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By yttire
October 24, 2008

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

This is a look at American Capital Ltd.

According to the CAPS rating this is a great buy. If we look at it, it has a yield of 36% kicking off a dividend earlier this month it appears of around $1.05. This must be too good to be true! How is it possible?

Of course, if you look at the company, it is a financial company. So we must ask, is this company being hammered with the rest of the financials because it is over leveraged and about to go broke, or does it have a solid foundation and is a screaming buy?

Probably they will cut their dividend if they are indeed bleeding cash, or at least, they should. Thus, the dividend doesn't tell us much.

About the company:

The Company is engaged in providing capital to middle market companies with sales between $10 million and $750 million. It primarily invests in senior debt, mezzanine debt and equity in the buyouts of private companies sponsored by the Company, the buyouts of private companies sponsored by other private equity firms and provides capital directly to early stage and mature private and small public companies.


They do offer debt on mortgage securities. Did they offer mortgage securities to subprime borrowers?

Are their borrowers going to default as the economy comes to a crawl, and then this company will simply go bust?

That appears to be what the street is pricing for this.

And it is difficult to tell at first glance.

Looking at their ten year income graph, it has a beautiful, upward curve.
http://quicktake.morningstar.com/StockNet/Income10.aspx?Country=USA&Symbol=ACAS

This would be fantastic curve in any other business. But in the business of offering debt, is it because they have been taking on extra risk?

Its revenue last year was 1,240 million dollars.

Its twelve month trailing revenues were -556 million dollars, according to Morningstar.

That is quite a drop in revenue!

In their 2007 annual report they state:

We have been particularly emphasizing that with less than 1:1 debt to
equity, we should be viewed as a haven in troubled times.


I am not sure how to interpret that seeing -556 in revenue.

They say further that as the subprime mess started to explode, they We reacted by accelerating our capital raising plans, exiting
many of our investments and making new lower risk investments
at better pricing, all in order to be as far ahead of the
contagion as possible.



With regards to their success in recessions, they state:
We are facing a difficult economic environment and we have
assumed for our business plan that the economy will be in a
recession in 2008. Therefore, it is important to remember that
we performed extremely well during the last recession in
2001, even though immediately prior to the last recession we
had a small, undiversified portfolio highly concentrated in
manufacturing, with few mature assets.



Looking at the 10Q for further clues to this stock (From June I don't see the third quarter), they list net asset value per common share at $27.01

They list losses in depreciation of investments of 1,261 million, and 406 million lost through shareholder distributions.

They have a nice list of consolidated investments, with details like:
63 million dollars lent to Affordable Care Holding Corp. with an interest rate of 15% a year maturing on 11/2013 (as I interpret this) Most of these take place as preferred stock, senior debt, or common stock investments.

If you scroll through the list, you come to "Commercial paper pass through certificate". What is that? Is that a credit default swap?

What is the potential loss on these?

Lets look at the total amount of these. If I am adding up this column right, which I may not be, it looks to be around 600 million of exposure to this. Note these holdings include "Wachovia", "Lehman brothers", etc. So it is safe to assume this portion of their portfolio is worthless.

They own a bunch of derivatives, but I am not able to ascertain what the risk on these are... they look like interest derivatives, but I am not sure if these are blowing up on them or not.

I see here For securities of portfolio companies for which we have identified the hypothetical secondary market as the principal market, we determine the fair value based on the assumptions that hypothetical market participants would use to value the security in a current hypothetical sale using a market yield ("Market Yield") valuation methodology based on an exchange valuation premise under SFAS No. 157.

Since the issue of interest here is the derivatives, I will include this from their 10Q We enter into interest rate swap agreements to match the interest rate basis of our assets and liabilities, thereby locking in the spread between our asset yield and the cost of our borrowings, and to fulfill our obligations under the terms of our revolving debt funding facilities and asset securitizations. However, our derivatives are considered economic hedges that do not qualify for hedge accounting under SFAS No. 133. Under GAAP, we record the accrual of the periodic interest settlements of interest rate derivatives in net unrealized appreciation (depreciation) of investments and subsequently record the amount as a net realized gain (loss) on investments on the interest settlement date. In the three months ended June 30, 2008 and 2007, the total interest benefit (cost) of interest rate derivative agreements included in both net realized gain (loss) on investments and unrealized appreciation (depreciation) of investments was $(10) million and $8 million, respectively. In the six months ended June 30, 2008 and 2007, the total interest benefit (cost) of interest rate derivative agreements included in both net realized gain (loss) on investments and unrealized appreciation (depreciation) of investments was $(16) million and $11 million, respectively.


