American Capital Remains Neutral

We have reiterated our ‘Neutral’ recommendation on American Capital Ltd. (ACAS - Analyst Report), following a detailed analysis of the company’s fundamentals in light of the current economic environment. Also, the restructuring efforts by the company have contributed to this stance.

In February 2012, American Capital announced the divesture of its portfolio company Aptara Inc., following the divesture of another portfolio company - CIBT Solutions Inc. in January. In addition to this, the company continues to lessen risks from its balance sheet through a number of initiatives like repayment and restructuring of debt. We expect these restructuring initiatives to significantly improve the company’s financials over time.

Moreover, American Capital continues to see strong liquidity in its investment portfolio and is focused on maximizing shareholder value through organic growth besides originating new and attractive investments. Further, the company looks forward to utilize opportunities in Europe as the latter goes through some difficulties, particularly in the capital markets and with respect to sovereign debt. Also, new investment opportunities in U.S. are expected to continue along with the economic recovery.

American Capital remains an attractive pick for yield-seeking investors. During the second-quarter, the company repurchased 9.1 million shares of its common stock at an average purchase price of $9.34 per share. Earlier in the first-quarter, the company extended the program, initiated in 2011, for stock repurchases or dividend payments through December 2013. Moreover, Fitch Ratings lifted its outlook on American Capital to ‘Positive’ from ‘Stable’ as part of its review of six Business Development Companies based on the company’s steady earnings performance.

The capital deployment efforts and the authorization of the new share buyback program as well as the rating upgrade by Fitch raise our hopes for an enhanced investor confidence in the company.

On the flip side, we believe that American Capital’s earnings continue to be affected by the spread between the interest rate on investments and the interest rate at which it has borrowed funds. An increase or decrease in interest rates could reduce the spread between the investment rate and the borrowing rate, thereby adversely affecting the overall profitability.

American Capital was significantly impacted by the negative developments in the financial markets worldwide over the past years. The global financial crisis limited the company’s access to the debt and equity markets and resulted in significant depreciation of its investment portfolio and overleveraging of balance sheet.

The reduced volume of mergers and acquisitions in the market place affected American Capital’s ability to continue generating additional liquidity through the sale of portfolio investments. The company also witnessed several payment defaults on its financial obligations. Though situations are slowly easing off, we don’t expect stability in the near future.

We believe that the risk-reward profile of American Capital is currently balanced and hence, we have reiterated our ‘Neutral’ recommendation on its shares.

American Capital currently retains its Zacks #3 Rank, which translates into a short-term Hold rating. One of American Capital’s peers, Ares Capital Corporation (ARCC - Snapshot Report) retains a Zacks #2 Rank (a short-term Buy rating).