Apollo Investment: Year-End Earnings and Outlook

|
 |  About: Apollo Investment (AINV)
by: Nicholas Marshi

Click to enlargeApollo Investment's (NASDAQ:AINV) fiscal year-end earnings for the period ended March 31, 2010, were released a couple of days ago, and the 10-K was released yesterday. After reading both documents and listening to the conference call (see transcript here upon availability), we came away with a few conclusions.

For those of you who want just the headlines and not all our supporting arguments, here's the summary: We found that Apollo's credit quality and earnings were nothing to write home about in the last quarter, and this is causing Apollo to modify its strategy, and may slow down new asset formation in the next few quarters. Apollo has the money to spend, but earnings per share may drop in the next quarter or two before rising back modestly over the current earnings level, as Apollo gets fully invested. However, the dividend seems secure for the moment, even if earnings drop below what it has earned for awhile due to the dilution from a successful April 2010 equity raise.

1. Financial results were nothing to get excited about. Both for the quarter and for the year, investment income was down, as was Net Investment Income and Net Asset Values. For the final quarter, AINV only earned $0.28, which was just equal with the dividend. NAV, as warned about by the Company a few weeks ago and discussed in the BDC Reporter, was just over $10. The Company wrote-off its disastrous control investment in Grand Prix Holdings. That accounted for just half of the Company's sales, as they continued the portfolio cleansing process: selling some portfolio investments (at a loss) and restructuring some other investments in order to live to fight another day. There were a few good news items, such as another $42 million distribution from GS Prysmian, but overall the quarter was marked by losses: ($58 million) for the 3 month period.

Management sought to argue that the "worst may be behind us" for credit quality, indicating that better times may lie ahead. This may turn out to be the case, but this quarter did see 3 new deals added to the non-accruing category and leaves the total at quarter-end at 4 companies (out of 67). These poor performing assets have been sharply written down. Their cost is 6.8% of the investment portfolio, but only 0.7% at fair market value.

It's not quite yet time to close the books on bad loans coming out of the Great Recession but Apollo has ($583 million) in Realized Losses to date, most of which were recognized in the past 12 months. We've said before that Realized Losses may top at ($600 million), and that may be optimistic. There's still ($384 million) in Unrealized Depreciation to work through after all. Not to rub it in, but if all those losses come to pass ($967million - gulp), they represent 37% of the equity at cost on the Company's books as of March 31, 2010. For an investor who might have bought into Apollo's stock at the height in mid-2007, when the stock was north of $17 (and paying $0.52 a quarter), it's not a pretty picture.

2. Both the Conference Call and the Company's performance in recent quarters suggest that management is chastened by its credit underwriting track record of the last few years. We didn't hear much about the Grand Prix fiasco, but in the prepared statements, AINV admitted the investment was a mistake and would avoid those type of investments in the future. Just what was meant by that (avoid what ? equity investments ? huge positions ?) was not thrashed out. However, Apollo did discuss focusing principally on yield investments, and seeking to get a position as high up as possible on the prospective borrowers balance sheet as possible.

Moreover, Apollo suggested that they were going to aim for bigger rather than smaller deals because of the perceived better risk profile, as discovered during the Great Recession. Three new deals were done during the quarter, all yield investments, with an aggregate cost of $142 million. Moreover, AINV is not shy to add to positions in existing borrowers as smaller position holders sell to them at favorable prices. Our guess is we'll see AINV with a greater proportion of yield assets than in the past, and bigger positions in bigger companies.

3. Market opportunity: Looking forward, Apollo says it believes there is a major opportunity developing from the $400 billion of private equity available for buyouts, which is why the Company raised new equity at over $12 a month ago. AINV seems to want to position itself as a reliable debt undewrwriter for larger private equity buyers seeking to arrange buy-out financing, and needing a reliable partner who can stick with them through these volatile markets. Management boasted that they can write a $100 million check for a single deal, and claims only a handful of competitors have such a capability.

Certainly, Apollo has plenty of liquidity. Helped by its Great recession de-leveraging, new equity raised in recent months, a renewed $1.5 billion Revolver (albeit with some lenders saying bye-bye shortly) and loan turnover, AINV has $700 million to spend (their number) , which is 25% of their current investment assets at FMV. Debt terms are not too onerous (by comparison with some other BDCs both large and small), and Apollo is even exploring some other low cost financing alternatives (discussed on the call, but little revealed except that it's unlikely to be a CLO).

In the short run though, management did not make much of a case for a sharp increase in investment assets. AINV wants to take advantage of market opportunities when they occur but did admit there were periods in recent months when mezzanine financing was getting unattractive for providers (too much money flowing into high yield and squeezing risk spreads). Management does not like to talk about "loan pipelines" or provide any guidance (which is their right and is probably wise given these roiled waters), but the impression given is that total assets will not be topping $3.5 billion (the total investments at March 31 + the $700 million available to spend) any time soon. There does not seem any meaningful primary LBO activity, so we might see more secondary purchases and portfolio cleansing dominate the rest of 2010.

4. Earnings Outlook: That segues nicely into our next point (which we've made before and has not been popular with all our readers): Apollo's earnings, and earnings per share should continue to trend downwards in the next quarter. The consensus (if Yahoo Finance is to be believed) is for $0.30 a share, but we'll stick our neck out and say that seems unlikely. There will be another 17.25 million shares issued in April to "feed." Then there might not be a distribution from GS Prysmian, and still those 4 non-accruing loans (3 new after all). If Net Investment Income just stays flat for the quarter, the per share number will be $0.24, down from $0.28 this quarter.

Further down the road we expect to see asset growth and earnings growth, but nothing dramatic We read that S&P is projecting Net Investment Income Per Share of $1.32 for FY 2011 (ended March 2011) and $1.56 the following year. We're not that optimistic. Again it comes back to the lessons learned from the Great Recession. We think Apollo is going to be more cautious than usual, and will be seeking to steer away from leverage that would take it anywhere near the levels which could cause it get into trouble on the asset:debt coverage. That will mean slower and less asset formation. Whether that will be good or bad, only time will tell. There's no one way to manage a BDC portfolio.

5. Dividend: Still, the dividend appears safe for the moment. Admittedly earnings are now only equal with the pay-out, and may soon be underwater. However, if Apollo wants to keep on raising equity from investors maintaining the dividend is a key selling point. The Company still has a huge pot of Undistributed Net Investment Income to make up any dividend shortfall, so there's no great hurry. A cynic might point out that Apollo has been under-distributing earnings to its shareholders for several quarters to keep monies around to pay old and new investors at the 28 cent distribution level , which just delays receipt for shareholders what they were due anyway and now have to share with new shareholders added in April. We just think it's good dividend management (stability is what most every shareholder looks for).

Disclosure: Author long AINV