a couple years ago when ACAS traded under a buck?
At its 25th anniversary, American Capital was able to look back on a pretty good year. ACAS' full-year 2010 result included over a billion in net earnings ($3.02/sh) reportable under the SEC rules. (The SEC-reportable income isn't the same as IRS-reportable income, which is what drives ACAS' dividend-paying obligation. One major difference is that under FAS 157, ACAS is required to call capital appreciation "income" which private investors are not required to do in their own portfolios, because the tax rules call for recognition of income on disposition rather than on change in value. This factor – the difference between earnings based on valuation change and earnings based on recognition at disposition – is likely to make SEC-reported income and taxable income rather different since ACAS' business is investments.)
Slide #10 of the investor presentation shows ACAS has continued to experience consistent (though "lumpy") liquidity. Some of the liquidity results from borrowers making repayments of obligations outside of ACAS' control, and some results from ACAS acting to dispose of a portfolio company. ACAS hasn't been trying to dump portfolio companies, but pursuing opportunities and consummating those that were good deals. The 2010 realizations may total $1.3B, but they don't represent ACAS bailing out of its equity investments: of the billion-plus in principal payments, $874m consists principal prepayments (e.g., principal returned on exit from entire investments in which ACAS held both debt and equity) and $36m resulted from scheduled principal amortization. $40m came back to ACAS from syndications and sales of debt. ACAS' equity sales of $266m aren't trivial, but that's not where ACAS seems to have been reclaiming cash. Slide #11 shows that ACAS has gotten for its investments what ACAS has reported the investments to be worth in its quarterly SEC filings. Slide 14 shows that ACAS' investment portfolio statistics haven't changed much with ACAS' realizations (i.e., ACAS isn't selling off its best investments and collecting dogs that will later bite investors; it's selling a fair cross-section of what it's got left). One thing that's worth noting is that as a percent of the fair value of ACAS' assets, equity has grown from 27% of the portfolio's value in 1Q2009 to 40% in 4Q2010, which may simply reflect that in 1Q2009 there was no market for the equity of illiquid portfolio companies and now there is.
Following the close of 2010, American Capital continued repaying debt, not satisfied to have hit its debt:equity target ratio of 0.6:1. Over the last 6 quarters, ROE has been 44% (so 4Q2010 wasn't a fluke). From ACAS' book-value nadir at the end of 2Q2009, debt repayments have exceeded $2.1B, book value is up $1.8B.
What's the future hold? ECAS alone offers $234M in further appreciation based on evaporation of internal discounts. Expected performance of debt currently bearing a FAS-157-compliant "fair value" below face value promises a further $237M in increases. Capital loss carryforward stood at $590M at the end of calendar 2010, protecting ACAS from future tax expense while that loss carryforward is eroded by future income. Loss carryforwards protect ACAS from tax expense this year or dividend obligation in 2012, so gross results and after-tax results will be the same and liquidity can be kept rather than drained in mandatory dividends. Management believes the reports that the economy is recovering, and offered Slide #6 to suggest an association between GDP and ACAS' net earnings. ACAS' pickiness in deal selection has paid off: despite the worst recession in decades, ACAS has over the last couple of years exited control companies at higher multiples than at the time of purchase (of course, if EBITDA sucks, a high multiple may not save price; the behavior of the market generally still matters ... still, having multiples go up over this period is quite a feat).
ACAS has continued to pay down debt following the close of the 2010 calendar year (to the tune of another $150M). This doesn't reduce ACAS' interest rate, as it's as low as its current debt facility permits. Debt retirement presently provides ACAS a risk-free 9% return while strengthening ACAS' balance sheet toward the ability to borrow at more favorable rates. ACAS' management made it very clear that it didn't think its existing cost of borrowing was attractive: ACAS prefers to borrow at AAA rates, and will repay debt to get there. Share buyback, by contrast, constitutes a leverage-increasing transaction that impairs liquidity without improving the balance sheet: don't expect share buyback soon. ACAS would rather improve its portfolio and balance sheet than shrink the company with share buybacks. Refinancing would occur following the expiration of the August, 2012, yield maintenance provisions of its current debt agreements. Prepayment is available without fees, however.
The recovery program at ACAS is being conducted in two phases: (1) growing book value, then (2) re-starting the dividend. While book can still be grown tax-free (due to loss carryforwards), current shareholders benefit. Dividend resumption will turn on taxable net income following complete erosion of the loss carryforward, and will when it appears will signify that ACAS has made enough money long enough that the government again wants it paying 90% of its taxable income. It will also put ACAS back on the map for income investors. If the dividend is attractive, income investors can be expected to bid ACAS back out of its discount-to-NAV share prices.
ACAS has gotten out of a few lines of business: (1) Credit opportunities, (2) early-stage technology investment, and (3) second-lien investing and trading. American Capital's financial services business hasn't been active, but management welcomes that business as it becomes available. ACAS continues to seek new investment opportunities.
ACAS has continued to increase its funds under management, reduce its operating expenses, improve its net income, and grow its asset value. The future promises more NAV discount evaporation within ACAS' investments, and when (after 2012) ACAS re-initiates its dividend (which will be required based on taxable income) its own NAV discount will be reduced by income investors seeking regular returns based on ACAS' trailing-year taxable income. Management is focused on near-term book-value-building enterprises based on sound financial theory rather than gimmicks designed to game per-share metrics.
I have only accumulated shares since the liquidity crisis in 2008, and I expect the shares to continue appreciating under the management that's helped ACAS to recover so well since the liquidity-related collapse in 2008-9. By the time ACAS resumes a dividend, I hope to have come up with some scheme to migrate those shares into an account in which the dividend – which I expect to become substantial once more – will be less painful than in a regular account. I don't think I'll manage to move it all, though ... ahh, well.
Paying taxes on a huge dividend isn't the most awful thing that ever happened at the Jaded Consumer :-)