We heard Ares Capital’s (ARCC) Q1 2010 earnings conference call (see here), listening for any interesting new info not covered in the earnings press release or the excellent PDF file which the company makes available. Here are our main findings:
1. The metrics of the financial performance of the companies in the Ares portfolio are on a very material upswing. Revenues are up 7% and EBITDA greater than 20%. Interest coverage is up to 2.9x.
2. On a related subject, the non-accrual portfolio picture looks encouraging. Yes, 3 companies were added to the non-accruing club this quarter (and one removed).
However, one of the three new additions was repaid at close to par (and for a profit over FMV) after quarter end.
The two other companies are Master Plan and Waste Equip, and their financial weakness has been known for 2 years. ARCC just decided to move them to non-accruing (which means interest will be applied to paying down the principal) because there is no “catalyst” in ARCC’s eyes for repayment of the debt.
Still, interest is current, which is something. As of right now, the non-accruing loans account for only 0.5% of the loan portfolio at fair market value (FMV), and 3.7% at cost.
3. Interestingly and astoundingly given what’s happened to the financial markets in the past two years, Ares reports that market conditions for the larger sized transactions is becoming irrational, as this segment competes with a junk bond new issue market awash in cash. This has caused the company to book most of its new activity on smaller than average transactions, usually in one stop situations (where the lender provides all but the equity). These are still loans of $30mn or so, but margins and terms are more conservative. Thankfully deal structures often involve heavy contributions of equity from the sponsor groups: 40%, according to Ares.
In its sweet spot lending area, Ares says loan margins remain 200 basis points above historic averages, but admits 50-75 basis points will come off as competition tightens margins. Thankfully, for the moment, Ares is generating loans at higher yields than the pay-offs.
4. On an unrelated subject, Ares warned that the post-closing costs of the merger with Allied Capital might be around $10mn , most of which will occur in 2010 but there could be a tail into 2011. Costs include severance, lease breakages etc. This will temporarily dampen earnings. At the moment Ares is asking investors to keep a series of non-recurring costs in mind when analyzing its numbers. For example, management on the conference call managed to add-back enough items to the Net Investment Income of $0.28 for the period to suggest recurring earnings per share were $0.32.
The elephant in the room (or the gorilla in the sports car/elevator if you watch the ads on CNBC) is what earnings might look like once the Allied Capital acquisition is figured in. When asked to estimate this by analysts, or provide any pro-forma calculations before the next earnings report, Ares’ answer was a resounding no. (After all, the equity has already been raised, and it is true that there are an astounding number of variables at work).
Nonetheless, management did reiterate that they expected the capital raising to be accretive, which seems to suggest that ARCC expect higher earnings per share to show up in the next few quarters. We look at the unused borrowing capacity, the relatively low cost of funding (just 2.3%) and an M&A market picking up (due to worries about Obama’s new capital gain proposals), and we’re bullish about earnings per share meeting or exceeding the $0.35 a quarter dividend. Still, if management won't opine...
5. Surprisingly for a company of this size, Ares indicated an interest in participating in the gold rush for borrowing inexpensive, long term monies from the U.S. government by applying for an SBIC license. Most of the smaller BDCs have gone this route, but we were taken aback to hear that Ares, which lends to much larger companies than the SBIC serves, would consider this route. It’s probably a good thing, but we’ll be interested to hear how this would work from an origination viewpoint.
Overall, the conference call was long, detailed and gave the impression that management was excited about an improving credit picture, and anxious to use its available capital resources (which are greater than expected by management due to the strength of the refinancing of the existing portfolio going on) to increase potential earnings. Much remains to be revealed about what the new Ares Capital will look like next quarter.
Disclosure: Author holds a long position in ARCC