Earnings projections are supposed to be simple and beautiful things. Earnings projections are a tool to compare valuations. All other things being equal, the lower the P/E, the better the value. This article will - at times - have a focus on the use of earning projections as a tool to measure dividend safety. A covered dividend is relatively safe. The better the coverage, the higher the safety.
But calendar and fiscal years do not overlap for many BDCs (Business Development Companies). So when you are comparing 2013 P/E ratios for two different BDCs - you may be comparing metrics for different time periods. When you are comparing dividend coverage ratios, you also have something of a time period problem. Apollo Investment Corporation (AINV) and Gladstone Investment Corporation (GAIN) started their fiscal 2014 in April of 2013. Full Circle Capital Corporation (FULL) started in May. This fiscal versus calendar issue messes up both the P/E ratio and the dividend/EPS ratio.
There is a second issue with EPS projections. The predictive nature of earnings varies significantly by BDC. Viewing a naked projection or ratio based on that projection, without knowing the predictive factor, results in an inaccurate picture of valuation. Put another way, while the sector average P/E ratio for the sector is 11.42, all BDCs with ratios around 11.42 are not equal values.
This article will focus on prior four quarter Net Investment Income (or NII - and that is an acronym I will use frequently) metrics and NII growth trends as an alternative metric to EPS projections in making valuation judgments, judgments of dividend safety and judgments on the credibility of the consensus EPS projection.
I want to get one confusing issue addressed at the start. Analyst EPS projections are actually a BDC's NII projections. GAAP EPS is actually the "Net Increase in Net Assets Resulting from Operations" - which is a different metric altogether. Since I will only talk about EPS projections, and since EPS projections are NII projections, I will use the terms NII and EPS as if they mean the same thing.
Those who track the quarterly stats may be at a significant advantage. Sector average EPS growth is projected to be 4.42% in 2013 and 5.55% in 2014. That growth rate is lower than the margin of error in most projections. One who tracks the quarterly NIIs can create a reasonable EPS projection by taking the sum of the last four quarters' actual NII plus any growth trend that is evident - and have a forward projection that is frequently more accurate than the consensus EPS projection.
Those who track quarterly numbers will also have an apples to apples valuation metric that corrects for the error caused by the lack of overlap in the fiscal and calendar years. Quarterly tracking is also another way to show the predictive nature of a specific BDC's earnings.
In this article, I will first show a historical spreadsheet with NII/share stats from this time last year, along with last year's 2012 EPS projections by quarter. I will show the lessons, perceptions and warnings an investor could have learned from this tool at that time. Then I will show a spreadsheet with current stats. I will produce my perception of the warnings that are in those numbers.
Be forewarned that this will be a slow and tedious read that is acronym and data intense. There are several small lessons in the data - but there is no big eureka moment. The payoff comes in understanding the forward warnings. But in order for those warnings to have credibility in your eyes, I need to show that the historical warnings were a mostly accurate indicator of future trouble. That will be a labor intensive task for both writer and reader.
Historical Four Quarters of NII/share
This spreadsheet shows a run rate estimate from Q2-12 that is provided by the sum of NII from the prior four quarters. It shows the beginning of the year 2012 EPS projections as the Q1 projection; other consensus analyst projections at the beginning of each succeeding quarters, my sum of NII through Q2-12: and the end of the year - fiscal and calendar - actual EPS numbers. The calendar NII/share is the sum of quarterly NII numbers. The numbers are stored as a hundredth of a cent data - and rounding results in some yearly sums having the appearance of a miscalculation. Even when the calendar and fiscal years overlap perfectly, the fiscal and calendar numbers may fail to match. There is no weighting done to the numbers in the sum of quarter's calculation. A BDC with a growing share count would logically have the earnings in the later part of the year more heavily weighted in its annual earnings number.
|Prior NII/Qtr||NII/Quarter||Sum||Projections||Ending 2012 NII|
Out of sync NII and EPS projections in the historical spreadsheet
For this analysis, I will use two concrete numbers and a nebulous number - the sum of the last four quarters of NII, the analyst projection, and a subjective - but not stated in the spreadsheet - NII trend.
