Medley Capital Corporation (MCC) IPOed on January 21 of 2011 at a price of $12.20 - and the price has been slowly rising ever since. The dividend for the first full quarter was $0.21/share - and has now risen to $0.36/share. But the dividend has been $0.36 for three straight quarters, after rising for the first four quarters. MCC has formal pre-license approval for issuing SBIC debentures - which is the cheapest form of long-term debt for BDCs [Business Development Companies]. That will aid in keeping net investment income at more than 50% of total investment income. BDC dividends are funded by net investment income [NII]. Thus the higher the percentage of total investment income [TII] that falls to net income, the better.
There is no 'one key' to BDC investing. But it makes sense that, if one could do a rough [but reasonably accurate] NII projection, you are one step ahead of the market. I do simplistic top down projections. How? I take the average portfolio yield times a projected portfolio amount for dollars invested in income producing assets. I then add to that a good run rate for fee income. I pause and compare what I have for TII to the TII for the last four quarters and the revenue projections done by the analysts. That revenue project can be found at Yahoo Finance. My revenue projection, the historical actual TIIs and the consensus analyst projection should be in the same neighborhood and moving in the same direction. I then generated an expense projection using the trends in NII to TII ratios. TII times the NII/TII ratio generates the NII expectation. That projection is compared to the NII for the last quarter and the 2013 analysts EPS projections. For BDCs, forward EPS projections are NII projections.
If you can build a logical case that the current consensus EPS projection is wrong - then the valuation [and price for] the BDC is wrong. This is a big red flag if the analyst projections are high - and a big green flag if the analyst projections are low. MCC is a relatively simple BDC to show an example of NII projecting.
In this article, I will show my Q4-12 metric intensive update for MCC; show my NII projection; show my analysis of MCC's current valuations; tell if I see green flags or red flags in the numbers; and go off on a tangent about BDC valuations in general.
MCC Reports NII of $0.3883 compared to a Dividend of $0.36
Medley Capital Corporation reported for Q4-12 Total Investment Income of $17.719 million [$0.7154/share] and Net Investment Income of $9.617 million [$0.3883/share]. Fee income was $2.879 million. The NII/TII ratio was 54.28%. The Net Increase in Net Assets Resulting from Operations was $9.613 million [$0.3881/share]. There was $2.4 million of fee income in Q4-12. The Net asset value per common share was $12.69 compared to $12.52 last quarter.
The ratio of net investment income net of management fee waiver to average net assets was 14.00% for the last three months. The ratio of incentive fees to average net assets was 3.50%. The ratio of total expenses net of management fee waiver to average net assets was 11.50%. Portfolio turnover for the last three months was 3.84%,
What They Own
MCC ended the quarter with investments in securities of 46 portfolio companies with approximately 64.9% consisting of senior secured first lien investments, 34.1% consisting of senior secured second lien investments; 0.3% in equities and warrants; and 0.3% consisting of cash and cash equivalents. As of 12-31-12, the weighted average yield based upon the original cost basis of our portfolio investments, excluding cash and cash equivalents, was 14.0%.
During Q4-12, MCC originated $133.2 million and had $16.8 million of repayments resulting in net investment originations of $116.4 million.
|Total investment interest income||14,839||12,374||10,179||8,465|
|Interest from cash + equivalents||1||1||1||1|
|Other fee income||2,879||1,690||1,832||1,508|
|Total investment income||17,719||14,065||12,252||9,973|
|Net Investment Income||9,617||7,103||6,208||4,565|
|Investments at Fair Value||520.694||401.949||363.094||306.258|
My Q1-13's Run Rate Estimate
Projecting a rate of portfolio growth at half the rate of Q4-12 [which is still a slightly bullish projection], MCC's average portfolio grows to [$521 million current + $50 million in growth adjusted for having that growth for only half the quarter] $546 million. MCC's weighted average portfolio yield is 14.0% - but there is some potential for that rate to drop in the current environment, Total Interest Income would be approximately [one fourth of $546 million at 14.0% per year] $19.110 million. I will be projecting fee income of only $1.200 million for Q1-13 - which is less than half of Q4-12's. Total revenues would be $20.310 million compared to Q4-12's $17.719 million. This is well above the consensus projection from the 13 analysts listed at Yahoo Finance. Their consensus projection is $18.380 million and ranges from $16.480 million to $20.050 million. But I am comfortable being close to the high projection. The consensus TII projection for Q4-12 was very low at $15.690 million.
