Medley Capital Corporation (MCC) IPOd 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 four straight quarters, after rising for the first four quarters.
MCC had a total return - or share price appreciation plus dividends paid - of over 50% in 2012. But the 2013 total return has trailed the sector. It is selling at a very attractive 9.46% yield. Its portfolio is over 90% comprised of secured loans. The weighted average secured investment has a loan to value ratio of 55%. Its current dividend to NII (Net Investment Income) ratio of 96.0% is slightly under the sector average. What's not to like?
In this update, I will cover the Q1-13 earnings release; do a Q2-13 earnings projection; cover an overly honest exchange in the Q1 conference call; do a risk and growth assessment; go on a quick tangent on where BDC investors should expect accretive growth; show two spreadsheets giving the BDC (Business Development Company) valuations; compare the valuations of MCC to the sector averages; and provide my buy, sell or hold judgment.
MCC Reports NII of $0.3626 compared to a dividend of $0.36
What It Earned: Medley Capital Corporation reported for Q1-13 Total Investment Income of $20.207 million ($0.7048/share) and Net Investment Income of $10.396 million ($0.3626/share). The NII/TII ratio was 51.44%. The Net Increase in Net Assets Resulting from Operations was $11.523 million ($0.4019/share). There was $3.5 million of fee income in Q1-13. The Net asset value per common share was $12.73 compared to $12.69 last quarter. The spreadsheet below displays key income components by quarter.
|Total investment interest income||16,707||14,839||12,374||10,179||8,465|
|Interest from cash + equivalents||0||1||1||1||1|
|Other fee income||3,498||2,879||1,690||1,832||1,508|
|Total investment income||20,207||17,719||14,065||12,252||9,973|
|Net Investment Income||10.396||9,617||7,103||6,208||4,565|
|Investments at Fair Value||594.163||520.694||401.949||363.094||306.258|
The ratio of net investment income net of management fee waiver to average net assets was 12.98% for the last six months. The ratio of incentive fees to average net assets was 3.25%. The ratio of total expenses net of management fee waiver to average net assets was 11.62%. The management fee waiver is currently zero. I believe MCC is still using that terminology so that it can have metric compatibility to prior quarters where there was such a waiver. Portfolio turnover for the last six months was 14.40%.
What It Owns: MCC ended the quarter with investments in securities of 51 portfolio companies with approximately 61.0% consisting of senior secured first lien investments, 33.6% consisting of senior secured second lien investments; 0.7% in equities and warrants; and 4.7% consisting of cash and cash equivalents. As of 03-31-13, the weighted average yield based upon the original cost basis of the portfolio investments, excluding cash and cash equivalents, was 13.9%.
Originations: During Q1-13, MCC originated $123.2 million in investments and had $53.0 million of repayments - resulting in net investment originations of $70.2 million.
My top-down net investment income projection for MCC: MCC's portfolio growth has a run rate of 23% per quarter while the NII/TII ratio is falling due to higher expenses with an added debt load. The weighted average yield is slowly falling - and that causes me to drop my Q2-13 projected weighted average yield of 13.8% from this quarter's 13.9%. Approximately 94.6% of a projected portfolio of (594 times half of that 23% growth) $662 million (or $626 million after "incoming producing" adjustment) is generating income. The top down formula would forecast (626 times .138 divided by four) $21.597 million in interest income. Using the same formula which I detailed in a prior update on BlackRock Kelso Capital, my NII "initial" projection looks like this:
|Metric||Fee Income||Interest Income||Totals|
|Formula||average for last 4 quarters||portfolio times yield / 4||Sum of components|
|Numbers||2.475||626 million times .138 / 4||24.072|
|Formula||provided above||TII times NII/TII||NII/ share count|
|Numbers||50%||.50 times 24.072||12.036 / 28.703||$0.4193/share|
The formula is projecting above trend TII growth - and that makes me uncomfortable. MCC may be closing deals too late in the quarter to justify that the weighted average deal closes mid quarter - which is what the formula is doing. I want to do a Q1-13 ending run rate number to compare to the above projection. At quarter's end, 94.6% of a portfolio of $594 million had a yield of 13.9%. That would produce a run rate interest income number of $19.658 million. Add Q1's above trend fee income of $3.498 million, and the result is TII of $23.156 million. In light of that run rate, my TII projection appears reasonable.
But there is a second potential problem with that first projection. With a debt/NAV already at 64.5%, there is some potential for another secondary offering that will increase the share count. That would lower my NII/share projection. The ending share count growth was 5.790 million in Q3-12 and 5.552 million in Q4-12. The ending share count growth was 8 thousand in Q1-13. Projecting a 6 million share offering that is done mid-quarter, my share count grows by 3 million to 31.703 million. That would drop my NII projection to $0.3796/share. Let's compare that second projection to that of the analysts.