American Capital (ACAS) had a sum of the four prior quarters of NII at $0.87 and an EPS projection of $0.97. There was an inconsistent trend of NII improvement. It was two steps forward, one and a half steps back kind of growth. The projection proved to be too optimistic. With first half NII of $0.43/share - second half would need to be $0.54 or an average of $0.27/quarter. With Q2-12 NII of $0.29, a $0.27/quarter end of the year looked possible - even conservative. But that perspective would ignore the large steps back. The sum of NII by quarter for 2012 was $0.92. The prior four quarters NII sum proved to be low to be a forward projection - but that was expected due to the trend of growth. The lack of NII consistency indicated that any EPS projection was risky.
Apollo Investment Corporation had a sum of $0.83 and a projection of $0.82. There was a consistent trend of falling NII numbers. The projection and the sum proved near accurate numbers. The trend suggested that the sum might be a high projection.
Ares Capital Corporation (ARCC) had a sum of $1.68 and a projection of $1.59. The ARCC analysts appear to use "core NII" as their projection metric. This does not appear to be true of other BDCs. The actual NII number proved to be more in line with the sum number. The projection proved to be low. ARCC has a business model that generates higher than average fee income. Fee income is lumpy by quarter. So having a high fee income component results in EPS projections that are less accurate. ARCC also has a history of having quarters where incentive fees are lumpy. These fees go to management and subtract from NII that goes towards paying investors dividends or raising the NAV when NII exceeds the dividend. Lumpy incentive fees also result in EPS projections that are less accurate.
BlackRock Kelso Capital Corporation (BKCC) had a sum of prior quarters of $0.95 and a projection of $0.97. The sum was signaling that the projection looked good. The history of NII by quarter was very volatile. Even though the projection proved to be fairly accurate, the quarterly NII history suggests that the analysts just got lucky in that call.
Fidus Investment Corporation (FDUS) was a NII growing newbie in 2012. The last four quarters sum was $1.38 and a projection of $1.60. The projection proved to be high. 2012 NII was $1.54. The sum produced a NII number that would be too low to be a good forward projection. On the other hand, the trend showed that the projection contained a very aggressive growth assumption. With first half NII of $0.74, second half NII would need to be $0.86 or an average of $0.43/quarter. The trend suggested growth would be more moderate than that. The trend provided a better nebulous projection than the analysts.
Fifth Street Finance (FSC) had a sum of $1.01 and a projection of $1.10. The 2012 sum of NII by quarter was $1.03. The analyst projection proved to be high. Given that first half NII was only $0.50 and there was no noticeable trend in growth, the projection looked to be optimistic. The sum of prior quarter NII proved to be a more accurate 2012 projection.
Full Circle Capital Corporation was a NII shrinking newbie in the first half of 2012. It had a sum of $0.73 and a projection of $0.84. Even though the trend of NII shrinkage turned around, the projection proved to be high.
Hercules Technology Growth Capital (HTGC) had a sum of last four quarters of $0.94, with an upward trend just under $1.00, and a projection of $0.97. The numbers were signaling that the projection looked good. HTGC ended 2012 with $0.97/share.
Horizon Technology Finance Corporation (HRZN) was a newbie in 2012. The Q2-12 NII was a disappointment. One disappointment is more of an inconsistency warning than a trend. The sum was $1.56. The projection was $1.43. The projection proved to be close. The sum proved to be high while the history did provide a warning.
Kohlberg Capital Corporation (KCAP) had a sum of $0.78 and a projection of $0.84. Both projection and trend proved to be low. KCAP lacks NII consistency. Both negative and positive surprises happen with regularity with KCAP.
Kayne Anderson Energy Development Company (KED) lacks accurate analyst EPS projections. I do not use them. There is nothing to gain by analyzing these numbers.
Main Street Capital Corporation (MAIN) had a sum of last four quarters of $1.85 with a good upward trend in NII. The projection was $1.89. The trend explains why the sum and projection were not in sync. The rising Q4-12 projection was up from Q2-12's $1.69, but it was still below the ending numbers. The trend lightly suggested that the projection was too low.
Medley Capital Corporation (MCC) was a NII growing newbie in 2012. It had a sum of last four quarters of $1.19 with a good upward trend in NII. The projection was $1.31. The trend explains why the sum and projection were not in sync. The rising Q4-12 projection was on target.
New Mountain Finance Corporation (NMFC) has a complex structure of public and private shares, which may cause my NII stats to be in error.
NGP Capital Resources Company (NGPC) had a trend of $0.56 and a projection of $0.62. The projection of Q4-12, which was falling during the year, proved to be high. The sum proved to be on target.
