Gladstone Capital: Recapitalization May Cause Dividend Cut

| About: Gladstone Capital (GLAD)

Gladstone Capital Announces Proxy Filing and Conference Call Date to Discuss Proxy Proposals – Yahoo! Finance.

Gladstone Capital (NASDAQ:GLAD) is selling at a 33% discount to its September 2009 NAV. The Company is seeking approval by its shareholders to raise more equity by selling stock below NAV, as required by the 1980 laws which spawned BDCs.

Many BDCs have done as much in recent months, mostly arguing that the opportunities for new investment offset the inevitable dilution to existing shareholders from the sale of new stock at such cheap prices. In recent months,though, most of those capital raising BDCs have seen their stock prices catch up or even exceed their NAV.

With Gladstone Capital our suspicion is that management is seeking to raise equity-at least in part-to continue de-leveraging rather than for growth. GLAD has not nailed down its financing for the long term, but has been suggesting that it may yet pay off its Revolver at or before its expiration in 2010.

In the IIIQ 2009 GLAD did not add any new deals (except a small advance to an existing company) and continued to shrink its balance sheet. Since the end of the quarter GLAD sold two of its remaining syndicated loans as well. At quarter end the Company had $83mn drawn on its Revolver, and that is probably lower today. KeyBank, which rescued Gladstone in the spring of 2009 when existing lender Deutsche Bank (NYSE:DB) wanted out, required the Company to pay down its line of credit from $100mn to $75mn at year-end. (BB&T (NYSE:BBT) also has a $27mn line to GLAD).

In its Conference Call Gladstone has been hinting about making a change in how it finances the $300mn plus in assets on its balance sheet which suggests reliance on its banks may reduce:

Our new investments, as you all know, are long-term, so we need long-term liabilities to go along with that. We can’t rely on a short-term line of credit for making long-term investments.

David Gladstone elaborated further:

Our plans today are to seek some long-term debt for our fund. We need to borrow long-term, because we invest long-term. We’re making the rounds with some of the long-term lenders such as insurance companies to see if we can raise some long-term debt.

Ironically Gladstone’s top honcho also said this about raising equity:

We are considering issuing common stock, but certainly not at this time. Its price is just way too low.

When that was said, GLAD’s stock price was $7.75. Today the stock has barely moved: it’s at $7.81.

This suggests to us that GLAD will be using all or some of the equity to pay down debt (probably by swapping out all or some of the Revolver for some lesser amount of long term debt, with the difference made up from the equity proceeds). Of course that will be good for the Company’s Liquidity (which we’ve all learned from the Great Recession is critical when things turn dark).

However, the outlook for the maintenance of the current 7 cents a month (21 cents a quarter) dividend is poor. That’s why we have a Red Flag warning on the Company. That’s our patented way of saying we think the dividend will be cut. If GLAD raises insurance company long term debt the interest rate will be higher than the current cost presumably. Plus there’s the dilution from the deeply discounted equity and the impact of the still ongoing de-leveraging mentioned at the top. Finally, let’s not forget market conditions are still bad and GLAD has 5 loans on non-accrual, and this could go higher. Everything points to lower earnings per share. In the last quarter GLAD only earned 20 cents a share in Net Investment Income so there’s no safety margin between earnings and distributions.

We’re predicting a lower dividend as part of this planned recapitalization (which is why the market has been punishing the stock presumably). We have no idea what the lower pay-out will be because there are so many moving parts: the amount of the equity raise, the price, the amount of debt, total assets etc. Still, we’re going to guess that at 4 to 5 cents a month ($0.48-$0.60 a year) GLAD will be in a position to stabilize its balance sheet and start to focus on growth. Management’s strategy over the medium term is to swap out low earning assets for higher margin loans. It’s a reasonable plan but we won’t see much impact on the bottom line for several quarters. In the short run, we envisage a stronger balance sheet but lower earnings per share, and a cut in the dividend.

Disclosure: No positions