The consensus projection TII projection from the 12 analysts listed at Yahoo Finance is $21.610 million and ranges from $17.580 million to $23.330 million. MCC may have pleasantly surprised the analyst with Q1 portfolio growth - and that result may have yet to be shown in the Yahoo Finance projections. The 2013 consensus analyst EPS projection is for $1.50/share or $0.3750/quarter. Due to being too optimistic in my personal TII projection in Q1-13, and due to the more pessimistic analyst projections being correct in Q1-13 with their NII projections, I am more comfortable with my second top down forecast. There is too little projected NII/share growth - compared to the last two quarters - to project dividend growth in the short term. And there is too small a dividend to NII ratio to project dividend growth in the short term.
Portfolio Quality Metrics: As of 03-31-2013, there were no non-accrual assets. (From the CC) Portfolio LTV was 55%. Portfolio company Debt/EBITDA metrics were not provided this quarter.
What It Owes: With Long-term debt ("credit facility" at LIBOR + 3.75%) of $26.100 million; a term loan of $105.000 million (at LIBOR plus 4.00%); and notes payable of $103.500 million ($40.0 million at 7.125% senior notes due 2019 and 60.0 million at 6.125% due 2023) for a total of $234.600 million. With shares outstanding of 28.703 million, the Debt/share was $8.1734 and the Debt/NAV ratio was 64.20%.
MCC's per share metrics:
- Total Investment Income $20.207 million (divided by 28.670 million average shares = $0.7048/share)
- Interest Expenses = - $2.933 million (- $0.1023/share)
- Base Management Fee = - $2.534 million (- $0.0884/share)
- Incentive Fee = - $2.599 million (- $0.0906/share)
- Total Investment Expenses = - $9.811 million (- $0.3422/share)
- Net Investment Income = $10.396 million ($0.3626/share)
- Realized gain (loss) on investments = $0.153 million ($0.0053/share)
- Unrealized appreciation = $0.974 million ($0.0340/share)
- Net Increase in Net Assets Resulting from Operations = $11.523 million ($0.4019/share)
A conference call with too much truth:
It was toward the end of a very good conference call when Troy Ward of Keefe, Bruyette & Woods noted that MCC was significantly growing its portfolio while dividend growth had been flat. MCC said that net investment income per share had stabilized and you will not have one growth projection (like dividend growth) follow the other (portfolio growth). What follows are not verbatim quotes:
Analyst Troy Ward: As you grow the portfolio through new equity and levering that equity, our hope is that it would be accretive to shareholders. Therefore, you should see some growth to that dividend.
MCC CEO Brook Taube: Even with growth in originations, the NII has to stabilize. Our assumption is you cannot bank on accretive issuances of new equity. It is not something we are planning as we grow. If it comes, we will definitely deliver net-excess net investment income back to shareholders.
Analyst Troy Ward: How did the shareholders benefit from the last three equity offerings?
MCC CEO Brook Taube: There was book value growth.
Analyst Troy Ward: Should not those equity offerings, with additional leverage, provide earnings growth at some point?
MCC CEO Brook Taube: In terms of dividend policy, we are not going to tell you that there will be NII/share growth that results in dividend growth. That would be projecting the future.
Can you see a pattern here?
- Ares Capital (ARCC) has had 29% portfolio growth over the last year while its dividend has grown 2.70%.
- Golub Capital (GBDC) has had 37% portfolio growth over the last year while its dividend has been flat.
- Triangle Capital (TCAP) has had 39% portfolio growth over the last year while its dividend has grown 14.89%.
- Fifth Street Finance (FSC) has almost tripled its portfolio in the last two years while its dividend has been flat.
- Main Street Capital (MAIN) has had 265% portfolio growth over the last two years while its dividend has grown 15.38%.
A person familiar with some important metrics can see a pattern in those random looking numbers. It strongly appears that (1) BDCs with high price-to-NAV ratios can raise equity in a manner that is more accretive to the dividend; or (2) BDCs with SBA (Small Business Administration backed) debt can raise debt capital in a manner that is more accretive to the dividend; or (3) BDCs with higher NII/TII ratios can grow TII in a manner that is more accretive to the dividend; or (4) all of the above - and in a potentially synergistic way.
It is no surprise that portfolio growth does not always lead to dividend growth. MCC sells at a price-to-NAV that is well above sector average, but nowhere near the ratios of MAIN or TCAP. And MCC has consistently had quarterly NII/TII ratios in the low-to-mid 50s while MAIN and TCAP have had ratios in the mid-to-high 60s. It is probably not a coincidence that MAIN and TCAP are internally managed BDCs with lower management expense levels while the slower dividend growing BDCs are externally managed BDCs with higher management expenses. MCC has a base management fee of 1.75% compared to the industry average of 2.00%. That should result in cost savings that should show up in the NII/TII ratio. So far, that advantage to shareholders has not materialized.
