ACAS: NAV Up Again In 2Q2011

American Capital announced its 2Q2011 quarterly result, and the result is more of the same: secured debt decreased ($100m repaid; ACAS has a debt:equity ratio of 0.4:1), and net operating income increased (to $71m, 145% above the year-ago quarter). But this is not the metric that most interests me as ACAS recovers from the liquidity crisis that crushed the valuation of its portfolio assets and share price. The single metric that most impacts my assessment of ACAS' recovery is the increase management is able to achieve in net asset value.

This quarter, management increased NAV to $13.16, up 10% from $11.97 in 1Q2011 and up 44% from $9.15 in 2Q2010. This valuation increase still shows some undervaluation in assets, though: ACAS claims the value of its investment in ECAS is $933m, though the value of ECAS' assets (over which ACAS has complete dominion, just as it has dominion over ECAS itself) is $1.035B. (Note that the gap between asset value and ACAS' claimed "fair value" is decreasing; it's just not yet at parity.)

One might try to draw some conclusion from ACAS' realized losses and compare them to ACAS' unrealized gains. A familiar meme among critics and a repeated question in conference calls is whether ACAS is selling its winners to look good and getting stuck with a portfolio of losers. The fact that ACAS is able to achieve $179m in realizations is nice, but the fact that this resulted in a realized loss of $177m strongly suggests that ACAS is reclaiming unproductive capital from investments whose thesis didn't survive the crash and isn't sticking investors with dogs in the name of making a quarterly number. The realized loss is a decrease from the year-ago quarter, but ACAS realized a gain last quarter. Which brings us to ...

... what games ACAS might be playing with its books. As suggested by management previously, ACAS has just announced that it had, or by the deadline would have, failed a RIC test. Intentionally failing a RIC test was one of management's schemes to roll forward operating losses whose value would otherwise be lost to ACAS and its shareholders. Losses are a tax asset: they offset taxable income. Losing the loss would really suck, and the failed RIC test preserves the perishable asset for next year. Management said at the same time that it expected to meet the RIC test in the future: this is a tax planning stratagem, not some kind of business failure. What does that mean? ACAS may be accelerating losses into this year when they are available so that it will make the most out of its carry-forward opportunity. We usually get an opportunity to see how the quarter's business has affected the portfolio mix, but there's strong reason to doubt that with investments as illiquid as ACAS', there's a lot of power to move the timing of deals in a transaction pipeline. I don't think we'll see that the quarter's business has really changed the overall numbers for the whole ACAS portfolio, even if ACAS management were trying to rush losses and working to bargain up gains in a way that would slow their transactions into a later reporting period.

The quarterly announcement discusses things like unrealized appreciation (can't complain about $587m in unrealized appreciation, can you?) and net earnings ($410m), but these things don't affect its eventual obligation to pay a dividend on resumption of BDC status (that is driven by taxable income, not SEC-reported "earnings"). For the time being, the metrics that have my attention are NAV (what the company is worth) and NOI (what the company earns without swapping assets around). The NOI increase has definitely shown the increases I expected following the debt restructuring, and I look forward to viewing it as a barometer of the success of the company's portfolio companies.

With respect to the NAV and NOI, ACAS has one strategy that has bourne some interesting fruit. Over the last year, ACAS has grown assets under management not only by holding them while value recovered, but by having controlled companies issue equity to new investors. American Capital Agency's issuance has been accretive to shareholders of AGNC (i.e., has raised AGNC's NAV at each issuance), and has boosted ACAS' assets under management – and thus ACAS' management fees, a source of NOI. Whether the public has an appetite for shares of American Capital Mortgage Investment Corp will determine whether ACAS can use MTGE to effect more of the same.

The breadth of the portfolio companies' business across industries and geographies makes it sensitive to broad macro-economic conditions, which is why management's prediction of success bears the qualification "if the economy continues to recover." I think long-term bets are in favor of recovery, and especially as ACAS has 0.4:1 debt:equity and is no longer in debt covenant default, there's very little reason not to regard ACAS as a long-term investment. Indeed, I bought some during the quarter for my niece. This is the niece whose mother sold the AAPL I recommended ten years ago, because her broker told her it had already moved up. This ACAS purchase is an account I won't be handing over to my sister's broker.

See you next quarter :-)