Prospect Capital Corporation (PSEC) had a sum of $1.61 and a projection of $1.42. PSEC lacks NII consistency. This is also an instance where calendar and fiscal years are out of sync. Projection proved to be very low. The sum proved to be closer to the actual.
PennantPark Floating Rate Capital (PFLT) was a NII growing newbie in 2012. It had a sum of last four quarters of $0.88 with an upward trend, and a projection of $0.98. The trend explains why the sum and projection were not in sync. The trend may have suggested that the projection was low - and it was.
PennantPark Investment Corporation (PNNT) had a sum of last four quarters of $1.22 with a downward trend, and a projection of $1.08. PNNT had a non-accrual problem in 2012 that hurt NII production. The trend explains why the sum and projection were not in sync. The projection was on target.
Prospect Capital Corporation had a sum of last four quarters of $1.61 with an upward trend, and a projection of $1.42. The sum and the trend were sending strong signals that the projection was far too low.
Solar Capital (SLRC) has had occasional NII inconsistency. The falling NII in Q2-12 did not happen again in the calendar year. The projection proved to be accurate and the sum did not. On the other hand, the inconsistency was an accurate warning flag for what was to happen in 2013.
Solar Senior Capital (SUNS) was a NII growing newbie in 2012 where the sum was not expected to provide information. In earnings releases, SUNS (and SLRC) fail to parse fee income from interest income. SUNS had a huge increase in Q2-12 NII that was due to a one time surge in fees. This disclosure failure may partially explain the jump in the analyst NII projection to $1.37 from $1.31. End of year NII was $1.31.
Medallion Financial (TAXI) has a complex earnings release that takes adjustments to produce a NII number. Those adjustments may cause my stats to be in error.
Triangle Capital Corporation (TCAP) had NII improvement over 2011, but there was no trend inside the last four quarters of any growth. The sum number was $2.05 and the EPS projection was $2.11 - which was not much of a difference. Then TCAP had strong third and fourth quarters - and ended the year with $2.16. TCAP has a very good NII/TII ratio. It has grown NII as its portfolio grew. And the TCAP investment portfolio grew from Q2-12's $21.962 million to Q4-12's $24.967 million. The deployment of funds from secondary offerings was the omen that the trend in NII/share was going to improve.
THL Credit (TCRD) was a slow but steady NII growing newbie in 2012 - where the sum was not expected to provide an accurate projection. TCRD is the mirror image of SUNS. TCRD had its analyst consensus projection fall after reporting its Q2-12 numbers. The beginning of the year projection - once again - proved to be accurate.
TICC Capital (TICC) is a venture capital BDC with extreme NII inconsistency. This results in the prior quarter sums and trends being much less meaningful tools in projections. That would lead us to believe that there would also be problems with the accuracy for any analyst projection. The 2012 projection proved to be in error.
For the BDCs that were not newbies in 2012, when the sum and projection numbers were not in sync, then this was frequently a good warning that the EPS projections were going to be in error. The visible trends helped explain why some BDCs had rising EPS projections that were not in sync with the sum of prior quarters' number. For the BDCs that lacked NII consistency, that condition also helped predict upcoming failures in the accuracy of the EPS projection. One still needed to know a lot of the earnings fundamentals within each BDC to successfully use this tool.
I believe that all income producing equities are headed toward future prices where they sell at logical yield plus dividend CAGR (Compound Annual Growth Rate) metrics with significant adjustments for risk. I capture the adjustment for risk with a RRR or Required Rate of Return assessment. The RRR rises as portfolio quality falls. The RRR rises as the accuracy of earnings projection history falls. Tracking NII by quarter helps to explain why there are specific troubles in historical projection accuracy with a specific BDC.
Only when the trend is flat is the sum of the prior quarter number a decent projection. And after writing that observation - I am embarrassed by how obvious that statement is. The point here is that the sum of prior four quarters NII should not be a good projection. But 2012 provided evidence that the historical sum was a good projection for many BDCs. When the sum varies from the projection, then one should question the projection. They should see if the trend supports a projection that is not in sync with the sum of the prior four quarters. If the size of the growth suggested by the trend varies from the projection, then one should seriously question the projection. "Serious questioning" is done by diving into the performance metrics in the earnings release and news in the conference calls.