The SBA advantage: SBA debt is very low cost debt, long-term debt, and zero covenant debt. And MCC is on the cusp of having a SBA license. That could result in an improvement in the NII/TII ratio - and result in dividend growth. So there is some logical basis for optimism. But I am not catching that optimism. If the advantage to the shareholders of a lower base management fee can disappear, then the advantage from a source of lower cost debt capital can disappear too.
My growth assessment of MCC: This is my short-term CAGR (Compound Annual Growth Rate) projection for the dividend. Q2-13 over Q2-12 dividend growth was zero. MCC once had dividend growth inertia. That inertia is gone. For the NII, growth is projected at [1.50/1.25] 20% in 2013; and is projected to grow [1.57/1.50] 4.7% in 2014. There is a small amount of room in the Dividend/NII ratio [1.44/1.50] for dividend growth in 2013. For NAV, growth for the last twelve months was [12.73/12.63] 0.79%. I also use the dividend discount model to solve for a price implied CAGR. That metric currently stand at 1.54%. For the years where I have visibility, I could see MCC growing the dividend at 1%. But it is just as likely the MCC will use any NII growth to improve MCC's dividend/NII ratio - with the hope that a dividend that appears more secure via better coverage will lead to more price appreciation than some anemic growth in the dividend.
My risk assessment of MCC: MCC has had very good EPS projection accuracy in 2012, and year-to-date in 2013. With a spread of 2013 EPS projections [high estimate minus low, with that result divided by the consensus estimate] at 10.67%, the spread indicates average risk. The portfolio debt/EBITDA and interest coverage ratio metrics are not provided - and that warrants a demerit. The portfolio weighted average yield is 13.9% - and this suggests above average portfolio risk. With MCC's debt/NAV at 64.20%, its leverage indicates average risk. The MCC portfolio is 94.6% in secured debt - which indicates well below average risk. MCC has no loans at cost on non-accrual - another very low risk indicator. But the portfolio is too young to have a good history on non-accruals. With investments in 51 portfolio companies, the MCC portfolio is close to average based on granularity or diversification. The yield-to-maturity numbers for MCC's publicly traded debt indicates a similar risk level as PNNT and TCAP - two subordinate debt heavy BDCs. That surprises me. MCC's cost on its credit facility is LIBOR plus 3.75. That is well above sector average - suggesting well above sector average risk. I strongly weight those last two metrics along with the portfolio weighted average yield because they are based on real world decisions with real money behind them. The risk qualities of MCC should result in a moderately above average "yield plus CAGR" valuation.
Before I show my valuation assessment, we need to look at the current BDC valuations in the two spreadsheets that follow:
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 four columns measure the percentage change in the 2013 EPS projection and the change in the price target since the beginning of the year; the change in the Q1-13 dividend from the Q1-12 dividend; and the change in the Q4-12 NAV from the Q4-11 NAV. Many BDCs have already started declaring Q2-13 dividends. KED and MAIN are the only BDCs to declare an increase in their Q2-13 dividend.
|Share Price||Div/||Div/||Q4-12||Price||YTD Percent Change||LTM||LTM|
|With the 10 Treasury at 1.75% and sector average yield (on Q1 dividends) at 8.91% - the spread is 716 bps.|
|The cap weighted ETF BDCS is up 4.26% year to date - with dividends its total return is 7.98%.|
|Sector yield, Dividend/NAV and Dividend/EPS ratio filter out the zero payout ACAS and SAR.|
|Weeding out ACAS and SAR, the average share price gain is 5.89%.|
BDC Earnings Growth & P/E Ratios 05-03
Fiscal and calendar years are not 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 dividend by the consensus estimate - and serves as one of several measurements for assessing risk. That average is currently inflated by almost 300 bps due to atypical spreads in the projections for ACAS and GAIN. With the exception of KED, all EPS projections are from Yahoo Finance.
|Earnings / Share||Earn. Growth||P/E Ratios||13 EPS Range|
My valuation assessment of MCC: I use a different set of metrics to assess risk - and my risk assessment of MCC places it close to average while the market could see it as lower than average. The market could still see dividend growth inertia. I do not. At a 9.46% yield, I can see why new investors could be attracted to MCC. I have been an MCC shareholder. I sold after the conference call. I also invest for an uncle. I told him why I sold, but advised him to hold. He did. He is in his 80s and he wants to maximize his portfolio yield with a moderate amount of risk. MCC fits that bill. I want to maximize my total return. I want high "yield plus CAGRs" investments. I no longer see MCC as a stock that fits that bill.
MCC's above sector average yield and below sector average P/E makes it an attractive investment. But the lack of good dividend growth potential along with a moderately high risk profile explains those valuations and offsets some of that attractiveness. Whether MCC is a buy, sell or hold depends on your goals and risk tolerances. I believe the readers can draw a superior amount of edification from knowing what I have done with two different portfolios severing inventors with different goals.