In the first quarter of 2013 several high flying Business Development Companies ("BDCs") stocks have dropped sharply in value. We are calling these the BDC Biggest Losers and we propose to analyze each company in turn to ascertain what may have caused the change in sentiment, and whether the new price level represents a bargain, or not, for investors.
We begin with Fidus Investment Corporation (NASDAQ:FDUS), a small Chicago-based BDC which lends and invests in smaller private companies undergoing buy-outs and recapitalizations.
BEFORE THE FALL
Fidus has been highly successful since going public nearly three years ago, but the early going was no fun. The Company came to market just before the Euro-crisis at $15.0 a share in June 2011, and was almost immediately caught up in the uncertainty about the future of the global capitalist system. The stock dropped up to 23%, reaching a low of $11.51 on September 19th, 2011. From that point on, though, Fidus has been a rock star in the BDC world, moving up to reach an-all time closing high on December 27, 2012 of $22.29. That's a 94% increase from low to high. Even against the IPO price and leaving out the price depression of what was happening in Europe, the stock is up nearly 50% in less than 3 years. See the Yahoo Finance chart.
Of course, the stock price reflects the positive earnings and distribution performance of the Company. Thanks exclusively to equity capital raised at the IPO and subsequently, and SBIC funding, Fidus has doubled the size of its investment portfolio since the first earnings announcement in June 2011. Recurring Net Investment Income Per Share (adjusted to exclude capital gain fees) is up 14%, and the corresponding dividend has risen steadily, to be higher by nearly a fifth over the starting point.
The cherry on the cake was in 2013, when the Company sold several investments for a Realized Gain, and announced two Special Dividends (which were "deemed distributions" where the Company pays the capital gain tax). As a result, Fidus paid out $1.94 in distributions in 2013. As a percentage of closing Net Asset Value of $15.35, that's a 12.6% return.
Since peaking on December 27, 2013, FDUS has lost a fifth of its market value, dropping to a low of $17.86 on March 27, 2014, before rallying sharply Friday to close at $19.14. At $17.86, the stock was at a level not seen since June 13, 2013.
Why the drop? We guess that a portion has to do with profit taking. On no news, and before the year-end earnings release on March 6th, FDUS was already down 6.5%, or a third of its ultimate loss. Then the IVQ 2013 earnings release did not help the cause. The stock did not drop straight down like many other BDCs we will cover, but the trend was down, and volumes were unusually high. This suggests many existing investors were folding their tents and going home.
On an annual basis, the earnings of Fidus for 2013 (as we've discussed) were excellent; investment yields remained very high at 14.5%; the balance sheet was very strong with net debt to equity of 0.4 to 1.0; all investment assets match funded with low-cost, long-term SBIC debentures, and so on. Furthermore, unlike many other BDCs, the Company's Net Asset Value was higher three years after going public, and that's after making those huge distributions in 2013.
The fly in the ointment may have been concerns about the Company's portfolio credit quality. For the first time since going public, one of the Company's 37 portfolio investments was placed on non-accrual: Elephant Bar, a restaurant company. The cost of the investment is $7.3mn, and was marked down to $3.0mn. That accounted for $0.32 a share of potential losses. An even bigger problem-although not on non-accrual-is Avrio Technology Group, in which FDUS has invested $12.1mn, but has been written down to $3.2mn.
A SENSE OF PROPORTION
In the bigger scheme of things, the impact of these reverses on the Company's recurring earnings and net asset value is relatively modest compared to the $60mn drop in market value experienced since December 27, 2014.
The impact on cash earnings should be minimal. The restaurant group's interest forgone is about $1mn a year, less than 2.5% of annual Investment Income. Avrio is not in default, but all interest is in PIK form, and may or may not be being accrued into the P&L. If we assume both investments no longer contribute to income in any way (whether in cash or PIK form), the loss of investment income is under $2mn a year. FDUS will need to deploy less than $15mn in new loans to make up for interest income forgone. Thankfully, the Company has oodles of unused capital available. There's $53mn in cash, $31mn in undrawn SBIC debt capital and another $50mn waiting in the wings. (Even more if the Congress ups the SBIC limits again). That's $134mn technically available. The real number is probably closer to $100mn (FDUS will never use up all its cash), but you get the idea. The Company can absorb the loss of income from the two under-performing investments many times over before recurring earnings and dividends are impacted.
POTENTIAL HIT TO NAV
From a Net Asset Value standpoint, write both those investments down to zero, and you've got a potential loss of about $20.0mn, or $1.48 a share. Assume some level of recovery and the loss may be $1.0 a share. Fidus has been conservative enough in its value marks, having written the two investments down by more than two-thirds already. Yet, the stock price-from high to low-is down $4.43.