And now for the current numbers:
Last Four Quarters NII/share used for Price/NII Ratios
For BDCs, GAAP Net Increase in Net Assets Resulting from Operations per share is EPS. But EPS projections are Net Investment Income per share projections. LTM = last twelve months, or the sum of the last four quarters' NII. The "Q2 only" price to NII used the Q2-13 NII times four to generate a ratio. "RnRt EPS" - or run rate EPS - is usually the sum of the last two quarters NII times two. The price to earnings ratios are based on prices as of 10-17-13.
|Prior NII/Qtr||NII/Quarter||Sum||Price||LTM||Q2 only||EPS||P/E||RnRt||RnRt|
Where do the NII/share/quarter trends show potential trouble?
American Capital is a concern due to it having two straight quarters of well below trend - and projection - NII/share. ACAS has had great share price appreciation the last two years. So despite not having a dividend, it has been worth holding. It appears to me that the key metric for ACAS is its NAV. As long as the NAV is rising, ACAS may be safe from a share price fall. But the falls in NII were led by falls in TII. ACAS ended Q1-13 with an 80% price to NAV ratio - and is currently at 70%. A stock without a dividend is worth whatever the market thinks it is worth - or whatever the market is TOLD by the analysts what it is worth. The events of falling TII and NII per share for three quarters would tend to result in the analysts writing that ACAS is worth less. If ACAS fails to reverse this falling trend, I would be selling ACAS before the analysts start telling the market to do so.
Fidus Investment Corporation had a big jump in incentives fees that crushed NII/share in Q2-13. FDUS is selling at a relatively low yield and relatively high price/NAV and P/E ratio. EPS is projected to grow from 2013's projection of $1.45 to a projected $1.80 in 2014. I would find it hard to have faith in that projection if there are two straight quarters in 2013 where the trend in NII is falling. FDUS has had good share price appreciation in 2013. If FDUS has another NII disappointment in Q3-13, I would err on the side a caution and sell before the analysts start dropping their EPS projections. And that assessment comes from someone who has had FDUS on his buy list before the Q2-13 numbers came in.
Fifth Street Finance has a current EPS projection showing needed EPS growth to get to a covered dividend in 2014. But there is no visible trend of NII growth. FSC has underperformed the sector average in 2013 - and that may be due to a falling 2013 EPS projection. If the NII for FSC is not shown to be rising in the Q3-13 earnings release, the 2014 earnings projections should begin to fall. On the other hand, the NII for FSC is relatively stable. It has limped along for some time without having a fully covered dividend. FSC, with its 11.43% yield, is priced to be a slightly troubled BDC. The NII trend is only projecting that such trouble will continue. FSC is priced slightly below sector average on the price to NAV metric - and well below average of P/E.
I personally want to be paid more than 11.43% for holding a slightly troubled BDC. I can see that others will find FSC a value due to its yield. If you fall into that group, then keep a close eye on the quarterly NII/share. Given the relatively stability of FSC's historical numbers, if there is a disappointment, sell first and ask questions later.
The Full Circle Capital Corporation EPS projections are projected to rise from 2013's $0.77/share to $0.89/share in fiscal 2015 - which starts three quarters from now. The sum of the last four quarters' NII is $0.77. The current trend is providing no reason to believe that EPS will rise. That lack of an improvement trend needs to change in Q3-13 - or the improvement projected in 2014 needs to be heavily doubted. FULL's current P/E ratio suggests that there is some doubt already priced in. FULL's 0.97 price to NAV ratio also shows some doubt being priced in.
But there is one metric that suggest all the bad news is already fully priced in. With a dividend of $0.231/share per quarter, FULL needs a yearly EPS of $0.924/share for the year to have a covered dividend. Cut the current dividend to (0.77/4) $0.1925 so that the dividend is covered, and the yield for FULL falls from its current 11.85% to (0.77/7.80) 9.87%. That would still be a yield that is above sector average. And that calculation suggests that a dividend cut is already fully priced in. So the bottom line is - if the market prices FULL as if the NII is not going to improve and the dividend is being cut, you should not buy or hold FULL unless you like it after adopting those assumptions, too.
That dividend cut would give FULL a yield plus dividend CAGR projection of 10%. And FULL has a relatively risky portfolio. FULL has a portfolio that is very heavy in first lien loans. But if the portfolio yield is 12.90%, then the loans have to be risky. The yield on its credit facility also suggest that FULL is high risk. The yield on its unsecured notes suggests that FULL is high risk. A 10% "yield plus CAGR" for a relatively risky stock is not a good value.
