American Capital Ltd. (NASDAQ:ACAS) reported a poor third quarter, mostly because of a writedown of its income stream from American Capital Agency (NASDAQ:AGNC) and American Capital Mortgage (NASDAQ:MTGE)
On the conference call, management reported three major developments that shareholders should carefully investigate:
1. mREIT management fees are priced for negative growth
In the last quarter, American Capital Agency and American Capital Mortgage reported less-than-impressive quarterly earnings. This time, that book value erosion hit to the heart of American Capital's management fees.
When asked how American Capital valued its fee streams from American Capital Agency and American Capital Mortgage, VP of investor relations, Pete Deoudes, noted that "Part of what we have in the models currently would be some form of capital base decline as the companies execute on their share repurchase programs."
That is to say that American Capital expects its two mREITs to see further declines in book value, with the model building in "any capital raises... projected to be out much further at this point in time."
What's that mean in non-corporate speak? Fee income from American Capital Mortgage and American Capital Agency will continue to fall. What growth the company does expect, if any, is perhaps months or years away.
2. American Capital is turning into a debt BDC
It's no secret that American Capital has more equity investments than your average BDC. Equity investments provide little to no cash flow, and thus American Capital's operating income has suffered as a result.
Just one look at American Capital's private finance mix shows its reliance on equity investments:
American Capital has a solution for falling operating income: Hold more debt investments. Not only will debt provide routine interest income, but it will also allow American Capital to pay itself larger dividends from its majority-owned companies. Previously, American Capital sold senior debt to other investors who could block dividend payments from its equity investments.
American Capital also revealed that, starting next quarter, it would break out dividends from its One Stop Buyout companies, in which it owns more than 80% of the equity. Doing so will allow investors to understand what kind of ongoing return it realizes from its investments. Currently, it only breaks out earnings from American Capital Asset Management.
Earlier this year, I criticized American Capital for its poor disclosures, noting that it was one of two things it needed to do before 2014. I'm encouraged by management's move to erase some of the opacity surrounding its majority-owned companies.
3. Slower buybacks ahead?
American Capital appears ready to make new investments a larger part of its capital allocation strategy. In recent years, virtually all of its available liquidity was used to repay debt or repurchase shares.
On the conference call, CEO Malon Wilkus said, "We feel like we have the opportunity to make new investments, as well as continue our stock buyback program," in response to a question from an analyst.
It's an interesting strategy. For years, American Capital has insisted on using cash for stock buybacks at prices below the company's net asset value. Now, management appears to have come around with the idea that it can repurchase shares and make new investments to grow operating income. At this point, shareholders are hyper-focused on operating income because NAV growth means very little if those assets can't generate cash flow.
After trading below NAV ever since the financial crisis, it's becoming apparent that the only way American Capital will ever trade at NAV is to increase residual operating income. Debt investments and new leverage help accomplish that goal.
The Foolish takeaway
American Capital nearly went to zero during the financial crisis, only to recover to nearly $14 per share. The company faces headwinds in its asset management business and inability to grow operating income, but a new strategy may help.
American Capital's fourth quarter is more important than ever as portfolio exits will fund new investments and share repurchases. Can management turn this stagnant ship around?