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We maintain our Neutral recommendation on American Capital Ltd. (ACAS - Analyst Report) as first-quarter 2011 earnings outpaced the Zacks Consensus Estimate. The results were also ahead of the prior-year quarter’s earnings.

In May, American Capital reported first-quarter 2011 operating earnings of 23 cents per share, surpassing the Zacks Consensus Estimate by 5 cents. The results were also ahead of the prior-year quarter’s earnings of 17 cents per share. The favorable outcome was due to a drop in operating expenses, partially offset by a decline in interest and dividend income in the reported quarter.

American Capital is focused on de-leveraging and de-risking its balance sheet. The company met the goal of reducing leverage and operated with an average debt-to-equity ratio of about 0.6 to 1.0 at the end of 2010 followed by 0.4 in the first quarter of 2011. The company intends to raise leverage in future based on balance sheet securitizations. Future investments would have a substantially higher proportion of debt versus equity investments in order to derisk the asset mix.

During the quarter, American Capital boosted by its success in 2010, continued to strengthen its balance sheet. The company paid down an additional $517.0 million of debt, including $300.0 million of secured debt due 2013, and improved its asset coverage ratio to 336.0%. The company continued to see strong liquidity in its portfolio during the quarter and focused on maximizing the value of investments through organic growth for generating shareholder value.

American Capital’s ability to fund the entire capital structure is a competitive advantage, which in turn, will facilitate in completing many middle-market transactions. The company sponsors One-Stop Buyout by funding the entire transaction. Moreover, if American Capital feels it is the appropriate time to sell the portfolio company, the company may provide the buyer with the appropriate debt financing to supplement its equity for funding the transaction, a capability lacked by most competitors.  Therefore, we continue to believe that the company’s capital flexibility and large deal flow will provide it with excellent investment and exit opportunities going forward.

On the flip side, as a Business Development Company (BDC), American Capital’s asset coverage must be at least 200%. With the company achieving asset coverage of 336% at the end of the March quarter, it does not have any restrictions on its ability to pay dividend. However, the company anticipates capital losses to be carried forward into 2011 tax year. As a result, we do not expect dividend payments to resume in the near term.

Furthermore, American Capital has been significantly impacted by the negative developments in the financial markets worldwide over the past three years, which have led to a recession in the U.S. and other countries. The global financial crisis has limited the company’s access to the debt and equity capital markets and resulted in significant depreciation of its investment portfolio and overleveraging of balance sheet. Therefore, we believe limited accessibility to capital and increased funding costs have weakened American Capital’s strategic position in its sector.

American Capital currently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. However, American Capital’s closest competitor – MCG Capital Corporation (MCGC - Snapshot Report) retains a Zacks #2 Rank (a short-term ‘Buy’ rating).

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