And more interesting drivel which tells us if this company is a worthwhile investment or not American Capital also has investments in Structured Products such as investment and non-investment grade tranches of CMBS, CLO and CDO securities. During the three and six months ended June 30, 2008, we recorded $46 million of net unrealized appreciation and $315 million of net unrealized depreciation, respectively, on our Structured Product investments. Our CMBS portfolio, which includes a commercial real estate CDO, experienced $52 million of net unrealized appreciation and $214 million of net unrealized depreciation and our commercial CLO and CDO portfolios experienced $6 million of net unrealized appreciation and $101 million of net unrealized depreciation during the three and six months ended June 30, 2008, respectively. We value our Structured Product investments using the Market Yield valuation methodology. We estimate fair value based on third party broker quotes and cash flow forecasts subject to market participant assumptions regarding the investments' underlying collateral including, but not limited to, assumptions of default and recovery rates, reinvestment spreads and prepayment rates. Cash flow forecasts are discounted using a market participant's market yield assumptions that are derived from multiple sources including, but not limited to, third party broker quotes, recent investments and securities with similar structure and risk characteristics. The $46 million of net unrealized appreciation and $315 million of net unrealized depreciation during the three and six months ended June 30, 2008, respectively and the accumulated net unrealized depreciation as of June 30, 2008 of $499 million is driven primarily by dramatic widening of the investments spreads caused by the liquidity crisis in the market. The liquidity crisis has driven investors' expected returns on Structured Products. In general, there is not a liquid market for our non-investment grade Structured Product investments. However, there have been a few trades of securities of similar Structured Products in what is considered to be an illiquid distressed market during 2008, which has had the effect of decreasing the values of the overall Structured Products market. Our unrealized depreciation has generally not been driven by actual credit quality of the underlying loan pools as the investments have generally performed as underwritten.



We expect that we will hold these Structured Product investments until settlement or maturity. Based on our current assumptions of future default and recovery rates, reinvestment spreads and prepayment rates, we anticipate that we will realize upon the settlement or maturity approximately $476 million more in proceeds than the fair value as of June 30, 2008. The primary difference between the fair value as of June 30, 2008 and the anticipated proceeds at maturity is that the current market yields used to value these securities do not have an impact on our anticipated proceeds at settlement or maturity if our current assumptions of the future credit quality and cash flows prove accurate.


So this is the bomb on their books which is blowing apart the stock.

Now this I do not understand Our CDO securities are generally secured by diverse pools of bonds of other securitizations including commercial loans, CMBS and residential mortgage backed securities. Our investments are in four CDO funds managed by four separate portfolio managers. Certain of our CDO investments are in a joint venture portfolio company. As of June 30, 2008, our total investment in CDO securities at fair value was only $3 million, or less than 1% of our total investments. Our CDO securities are secured by approximately $2 billion of collateral, although senior creditors typically have claims against those loans that are superior to our interests.

They state they only have 3 million in CDOS, but this is backed by 2 billion of collateral? What does this mean? Why would you have two billion in collateral against only 3 million dollars?

So here is my summary:

I can't honestly tell if this is a good stock or not. Just reading through this, it seems they have high, but limited exposure to the mortgage failures.

More troubling is the fact that they basically own debt. In a recession, they will be subjected to defaulting creditors, and may blow apart. I think this is the real reason for the complete collapse of this stock, that the whole company could blow based on its business model, more so than its exposure to credit default swaps or bad mortgages. The entire business may be bad.

However, it depends completely on how this recession plays out. If it is short and sweet, then they will not have a lot of defaults, and they will clean up their books (write this stuff off and lose market capitalization) but be a great investment at this price (assuming this exposure is limited, which I can't really tell but it appears at first glance to be so). If the recession is long lived, this company looks like it is going into the grave.

So based on this (faulty analysis) it looks like a high risk stock with a possible high reward. Isn't that how it always is?

Can anyone else examine this and tell me what they think their exposure is?

Also can anyone see their latest 10Q (for the third quarter) and give us some info, this is all from the June 2008 10Q.

Thanks!


Technicals

It fell 12% today, so is in falling knife mode. I would wait for at least a 5% bounce before even considering buying this.

http://quicktake.morningstar.com/StockNet/SECDocuments.aspx?Country=USA&Symbol=ACAS
http://www.americancapital.com/investor_relations/annual_reports/2007/ACAS_AR_2007.pdf