Solar Senior Capital has problems. Its failure to parse fee income from interest income results in a failure to gain significant information in its historical numbers. The 2014 projection for SUNS is $1.39 - or an average of $0.3475/quarter. SUNS has had two quarters - in Q2-12 and Q4-12 - of NII at $0.36/share. So a climb from the $1.20 2013 projection to the 2014 $1.39 projection is possible. But I would really like to see something in the Q3-13 numbers that indicates that this size of climb is possible. After dipping to $0.28 in Q1-13, NII climbed to $0.29 in Q2-13. That climb has to continue. And even if that climb continues, I would want to know if the improvement results from another quarter of atypical fee income.
With a current yield of 7.56%, SUNS is priced as if it has a safe dividend. And the SUNS NII is produced by owning lower yielding floating rate senior secured loans - the safest source of income. But Q2-13 NII was $0.2890/share compared to a dividend of $0.3525/quarter. The degree to which the SUNS dividend is not covered is a problem. SUNS strongly needs to have a quarterly NII that is growing towards 2014 dividend coverage in order to justify its current valuation. I need to see a rise in SUNS' weighted average portfolio yield - or an increase in portfolio leverage - and this may have happened with SUNS' recent purchase of Gemino Healthcare Finance (with 30 clients and approximately $162 million in outstanding loan commitments). With a Q2-13 Debt/NAV ratio at 18.97% - an atypically low level of leverage for BDCS - SUNS has lots of room to increase its leverage and generate a higher NII/share. SUNS weighted average portfolio yield has fallen to 7.3% from averages near 8% in 2012. PFLT - another floating rate senior secured loan BDC - is also having problems with falling weighted average yields. The cure for this problem may be out of the control of BDC management. The Fed's asset purchases in its quantitative easing program may be driving down the cost of the senior secured loans.
Triangle Capital Corporation has a last four quarters' sum of $2.31 and a 2013 projection of $2.40. Just like 2012, TCAP lacks any trend inside the last four quarters of any NII/share growth. TCAP ended Q2-13 with $650 million in investments (falling from Q1's $715 million) and $117 million in cash. TCAP has room to grow NII simply from deployment of that cash. Given TCAP's prior success, I would feel comfortable with the current growth projection in the consensus analyst number. But that is still a "trust, but verify" thing for TCAP shareholders.
Main Street Capital is in the same boat as TCAP. It has a last four quarters' sum of $2.06 and a 2013 projection of $2.22 and lacks any trend inside the last four quarters of any NII/share growth. With year to date NII/share of $1.01, the second half of 2013 needs to have NII of $1.11/share or $0.555/quarter. Given that Q4-12 had NII of $0.56, a resumption of that pace is possible. Q2-13's portfolio growth may have been deployed late in the quarter, and that resulted in NII growth that will not be captured until Q3-13 - but we will not know that until we see the Q3-13 numbers. Like several other BDCs, MAIN fails to parse interest and fee income. It would be nice to know if the growth in NII that came in the Q4-12 period contained a surge in fee income - but we will not know that until MAIN improves its earnings disclosure. Like PFLT and SUNS, MAIN has a portfolio of senior secured loans. And the weighted average yields of that portfolio have fallen from Q4-12's 8.8% to Q2-13's 7.9%. Is the lack of NII growth in 2013 due to that falling yield? Will the falling weighted average yield continue? In summation, there are several important questions that could be answered in the Q3-13 earnings release. MAIN shareholders need to be paying close attention.
What one can read between the lines can be just as important as what I have physically typed. Between the lines, this article - just like my prior articles - is about due diligence. I am a retail investor - not a full time professional. Your level and analysis needs to be approaching something close to the level I have shown.
I am suggesting to you that one of the keys to due diligence is for you to be prepped for the earnings release and the conference call. Just as I have written for some specific BDCs in the text above, one should begin their reading of the earnings release and the conference call text with pre-existing questions. Too many retail investors fail to come out with answers after their exposure to those two events. It is my hypothesis that if you fail to go into those events with important questions, you are less likely to come out with important answers.
I believe that all income producing equities are headed towards future prices where they sell at logical yield plus dividend CAGR metrics with significant adjustments for risk. Two of the metrics on which a risk assessment is based is dividend coverage and the lack of NII volatility. In future articles, I plan to write on how the quarterly NII numbers can be used to help in setting a risk assessment.