BDCs (business development companies) receive the bulk of their income from interest. The rest of their income is generated by activities that are related to lending money. This includes fees for restructuring existing loans, prepayment fees from early termination of loans, and dividends on equity investments. The non-interest income is lumpy by the quarter, but fairly persistent by the year. Income grows as the portfolio grows. A reasonable projection of BDC earnings is a process of plugging numbers into a simple formula. This is something that even retail investors can attempt. When I have done these formula based projections, I have produced results that have had an acceptable degree of accuracy. The EPS projections from the analysts will sometimes vary over a significant range. I have found it useful to have a self-generated idea about which part of those ranges I should base my expectations.
This is a multipurpose article. I will present data from the BlackRock Kelso Capital (BKCC) Q4 2012 earnings release from March 7, 2013. I will then go into detail on the process of doing a top-down run rate projection. This article will show why the 2013 analyst EPS projections for BKCC have been falling since the beginning of the year. BDCs fund their dividends with their net investment income (or NII -- and the analyst EPS projections are NII projections). My projection leads me to question whether BKCC will maintain its current dividend based on the lack of coverage that NII will provide in 2013 and 2014. This will be a data-intensive article.
In a separate article, I will produce two spreadsheets that show the current BDC sector valuations. I will show how I produce a short-term dividend growth projection and a risk assessment. And I will tell if I perceive BKCC to be a buy, sell, or hold. Along the way we will go off on a few tangents.
Some BlackRock History
BlackRock Kelso Capital provides middle-market companies with flexible financing solutions, including senior and junior secured, unsecured and subordinated debt securities and loans, and equity securities. BlackRock Kelso Capital was formed in 2005 by management, BlackRock and principals of Kelso & Company. The BKCC IPO was in June of 2007 at a price of $14.90 and a dividend of $0.42/share/quarter. BKCC closed Friday at a price of $10.41 and paying a dividend of $0.26/share/quarter.
Many of the BDCS that were public before 2008 have prices below their 2008 prices and dividends below their 2008 dividends. What matters is where they are going -- not where they have been. Do not let this unfavorable dividend change scare you away. The 2008 recession was the great recession. The unpleasantness that we will face in our futures is likely to be smaller than the unpleasantness we have faced in the recent past. At the same time, we should be informed by this history. The flows of dividend income from BDCs are not a sure thing. We need to manage that risk in at least four ways. One way to manage is by having a light allocation to this sector. We should logically want some diversification in this sector as a second means of risk management. I would also want most of my weighting in lower-risk BDCs. And we need to look at each quarterly update for the metrics that signal when trouble lies ahead.
BKCC Reports NII of $0.1126/share Compared to a Dividend of $0.26
What It Earned: BlackRock Kelso Capital Corporation reported for Q4 2012 total investment income of $37.898 million ($0.5133/share) and Net Investment income of $8.316 million ($0.1126/share). The NII/TII ratio was 21.94% for the quarter and 50.01% for full year 2012 compared to 55.42% for 2011. Net increase in net assets from operations was $1.742 million ($0.0235/share). Fee income was $4.4 million compared with $9.0 million last quarter. For the last four quarters, fee income was $20.724 million -- or an average of $5.2 million per quarter. PIK income was 4.5% of interest income earned in 2012. The net asset value per share was $9.31 compared with $9.55 at the end of Q3 2012; $9.61 at the end of Q2 2012; and $9.59 at the end of Q1 2012.
For the 12 months ending Dec. 31, 2012, the ratio of operating expenses to average net assets was 7.28% while the ratio of interest and other debt related expenses to average net assets of 3.13% resulting in total expenses to average net assets of 10.41% (compared to 8.22% in 2011; 7.40% in 2010; and 9.29% in 2009). The ratio of net investment income to average net assets was 10.41% (compared to 10.22% in 2011; 9.68% in 2010; and 14.47% in 2009). Portfolio turnover was 29%.
|Total interest income||30,972,239||31,652,094||31,312,505||29,393,095||34,379,052|
|Total fee income||4,394,969||9,029,163||3,814,490||3,485,540||938,217|
|Total dividend income||2,530,344||38,845||339,282||328,030||671,326|
|Total investment income||37,897,552||40,720,102||35,466,277||33,206,665||35,988,595|
|Total investments at fair value||1,061,597,541||1,093,978,117||1,165,543,114||1,095,390,307||1,048,952,442|
The $2.5 million dividend from "non-controlled, affiliated" investments in Q4-12 related to BKCC's investment in M&M Holdings. BKCC reported that it has "no insight as to if this will continue in 2013." Q3 2012 had unusually high fee income. I will provide two 2013 income projections toward the end of this message -- and both presume that the annual income rates will continue the 2012 yearly averages for these two lines.
