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American Capital Remains Neutral

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We maintain our Neutral recommendation on American Capital Ltd. as second-quarter 2011 earnings were in line with the Zacks Consensus Estimate. However, the results were ahead of the prior-year quarter’s earnings.

In August, American Capital reported second-quarter 2011 operating earnings of 20 cents per share, in line with the Zacks Consensus Estimate. The results were ahead of the prior-year quarter’s earnings of 9 cents per share. The favorable outcome was attributable 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 two quarters of 2011. The company intends to raise leverage in future based on balance sheet securitizations.

During the quarter, American Capital was boosted by its success in 2010 and in first-quarter 2011, and continued to strengthen its balance sheet. The company paid down an additional $100.0 million of debt and improved its asset coverage ratio to 376.0%. The company continued to see strong liquidity in its portfolio during the quarter, focusing on maximizing the value of investments through organic growth for generating shareholder value.

During the second quarter of 2011, net asset value per share grew $1.19 over the prior quarter to $13.16, delivering a 38.0% annualized return on equity. The company has experienced eight successive quarters of net earnings on investments, and earned $844.0 million in the first half of 2011, an 80.0% surge over the prior-year period.

Further improvement of the portfolio performance depends on the economic recovery and therefore American Capital remains focused on improving balance sheet, growing portfolio companies and initiating high quality investment opportunities.

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 376% at the end of the second quarter, it plans to resume its cash dividend payments by the end of 2012. However, the company expects to incur a taxable ordinary loss along with a net long-term capital loss in the near term, which might act as a deterrent in the dividend payment.

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

The market disruption and liquidity crisis also dramatically reduced the volume of mergers and acquisitions in the market place, thereby affecting the company’s ability to continue generating additional liquidity through the sale of portfolio investments. The company also suffered payment defaults on its financial obligations. Though situations are slowly easing off, we do not expect stability to come in the near future.

American Capital currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. American Capital’s closest competitor – MCG Capital Corporation also retains a Zacks #3 Rank.

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