Finance CEOs are usually tight-lipped on conference calls, but put them in a room of their peers -- bankers and analysts -- and they'll really open up.
Malon Wilkus, CEO of American Capital Ltd. (ACAS +0.00%), recently appeared at the J.P. Morgan SMid Cap Conference to deliver some very interesting tidbits of information to close observers.
Here's the "meat" of the presentation in fewer than 600 words:
1. The asset management business is gravy
American Capital's asset management business is its bread and butter, providing dividends in the range of $25 million quarter after quarter. The biggest slice comes from its management fees from its prized mREITs, American Capital Agency (AGNC +0.94%) and American Capital Mortgage (NASDAQ: MTGE).
American Capital Agency is the bigger mREIT of the two, holding $10 billion in fee-earning assets, on which American Capital Ltd. earns 1.25% ($125 million in annual fees). American Capital earns annual fees of 1.5% from American Capital Mortgage.
Asset management is a fantastic business because it requires little to no new investment to grow income. If there is any one business under the American Capital umbrella that "moves the needle," it's the asset management business.
2. Structured products are a cash machine
Second to the asset management business is the structured product business, in which American Capital invests in collateralized loan obligations and commercial mortgage-backed securities. Malon Wilkus commented that the CLO book earned a 17% internal rate of return over its history. The mortgage-backed securities business performed poorly, producing negative 18% internal rates of return.
The structured product business is a very small slice of American Capital's asset value, but like the asset management arm, it produces an outsized amount of net operating income. In the third quarter of 2013, structured products were valued at roughly 5% of NAV, but produced 21% of revenue.
3. Wilkus doesn't think BDCs are American Capital's peers
American Capital Ltd. is a business development company, much like Prospect Capital or Ares Capital. However, it is very different than most BDCs on the public market. For one, it doesn't pay a dividend. Secondly, it invests primarily in equity, not debt. Wilkus called other BDCs "finance companies," whereas American Capital Ltd. is more of an operating company because it invests heavily in companies it controls.
Wilkus believes American Capital is best compared to a diversified growth company like Roper Industries or Danaher, both of which own numerous subsidiaries that drive total corporate-level income. Alas, in the eyes of the regulators and IRS, American Capital is every bit of a BDC.
Comparing American Capital to Roper and Danaher is interesting. It's largely expected that American Capital Ltd. will eventually become a diversified growth company by splitting its debt and equity investment portfolios into two publicly traded entities. Such a move could help it realize a higher valuation.
4. Controlled companies are earning money
One of the problems with American Capital Ltd. is that it is an investment company. Thus, it doesn't report income earned by portfolio companies unless that income is paid to American Capital Ltd. as a dividend. The only insight into its portfolio company earnings comes from how American Capital values its investments in its operating companies in quarterly SEC filings.
Wilkus noted that its controlled companies were producing earnings before interest, taxes, depreciation, and amortization of about $720 million per year. In its presentations, we find American Capital's companies are also spending about $115 million annually on capital expenditures.
Though these numbers are not perfect -- the footnotes reveal they include estimates, and may be forward- or backward-looking numbers -- if they are even remotely correct, American Capital's control companies should be capable of paying big dividends back to their corporate parent.
American Capital has a plan to make its portfolio company earnings more transparent to investors. It will finance new buyouts in a way that will allow the parent company to collect routine dividends, which will flow directly to net operating income. Thus, dividend income going forward will be a proxy for how profitable its portfolio companies really are.
The Foolish bottom line
American Capital is between a rock and a hard place. It's a BDC unlike any other, which complicates investors' understanding of how it makes money, and how it should be valued. Recent efforts to make its portfolio more transparent should be applauded, but it still has a long way to go.
