This article looks at three business development companies (BDCs), Prospect Capital Corporation (PSEC), BlackRock Kelso Capital (BKCC) and Main Street Capital (MAIN), and is a follow up to Part 1. I decided not to rank Gladstone Capital (GLAD) and Technology Investment Capital Corp. (TICC) in this analysis. GLAD recently reported quarterly results, beating revenue estimates by 7%, as well as having sufficient net investment income to sustain and potentially grow its dividend, unlike BKCC. TICC released preliminary results, missing expectations, which would be the second quarter in a row, but will release final results the week of March 11th. Also, I need to spend more time understanding TICC's recent $160 million collateralized loan obligation (CLO) investment strategy. I still get nervous when I hear the word "collateralized," and it currently accounts for 32% of the portfolio and growing. KCAP Financial (KCAP) has over 20% CLO as well, and I am long both.
These are the five general criteria I use to evaluate BDCs:
- Profitability (EPS, growth)
- Risk (diversification, volatility, leverage)
- Payout (sustainable, consistent, growing)
- Valuation (P/E, PEG, NAV)
- Analyst Opinions
For more detail, please see Part 1.
Here is an oversimplified chart evaluating these three stocks, along with the first three, among my universe of 30 BDCs, giving them a relative score between 0 and 10 (10 being the best). In reality, I use different weightings for each criterion. Again, in future articles, I will add the new companies to this chart, as well as updated info.
Prospect Capital Corporation
PSEC is one of the larger BDCs that constantly raises cash in the equity and debt markets. As with all BDCs, the key is good management that can keep a healthy pipeline of small to midsized companies to build a strong portfolio and keep the dividends rolling in. The number of shares has almost doubled in the last 12 months, making it difficult to normalize quarterly EPS. But in 2012, it announced origination records of over $2.25 billion, with more than $750 million in the last quarter. Since December 2010, quarterly net investment income has grown almost 400% from $19 million to $74 million, and EPS grew almost 200%.
As of September, PSEC's portfolio was heavily weighted toward consumer goods and services, but it recently announced additional investments in finance, healthcare, energy and industrial. PSEC has better than average leverage and volatility ratios.
Dividend yield is 11.7%, currently the highest in the group, and has a history of monthly increases since June 2010. This seems like one of the more stable dividends with good growth prospects, since its net investment income last quarter was $74 million, but only paid $51 million in dividends. So even with the dilution from recent offerings, PSEC has grown EPS well in excess of the dividends it pays. There is a slight chance of a special dividend this year, according to this earnings call last August, when the CEO said "we would have to distribute I think it's by May, somewhere in that timeframe, Brian -- in order to meet our distribution requirement for the August tax year. So we have plenty of time to meet that requirement. We're being very, very careful to make sure investors are seeing the dividend as a rock solid proposition." The only reason PSEC is not at the top of my payout rankings is the slow dividend growth rate, with the exception of the announcement last December, increasing it by 8.2%.
This stock is currently trading 4% above NAV, but it has grown book value 5% over the last 12 months. The P/E is among, if not the lowest, in the industry at 6.5 to 7 compared to an average of around 12, also giving it one of the lowest PEG ratios as well. This is why PSEC is at the top of my valuation criteria.
The analysts are lukewarm at best, and there might be a few reasons for this. One is the rapid growth and constant issuance of shares, and the stock price has yet to recover from the most recent one. Another is the $647 million in convertible notes that are going to be adjusted for a new conversion price due to the recent increase in dividends that triggered the new conversion rates. Currently, the first group of $150 million due in 2015 is the closest to being "in the money" at a conversion price of $11.35 before applying the new conversion rate, but they do have a "conversion rate cap" that should limit the liability. This is not my area of expertise, so I will leave it to someone else to comment, correct, or explain the potential impacts.
PSEC's earnings release is scheduled for February 7th. A few articles on SA have discussed the potential for a secondary offering after the release, which might be an opportunity to add to my position, especially if the stock drops below $10, as it did briefly after PSEC's last shelf offering in November. I consider PSEC one of "The Good" BDCs, along with Medley Capital Corporation (MCC).
BlackRock Kelso Capital
I have owned BKCC on and off over the last couple years and have done well. It has decent revenue growth, but annual EPS for 2011 was $1.00, 2012 is projected to be $1.01 and the same for 2013, yet it pays out $1.04. Net investment income for 2012 should be around $74 million with at least $76 million in dividends, making it breakeven at best. I don't expect much growth in the near term, since BKCC is turning down deals and taking a more conservative approach. In the most recent earnings call, the CEO stated, "We're working on a number of things that we were working on in the last quarter that didn't come to pass. They may or may not come to pass in the fourth quarter. So I certainly wouldn't expect the fourth quarter to be robust in terms of originations." This is not necessarily a bad thing and hopefully, it means the credit quality of the portfolio is better than most.
BKCC has one of the highest betas in the group, and tends to do poorly in down markets. However, its portfolio has become more diversified, and it looks like BKCC is becoming more cautious about the companies it invests in. Its leverage ratios are a little above average, but with good interest coverage, making it middle of the road in my risk category.
BKCC cut dividends in 2011, and it currently has a yield of 9.8% with little hope for growth until EPS can support. The stock is trading 12% above NAV and since 2010, NAV has declined slightly. BKCC has an average P/E, and I'm not sure how to calculate a PEG if there is no G.
Most analysts I follow, including the ones that actually ask questions on the earnings calls, rank BKCC a hold or sell. I know there are some people on SA that are bullish on BKCC, and I have owned it in the past, but I believe there are many other BDCs that offer higher growth with less risk. I'm going to have to put BKCC in "The Bad" BDCs category, at least for now, but there are worse stocks, like MCG Capital Corporation (MCGC).
Main Street Capital
MAIN is one of my larger holdings and has done very well, currently at an all-time high. It has delivered consistent quarterly growth in revenue, earnings, and dividends for the last two years. Over the last three quarters, it earned $41 million and paid less than $29 million in dividends, which is probably why it paid a special dividend to preserve its RIC status.
Main Street has one of the most diversified portfolios among BDCs with a good balance in consumer goods & services, energy, healthcare, industrials, materials, and technology. The one industry it seems light in is financials, but with stocks like PSEC, KCAP, and Solar Capital (SLRC), it balances out my overall BDC portfolio. MAIN has some of the best volatility ratios and seems to do well in down markets, putting it near the top of my risk category.
One issue I have with MAIN is that it has the lowest dividend yield of the BDCs I follow, with the exception of American Capital (ACAS), which does not pay a dividend. Even with the special dividend, the yield is low for two reasons: the first being the low payout ratio of income, and the other is the rise in stock price. The good news is that MAIN continues to increase its dividend in a consistent and fiscal manner, probably to ensure future growth and spillover taxable income (which as of September 30, 2012 was $30 million, or $1 per share), so we can expect to see special dividends as stated in the most recent earnings call.
The other issue I have is the valuation metrics. It's currently priced 85% above NAV and has almost the highest P/E ratios in the group, second only to MCGC. Obviously, it has a recent track record of growth, but I think it might be overvalued at this point.
Most analysts consider MAIN a strong buy, with the exception of First Call and Dividend Channel, but that's probably due to pricing. Again, I don't pay much attention to analysts and see them as a lagging indicator.
I'm looking to add to my position, but will wait for some pullback, so I consider MAIN a "Maybe," but I still like it better than Fifth Street Finance Corp. (FSC).
In my next article, I will cover three more BDCs.