I will project expenses at 48% of TII [they were only 46% in Q4-12], NII would be $10.561 million. My share count estimate is 28.662 million shares. That would make the $10.561 million of NII $0.3684/share for Q1 - with the per share number growing a bit each quarter. Portfolio growth has grown NII/share/quarter. The 2013 consensus analyst EPS projection is for $1.49/share or $0.3725/quarter. It is my opinion that the full year projection is too close to the Q1 run rate projection. At a debt/NAV of 45%, MCC still has room for portfolio growth that will grow NII/share.
Portfolio Quality Metrics
As of 12-31-12, there were no non-accrual assets. [From the CC] Portfolio LTV was 56%. Portfolio company Debt/EBITDA metrics were not provided this quarter.
What They Owe
With Long-term debt ['credit facility'] of $44.000 million; a term loan of $80.500 million [at LIBOR plus 4.00%]; and notes payable of $40.000 million [at 7.125% senior notes due 2019] for a total of $164.500 million; and with shares outstanding of 28.662 million, the Debt/share was $5.7393 and the Debt/NAV ratio was 45.22%.
Sector Valuation Spreadsheets for 3-01-13
Yield in the spreadsheet below is based on the Q1-13 dividend. Spreadsheet header abbreviations: Div = dividend; EPS = earnings per share; LTM = last twelve months; YTD = year to date. The dividend to EPS ratio is a measure of dividend safety. The dividend to NAV ratio is a measure of safety and efficiency. The last three columns measure the percentage change in the 2013 EPS projection and the change in the price target since the beginning of the year; and the change in the Q1-13 dividend from the Q1-12 dividend.
|Share Price||Div/||Div/||Q3-12||Price||Q4-12||Price||YTD Percent Change||LTM|
|With the 10 Treasury at 1.84% and sector average yield [on Q1 dividends] at 8.94% - the spread is 710 bps.|
|The cap weighted ETF BDCS is up 4.78% year to date - with dividends its return is 6.65%.|
|Average yield and average Dividend to EPS ratio were divided by 28 - not 30 - to filter out the effect of the zero payout ACAS and SAR.|
|Weeding out ACAS and SAR, the average share price gain is 5.74%.|
BDC Earnings Growth & P/E Ratios 03-01
Fiscal and calendar years are not always in sync. BDCs that began fiscal 2013 on or before calendar Q3-12 include AINV, FULL, GAIN, GBDC, GLAD, MCC, PSEC, PFLT, and PNNT. The 'range' metric is the high estimate minus the low estimate, with that result divided by the consensus estimate - and serves as one of several measurements for assessing risk. All EPS projections are from Yahoo Finance.
|Earnings / Share||Earn. Growth||P/E Ratios||13 EPS Range|
My Assessments and Conclusions
MCC's yield as of 3-01-13 was 9.51% compared to the sector's 8.94%. The price/NAV [based on Q3-12 NAV or Net Asset Value] for MCC was 1.20 compared to the sector average of 1.10. The 2013 projection P/E was 11.21 compared to the sector's 11.00. So MCC is in the neighborhood of average valuations on yield and P/E with the price to NAV looking a little pricey.
MCC is a thinly traded small cap that has slowing dividend growth. The dividend coverage ratio [based on current consensus analyst EPS projection] is not strong enough to support NAV growth. With only 46 portfolio companies, MCC is still too small to have a granular portfolio. And those flaws are showing up in MCC's current valuations.