What It Owns: As of Dec. 30, 2012, BKCC's portfolio consisted of 47 portfolio companies with a fair value of $1,061.598 million, and was invested 18.3% ($193.934 million) in senior secured notes; 6.57 ($69.725 million) in unsecured debt; 9.2% ($97.911 million) in subordinated debt securities; 17.5% ($185.983 million) in first lien senior secured loans; 34.9% ($370.474 million) in second lien senior secured loans; 0.5% ($5.848 million) in preferred stock; 6.8% ($72.341 million) in common stock; 4.6% ($49.037 million) in partnerships; and 1.5% ($16.344 million) in equity/warrants.
The weighted average yield of the debt and income producing equity securities in their portfolio at fair value was 12.6%. The weighted average yield on senior secured loans and other debt securities at fair value was 11.9%. Yields exclude common equity investments, preferred equity investments with no stated dividend rate, short-term investments and cash and cash equivalents.
During Q4 2012, BKCC invested $78.6 million across two new several existing portfolio companies. Sales, repayments and other exits of investment principal totaled $111.3 million.
What It Owes: In January 2011, BKCC closed a private placement issuance of $158 million in five-year, senior secured notes with a fixed interest rate of 6.50% and a maturity date of Jan. 18, 2016. On Feb. 19, 2013, BKCC closed a private offering of $100 million in 5.50% unsecured convertible senior notes due 2018. Credit facility pricing at year end was at LIBOR + 3.00% or 3.25% for revolving loans and LIBOR + 3.00% for term loans. Debt at year end was $188.850 million from the credit facility and $158.000 million in secured notes. This sum of $346.850 million divided by ending shares outstanding of 75.258 million produces a debt/share was $4.6088 and a debt/NAV ratio was 49.50%. The BKCC 10-K noted that the 2012 average debt outstanding was $381.451 million -- and the weighted average cost of debt was 4.90%.
Portfolio Quality Metrics
The 10-K stated that as of 12-31-12, 0.5% of BKCC's total debt investments at fair value (or 0.8% at amortized cost) were on non-accrual status. But in the conference call (see this article) it was stated that BKCC had no investments on non-accrual at year-end. Since year-end, BKCC has "been actively engaged in the restructuring of two portfolio companies, at least one of which we anticipate will result in a non-accrual, as of the end of our current first quarter of 2013." BKCC fails to disclose debt to EBITDA and interest coverage ratio metrics for its portfolio companies.
BKCC Per Share Stats
- BKCC has a current dividend of $0.26/share
- Total Investment Income $37.898 million (divided by 73.829 million average shares = $0.5133/share)
- Interest Expenses = - $4.689 million (- $0.0635/share)
- Incentive fees paid to management = - $17.314 million (- $0.2345/share)
- Total Investment Expenses = - $29.582 million (- $0.4007/share)
- GAAP Net Investment Income = $8.316 million ($0.1126/share)
- Realized gain (loss) on investments = - $15.685 million (- $0.2124/share)
- Unrealized appreciation = $9.110 million ($0.1234/share)
- Net Increase in Net Assets Resulting from Operations = $1.742 million ($0.0235/share)
- Investments at fair value = $1,061.597 million
- Cash and cash equivalents = $ 9.122 million
How I Generate a Top-Down Run Rate NII Projection
Step 1: Generated a projected interest income producing portfolio number taking into account the current trends in portfolio growth. Your projection will tend to under estimate forward earnings if you use the ending portfolio amount. The goal is to produce a good quarterly run rate. In most cases, I project growth that was similar to last year. BDCs will tell you the quarter to date net originations for the upcoming quarter in its earnings release. Adjust your projection using that information. If a BDC has already had a secondary offering this quarter, make your projection more bullish.
Step 2: Generated a run rate total investment income number by taking the average portfolio yield times projected portfolio dollars of income producing investments, to get interest income. The result is added to a quarterly average for the last four quarters for fees and other sources of income to produce the total investment income (TII) projection.
