Business Development Companies in General: BDCs lend to small and mid-sized businesses, with limited financial leverage, paying out most of their income to investors and pay little to no corporate tax. They operate in a market that is mostly overlooked by banks and their non-bank structure gives them flexibility to invest in multiple levels of a company's capital structure. Despite all the focus on investor yields BDCs seem to go unnoticed, in part due to the relatively small industry market cap of around $25 billion, but currently yielding 9% on average.
Prospect Capital Corporation (PSEC) reported results on February 7th with quarterly net investment income of $99 million almost three times as much as the same period last year and EPS of $0.51 compared to analyst expectations of $0.42. The NAV dropped a little from the previous quarter but is still above where it was the same time last year. On the February 8th earnings call someone asked questions about three concerns I outlined in Part 2. The first was regarding the convertible notes due in 2015 and the potential impacts. The CFO stated "Those impacts are almost negligible. I mean, they're very immaterial. So that price will not move more than $0.01." The second was regarding the potential for a special dividend to payout some of the accumulated spillover earnings. You can read the transcript but the answer was basically not anytime soon. The third was about a potential for secondary offering and again the short answer was not anytime soon. I adjusted the risk category down (less favorable) due to changes in portfolio composition and recent increases in debt though they still have better than average leverage ratios and interest coverage. Their P/E ratios are still among the lowest in the industry. For obvious reasons PSEC remains among 'The Good' BDCs.
Medley Capital Corporation (MCC) also reported last week with better than expected results. MCC doubled quarterly net investment income from the same time last year and had EPS of $0.39 compared to expectations of $0.36. The CEO stated "As we look forward in this quarter and further into 2013, we expect net investment income will meet or exceed the current dividend assuming we are able to deploy capital as planned". The payout category was adjusted up because of increased sustainability of the dividend and it's safe to assume they will keep up their dividend increases for the quarters to come. NAV continues to grow and they are still trading at a P/E less than 10. Due to increases in EPS and overall growth the profitability and valuation categories were also increased securing a position with 'The Good' BDCs.
Fifth Street Finance Corp. (FSC) was another company I reviewed in Part 1 that also reported last week. They matched the consensus EPS of $0.27 but still short of the $0.29 dividend. Revenues surpassed expectations due to the recently announced record of $422 million in gross quarterly originations for the quarter. Due to increases in EPS and overall growth the profitability and valuation categories were increased, however the payout category was adjusted down because they are still short of covering their dividends while continuing to issue new shares and show no signs of increasing payout anytime soon. FSC is still a 'Maybe' until there's a likelihood of dividend and NAV increases.
These are the five general criteria I use to evaluate BDCs:
- Profitability (EPS to cover dividends, growth)
- Risk (diversification, volatility, leverage)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (P/E, PEG, NAV)
Evaluation Detail: A well-managed BDC will have net investment income that matches distribution and I try to normalize EPS assuming they deploy capital consistently and consider analyst earnings expectations. Many of the typical market risks are involved with investing in BDCs; I focus on portfolio composition including credit quality, industry diversification, and investment concentrations, as well as market cap, volatility and leverage ratios, institutional ownership, and interest coverage. My primary concern regarding payout is if the company can sustain current distribution levels, consistency, and potential for increases. Analyst opinions are important but seem to be more of a lagging indicator. The metrics I use for relative valuation are mostly based on earnings and book value. For more detail, please see Part 1.
Below is an oversimplified chart evaluating the companies I have reviewed 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. In future articles I will add the new companies to this chart as well as update info.
Apollo Investment Corp.
- Market Cap: $1.68 billion
- Yield: 9.7%
- Div/EPS: 96%
- Div/Proj. EPS: 96%
- P/E: 9.9
- Price/NAV: 1.02
- Debt/Equity: 0.63
- Portfolio Yield: 11.9%
On February 6th AINV reported Q3 2013 results with EPS of $0.21 down from $0.22 the previous quarter but in-line with analyst expectations and covered their quarterly dividend of $0.20. Revenues have been stagnant for the last five consecutive quarters as they continue to retool their portfolio toward more secured loans that are longer term and less liquid than subordinated/mezzanine debt. There are pros and cons to this but I think the overall goal is to use the capital they have and improve the credit quality while maintaining portfolio yield. Their quarter-to-quarter expenses increased because of higher outstanding debt and average interest costs. The next two quarter are expected to look the same with $0.21 EPS.
They reported a decrease in net assets for the quarter due to their investment in Cengage Learning Acquisitions, Inc. which reported weaker-than-expected earnings resulting in Moody's lowering the credit rating by two notches and a decline in the value of the note equating to a $0.30 decline in NAV per share. They sold some of their position during the quarter, realizing a $24 million loss.
As of December 31, 2012, their portfolio had a fair market value of $2.63 billion invested in 71 companies in 27 different industries with 40% in secured loans, 48% in subordinated debt, 12% in common equity, preferred equity, warrants and collateralized loan obligations measured at fair value. AINV has one of the most diversified portfolios and a good balance among the major sectors with the exception of energy. Over the past year they established an energy financing team based in Houston and an aircraft leasing team in New York. The energy team has resulted in the closure of nearly $170 million of investments to date. There are two education based companies (one of which is ATI Enterprises highlighted in this Forbes article) on non-accrual status, representing approximately 3.2% of the portfolio on a cost basis. Loans are placed on non-accrual status when there is reasonable doubt that principal or interest will not be collected in accordance with the terms of the investment.
AINV has relatively high volatility ratios and has historically performed poorly in down markets including the financial crisis where the stock declined over 80%. During the same period other BDCs like Main Street Capital (MAIN) and FSC only fell 30% to 40%.
They had over $1 billion of total outstanding debt at December 31, up from the previous quarter because they issued $150 million of 30-year unsecured notes in early October at an interest rate of 6.625%. Their current debt to equity ratio of .63 is average but the interest coverage ratio of less than 4 times is on the low side and increasingly impacts EPS.
The current dividend yield is 9.7% and covered by net investment income after being cut early last year. I do not see the potential for dividend growth until EPS can support.
Various analysts have recently downgraded the stock citing reasons such as elevated risk levels and nearing the top of valuation ranges.
The stock is currently priced close to book value and the P/E of 9.9 is at or below other BDCs in the group. Coming up with a PEG for AINV could be challenging since EPS was $0.88 for FY 2012, projected to be $0.83 for FY 2013, and $0.86 for FY 2014. It reminds me of the growth (or lack of) pattern of BlackRock Kelso Capital (BKCC).
Until AINV focuses less on retooling their portfolio and more on growing net investment income, I would put it in the 'Maybe' category.