I use the BDC's weighted average yield as the main indicator of risk. A 65% weighting in senior secured first lien investments causes MCC to look like a low risk BDC. But the 14.0% weighted average yield says something different. TCAP's weighted average yield in Q3-12 was 14.7% while it had 76% of its portfolio in subordinated debt. Without knowing the specifics, it looks like MCC has senior debt in less credit worthy customers while TCAP has junior debt in more credit worthy customers. It will take a few years of watching MCC's non-accrual performance before that perception in verified. It is my perception that MCC is a little bit risky - and that is showing up in MCC's current valuations.
A quick tangent - The other measures for risk are  the spreads in the current year EPS projections;  historical EPS projection accuracy;  the yields on publicly traded debt;  the cost of its credit facility; and  the relative weightings of senior debt to junior debt. New equities lack a sufficient track record to generate a risk picture based on historical EPS accuracy. MCC also lacks publicly traded debt. MCC does have a larger than average spread on current year EPS estimates. I believe that the large spread exists because of one or two overly bearish or erroneous projections. But I own share in MCC, and that assessment could reflect my bias. I am going to ignore my informed bias and say we have confirmation from a second metric that MCC is a bit more risky than the average BDC. The cost of MCC's credit facility is LIBOR plus 4.0%. That is higher than average - which makes it the third metric that implies that MCC is a riskier than average BDC
But the valuations change if you buy into my slightly bullish NII projections. The more bullish adjusted Dividend/EPS ratio supports the expectation of mild dividend growth and mild NAV appreciation. When one forecasts 2% dividend growth, the CAGR [the dividend projected Compound Annual Growth Rate] plus yield adds to 11.51% - which is slightly better than sector average. The current analyst projected EPS growth makes that 2% CAGR projection look like a way too conservative of an expectation. And I think the current EPS projections are still too low.
There are many BDCs that have to change to improve - with an example being fellow BDC newbie FULL [Full Circle Capital]. MCC just needs to keep on doing what it is already doing to improve. It has proved it can grow NII/share. It has proved that it is efficient at dropping more than 50% of TII into NII. It has proved it can grow its portfolio. I would like to have seen more NAV growth - but that is wishing for perfection. I would like to have a longer performance history to have evidence that MCC can avoid non-accrual problems. On the other hand, if MCC already had those attributes that I now find it lacking, MCC would probably be selling at a lower yield.
The biggest word of caution I would have to potential MCC buyers is - be careful of the price you pay for your shares. Be a patient buyer. Market psychology plays a big role in BDC pricing. You can bet on there being gloomy days when you can buy MCC at or below $15.00 -- as long as the analyst EPS projections stay this low. Buying during secondary offerings is also a good strategy for all BDCs.
Second words of caution - there are going to be unpleasant surprises happening to some of your BDC holdings. There will be a quarter where the management incentive fee jumps up and kills your NII projection. Non-accruals problems will pop up and hurt TII. Fee income will be lumpy. Some will have prepayment fees on new credit facilities that will significantly increase expenses and crash NII.
But this projected unpleasantness is already mildly priced in. Why do you think BDCs sell at such generous yields? All income stocks sell at something close to logical yield plus dividend CAGR metric - with  an adjustment for dividend security that is based on the degree of certainty in the EPS [or FFO or DCF] forecast and whether the dividend is well 'covered' - and  an adjustment or discount given to the CAGR that varies in line with the confidence the market has in the CAGR projection. BDCs have thinly covered dividends; potentially volatile EPS projections due to their economic sensitivity; and uncertain dividend CAGR projections. The last two years of a persistent anemic economic recovery has generated atypically persistent NII projections for the sector. History tells us that 'persistence' is an unsustainable attribute. There should be [and there currently is] a reasonable amount of negative valuation adjustments based on a moderate level of uncertainty in BDC EPS and CAGR projections.
Summation - MCC is a buy at the right price based on its yield plus CAGR [or dividend growth] potential. I believe MCC merits a lighter than average weighting in your portfolio because of it having higher than average risk. If your next BDC purchase is going to be your first and only BDC holding, then MCC is not a good candidate. BDC newbies should start with a BDC that has a longer history of superior performance - ARCC being an example. I also have a second impression that those new to BDCs should start with one of the lower risk BDCs based on their weighted average portfolio yields. That would mean KED, NMFC, PFLT or SUNS.