Step 3: Yahoo Finance is my source for finding numbers to compare to the above result. Yahoo shows the consensus revenue projections for both the next quarter and the full year. For BDCs, revenue is TII. Yahoo shows the consensus, the high and the low projections. If my TII projection is not in the same neighborhood as the TII from last quarter or the analyst projections, then I strongly suspect that I made an error -- and hunt for reasons why. It is during this hunt where I have made some of my best discoveries. Thus the absence of agreement is not immediately viewed as a failure.
There have been cases where it was just a failure. There are quarters where the weighted average portfolio is higher than the ending portfolio. A few BDCs bulk up their portfolio during the quarter and then slim down out the end -- and vice versa. This portfolio oscillation causes a projected portfolio amount based on the ending portfolio to produce a bad TII projection. The lumpiness of fee income will frequently make fee income projections inaccurate. Non-accruals happen with irregularity -- reducing the income producing portfolio size.
This projection is an imperfect tool. But it is a tool that can raise red and green flags. I have saved money selling when this tool has produced red flags. I have made money buying when this tool has produced green flags. I have even kicked myself for ignoring some of those green flags. I also know what a good projection feels like -- and when to doubt the produced results.
Step 4: Generated an expense expectation. I track the trends in NII to TII ratios going back to 2010. All you really need for an acceptable projection is the trend for the last four quarters. TII times the average NII/TII ratio generates the run rate NII expectation.
Step 5: Divide NII by your share count projection to produce your NII/share ratio. In most cases, the divisor will be the ending share count. In the case of BDCs that have had secondary offerings, an adjustment needs to be made for that event. Per share calculations are based on the weighted average share count. There are 13 weeks in a quarter. Count the weeks that the BDC will have those increased shares. Divide that number by 13. Your adjusted share count will be the secondary offering shares times that ratio, which is then added to the ending share count.
Step 6: That forward estimate is then compared to two or three other know quantities for alignment and one nebulous quantity. This comparison is done to verify that your projection is in the right neighborhood. But the comparison is also done to see what direction the company is going and how fast it is traveling.
- The NII for the last reported quarter.
- The consensus analysts EPS for the current year.
- If the projection is one in Q4 -- I also compare it to the next year analysts EPS projection.
- If the projection is one in Q1 -- I also compare it to the last year analysts EPS projection.
- An estimate for TII and NII just looking at the four quarters trend (the nebulous quantity).
A Simple Top-Down NII Run Rate Estimate: TII for BKCC came from interest income, fee income and dividend income. I will not forecast any portfolio growth because 2012 growth was anemic. But BKCC's debt/NAV ratio indicates room for portfolio growth without the need to issue new shares. BKCC reported 2012 dividend income of $0.632 million per quarter. This will be the income provided by BKCC's investments in partnerships, preferred stocks, and common stocks. 2012 fee income averaged $5.181 million per quarter. Current investments of income producing debt totaled $918.027 million. The average yield on that debt was 12.6%. The quarterly TII projection then includes interest income (918 million times .125 divided by 4) of $28.687 million; plus dividend income of $0.630; plus fee income of $5.181 million. This sums to a $34.728 million. This compares to the current quarter's TII of $37.898 million; the consensus analyst "revenue" projection for Q1 2013 of $32.950 million, with a high of $33.600 million and a low of $32.480 million; and a quarterly average of the 2013 analyst revenue projection of $35.395 million. Fee income tends to fall in Q1. Comments in the conference call about low originations probably led to assumptions of a falling portfolio in Q1. If I had made adjustments for those factors in my model, my numbers would be very much in line with the analyst projections. In this specific example, I wanted a yearly run rate instead of a unique first quarter projection.
The NII/TII ratios are lumpy by quarter due to the lumpy reporting of incentive fees. I will use the full-year 2012 numbers and find that ratio was 50%. Using the 2012 average -- 50% of $34.728 million leads to a NII projection of $17.364 million. Dividing that by a share count of 75.258 million shares, I get $0.2307/share. The 2013 consensus analyst EPS projection is for $0.96 or $0.24/share per quarter. I know my projection is a rough estimate -- and this first projection is in near agreement with the analysts. I can follow the math better in a spreadsheet than in text. The two spreadsheets below are a second telling of the math that was done to reach my NII projection.
