ACAS Trade Idea

July 7, 2008

190

Market Thoughts and Trade Idea: ACAS

Courtesy of Daniel Jones at Options Notions

Markets have calmed a bit since the late-June selloffs. We’d like to say the fireworks have died down, but that would be too easy (and too lame) of a pun. As this newsletter is being penned, we’re seeing oil prices heading down $4 per barrel; the market news services are pointing to a stronger dollar and reduced Middle East tensions as the prime reasons for that move. We like to think that the VLO pick from last week still has some prime merit. If oil prices start to fall in the near future, that pick will perform very well.

Was last week the "tradeable bottom" we had been looking for? It’s tough to tell based on light pre-holiday trading. We’ll only know for sure by looking in the rear-view mirror, but it sure feels like we have come through a period of maximum bearishness. All we need is a cover of a major magazine trumpeting that we’re in a bear market, and it will be all over. Newsweek’s "Recession" cover of a few weeks ago was pretty close – maybe that will have to do for now.


Today’s Recommendation: American Capital Strategies, Ltd. (ACAS)

Private equity has literally gone to the dogs this year, and our pick this week is one of the lesser-known, but higher quality names in the industry. It’s not the "rock star" type of private equity company that makes headlines on a regular basis, like a Blackstone or a Fortress Group, but it’s got some very strong internals to it, despite having been pretty much the baby that is being thrown out with the PE bathwater this year.

American Capital Strategies (ACAS) is a principal investment firm specializing in management and employee private equity buyouts, acquisitions, recapitalizations, mergers and acquisitions, add-on acquisitions, securitizations, special situations, growth capital investments in middle market companies, early stage in mature private and public companies, corporate divestitures, acquisitions of portfolio companies of private equity firms, acquisitions of family-owned or closely held businesses, change of control, or the exit of minority shareholders, going private transactions, and ownership transitions.

The Special Situations Group invests in troubled and distressed situations including operational turnarounds, auctions, corporate and orphan carve-outs, portfolio add-ons, complex management buyouts and provides debtor-in-possession (DIP) financing, exit, mezzanine for sponsored buyouts, second lien refinance, and direct lending to distressed companies.

The Second Lien Group offers secured and unsecured junior capital investments to support an array of financing needs across a variety of industries primarily, focusing on syndicated junior capital opportunities sourced through the loan sales desks of the market’s growing junior capital arranger community. ACAS prefers to invest in manufacturing, services, and distribution companies. The firm also makes investments in companies that provide services or products to federal, state, or local governments, focusing on information technology for custom information technology solutions, technology and software enabling headcount reduction, technology and software enabling cost reductions in conducting transactions with or within government.

This chart shows ACAS for the last six months. The stock has been battered along with most of the other companies in the finance sector. ACAS is lumped in with the "closed-end fund" group in the S&P 500.

The Relative Strength Index (RSI) and Moving Average Convergence / Divergence (MACD) stochastic lines are both rounding out at low levels, indicating a bounce, at least on a technical basis, could be coming.

ACAS Fundamental Data:

Current Price: $21.70
Shares Outstanding: 202.9 million
Market Cap: $4.5 billion
Forward Price / Earnings (avg. Est): 6.9x
PE/G Ratio (5 Year Expected): 0.9x
Price / Book: 0.8x

ACAS’s revenues have been stymied lately, as the financing sector of the US economy has slowed. In 2Q07, ACAS saw revenues of $326 million, and this year, in 2Q08, analysts are expecting about $285 million in revenues. This equates to an annual decline when comparing quarterly numbers of about 12.5%. On an annual basis, revenues for the year ending 31 December 2008 will be around $1.15 billion according to the average estimate of the 18 analysts who follow this company. That’s down about 8% from 2007’s revenue levels which came in at $1.2 billion.

We think that revenue declines will bottom in ’08, and next year (2009) we will see a return to high annualized revenue levels of about $1.3 billion. This estimate is in line with the analysts’ best guesses as well, although some 2009 revenue estimates range as high as $1.5 billion. We want to be long-term owners of this company as it makes its transition through the trough of the financial crunch, and we want to be riding the recovery with them through the end of ’08 and into 2009.

ACAS pays a significant dividend to its shareholders, with the latest distribution being $0.31 per share payed for the most recent quarter. Annualized, that’s at least a 5% dividend yield on today’s price of $22 per share.

There is also a significant short position in these shares, with 31.8 million shares short as of June 2008, or nearly 16% of the outstanding float of the company. On ACAS normal daily volume, this equates to a short ratio of 14.9 days. There have been arguments posted in news articles and on blog sites on ACAS’ valuation strategies for some of the investments they manage. One of these arguments comes from Greenlight Capital’s David Einhorn, who is short these shares. The short-side argument is that most of the assets under management by ACAS are classified as "level 3" assets, meaning they are marked to model as far as quarterly or annual valuations. With over 170 portfolio investments, questions arose out of the mid-June investor’s meeting about the valuations and the methodology behind them. In early May, ACAS reported an $813 million loss, primarily driven by over $997 million in accounting writedowns on the value of investments in the portfolio. This act raised a number of questions about the value of the private equity portfolio.

The resulting collapse of the company’s share price has been fast and furious, as the chart above reflected. Not only have retail investors abandoned the shares, the professional short seller community has attached as well.

ACAS’ balance sheet currently has a cash cushion of just over $37 million. The debt they carry though, amounts to over $4 billion. This is prudent leverage on the assets that the firm has under management, and the annual operation margin (for a trailing 12-month period) is a strong 72%. Despite the accounting write downs, cash flow is still very strong in this company, with over $400 million in operating cash flow on a trailing 12-month basis.

Our recommendation this week is to buy ACAS stock at its present price of $21.70. We would also buy a November 2008 call spread in the $20 / $30 strike prices. We would look to acquire the ACAS Nov $20 call for $3.00, and write the Nov $30 call for $0.40, for a net cost of $2.60 to this spread. We would look to sell this call spread at a level of $8.00 or higher between now and the future expiration, giving us a return of just over triple the money.

We’ve heard from a few of our readers who just want straight option buy recommendations, rather than spreads. For investors who do not wish to write the higher strike call, a direct purchase of the November $20 call for $3.00 would be an alternative. We would look to sell that call at a level of $9.00 or higher.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.
Disclosure: Analyst has no position in ACAS stock or ACAS options.