So what to make of all this dramatic apparent over-reaction to two troubled loans? (By the way, as far as we can tell the rest of the portfolio is performing as expected). The Company appears to have substantial growth prospects in the years ahead. If you believe the Analyst Consensus (there are only two firms involved), the Company's adjusted Net Investment Income Per Share should increase from $1.54 in 2013, to $1.77 in 2014 and $1.86 in 2015. If you annualize the IVQ 2013 results, recurring Net Investment Income Per Share is already running at $1.64.
WHY THE DROP?
There are a number of possible explanations:
- The sector is down because of concerns about certain stock market indices dropping BDCs from inclusion: This may be a contributing factor, but the sector as a whole is down -3.8% since Fidus was at its all-time high to the low, but the Company is down closer to -20%.
- Market over-reaction: Fidus is a micro-cap, and trades only about $1.5mn worth of shares a day. When any big number of investors-which might include some "momentum" type investors who had been drawn in by the ramp up in prices that preceded the fall- the drop in the stock price can be amplified.
- FDUS was over-valued, and has adjusted down to "fair value". The argument here is that the stock "got ahead itself" in the last couple of years-with the stock price increase far outstripping the increase in earnings. (Isn't that what the bears say about the S&P?). The drawdown has just brought sanity back to the stock price, and FDUS is now "fairly valued". This suggests Mr Market was a little over-the-top for awhile, but has regained his senses. The current forward Price to 2015 projected earnings of 9.6x is more reflective of how a small, mezzanine-focused BDC will trade going forward. One could argue that the recurring dividend of $1.52 which the Company is paying yields just 8.5%, and that the Company still trades at a premium to Net Asset Value.
GOING THE DISTANCE?
All the above may be true to varying degrees. However, we believe the key issue is that the market is undecided about how sustainable the Company's Net Asset Value will be over time, and in all market conditions. Only a handful of Business Development Companies have been able to maintain or increase upon book shareholder value through a full business cycle. Usually a BDC will incur losses and Net Asset Value will permanently erode. A few months ago, it appeared that Fidus, with a diversified loan portfolio, but also equity investments in virtually all portfolio companies would be able to generate sufficient Realized and Unrealized Gains to offset the inevitable credit losses that inevitably come with lending money.
CAN FDUS MATCH MAIN STREET ?
BDCs which have managed to pay a handsome dividend AND demonstrate an ability to maintain net asset value over the long term have been rewarded with very high multiples, and significant premia to book value. Take for example another lower middle market lender: Main Street Capital (NYSE:MAIN). The company is a proven performer, which been around for years. Today, the value of the loan portfolio exceeds the modest Net Realized Losses accumulated since inception. MAIN has recently traded at an 80% premium to NAV, and 14.5x future earnings.
RETURN TO GLORY OR NEW NORMAL?
Till recently FDUS was being considered by the market as one of that small minority of BDCs that could regularly increase dividends and Net Asset Value over the long haul. FDUS traded as high at 12.0x future earnings.
If Fidus is able to demonstrate that portfolio credit losses can be offset-over time-by harvesting capital gains amongst its myriad equity investments-we expect to see the Company's stock, premium over NAV and multiple move back to the levels already seen. That might mean FDUS could revisit a $22.50 (or higher) price, an 18% jump from Friday's close and 26% above the recent low. However, if the market believes that over time losses will overtake gains, we may not see much of a run-up in the price from here.
WHAT SOUTHLAND CAPITAL MANAGEMENT IS DOING
We don't want to be coy. Southland Capital Management, the Registered Investment Advisor which publishes the BDC Reporter, is bullish on the Company's long-term prospects. We did sell a portion of our holdings when the stock was close to all-time highs, but only to have room to buy more if and when we had a sell-down. Which we did, as we've discussed in detail above. So we bought more in our Funds (for more information about Southland Capital Management's "hedge fund" go to www.southlandcapitalmanagement.com). We also added in recent days to our FDUS position in one of the portfolios we manage. We have a $22.0 Target Price.
There is no guarantee that FDUS will re-visit its prior heights, but given the ample liquidity of the Company; the investment track record to date; the reputation of the Manager (we've heard good things from people in the know in Chicago) and the successful business model (15% loan yields, low cost, long term capital, a fair management fee), the downside risk is limited, and the potential capital gain upside equal to two years of distribution income.
Disclosure: I am long FDUS, MAIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.