|Metric||Fee Income||Dividend Income||Interest Income||Totals|
|Formula||average for last 4 quarters||average for last 4 quarters||portfolio times yield / 4||Sum of components|
|Numbers||5.181||0.630||918 million times .125 / 4||34.728|
|Formula||average for last year||TII times NII/TII||NII/ share count|
|Numbers||50%||.50 times 34.728||17.364 / 75.258||$0.2307/share|
A News-Adjusted Top-Down NII Run Rate Estimate: But the conference call noted that BKCC will shift from inexpensive credit facility debt to more expensive longer maturity publicly traded debt will lead to a less favorable NII/TII ratio in 2013. $158 million of new debt will temporarily replace old debt at a yield difference of (6.5% minus 3.0%) 3.5%. That comes to $4.740 million a year or $1.185 million a quarter.
|New NII/TII Ratio|
|NII/TII||Old Ratio||New NII/TII||New Ratio|
|Numbers||17.364/34.728||50%||16.179 / 34.728||46.59%|
The call also projected an increase in non-accruals. Given that the adjustments are adding up, I wanted to do a second adjusted projection based on factors that are already in the news. With 47 portfolio companies -- two non-accruals could be about 4% of the portfolio. I am going to project that these problem items are already marked down, and take only a 2% reduction. I will subtract another 1% from the portfolio due to redemptions being higher the originations, which was also foretold in the conference call. The net portfolio reduction is 3% less than in the above first projection. I also will drop the NII/TII ratio to 46.6% to adjust for the anticipated increase in credit related expenses. The news-adjusted TII would be (.97 times 918 times .125 divided by 4) $27.827 plus $0.630 plus $5.181 million, which produces a result of $33.638 million. NII would be (33.638 times .466, with that result divided by 75.258) $0.2083/share. This projection is not for the "headline" Q1 2013 NII, because BKCC will have a great NII/TII ratio in that quarter. This is an "incentive fee adjusted" quarterly run rate for full year 2013. I would expect the performance to improve a penny or so a share as the year progressed. That progression (21 + 22 + 23 + 24) would lead to a $0.90/share 2013 projection.
|Metric||Fee Income||Dividend Income||Interest Income||Totals|
|Formula||average for last 4 quarters||average for last 4 quarters||portfolio times yield / 4||Sum of components|
|Numbers||5.181||0.630||890 million times .125 / 4||33.623|
|Formula||provided above||TII times NII/TII||NII/ share count|
|Numbers||46.6%||.466 times 33.623||15.668 / 75.258||$0.2082/share|
I am now less than comfortable with the $0.96/share 2013 projection of the analysts after doing my news adjusted projection. I would be more comfortable with a 2013 projection of $0.90 or $0.92/share. I do not have a strong degree of confidence that I have correctly sized the amount of the exact fall in NII because there are multiple events involved. But I do suspect that some degree of shortfall from the current projection is coming.
The above projection turned out to be in the right neighborhood. And in the short term, BKCC is going in the wrong direction and traveling fast. We know in our gut that non-accruals are bad. We now have a guesstimate on the size of that badness. We know in our gut that a higher cost of credit is bad. Once again, we now have a guesstimate on the size of that badness. And our guesstimate was not overly bearish. I used a potentially optimistic projection on both dividend and fee income. I also used a potentially optimistic projection on the size of the hit BKCC will have with the two new non-accruals.
Any reasonable amount of extra effort spent building a tool that helps a retail investor correctly size upcoming events is time well spent. Our guts can sense direction, but they are frequently poor judges of size. We now have a more informed sense that the upcoming quarters faces several sizable headwinds. My adjusted projection is not in the same neighborhood as the current analyst projections -- and we know the specific events that are the cause.
BKCC is already selling at a below sector average P/E. But I believe that is due to BKCC having a less-than-average dividend growth projection. A $0.26/share dividend still looks safe enough in 2012 when EPS averaged $0.25/share. Drop that EPS projection to $0.2350/share/quarter, and the market's perception of the safety of that dividend should fall. Drop the yearly EPS projection to $0.90/share -- and BKCC's P/E ratio rises to (10.41/0.90) 11.56 -- which is above sector average of 11.20. This is based on the pricing of March 15, 2013. BKCC does not merit an above average P/E.
In a separate article, I will produce two spreadsheets that show the current BDC sector valuations. I will show how I produce a short-term dividend growth projection and a risk assessment. And I will tell if I perceive BKCC to be a buy, sell, or hold.