Main Street Capital (NYSE:MAIN) has been one of the better performing business development companies ("BDC") over the past year, as strong net investment income ("NII") has allowed it to increase its monthly distribution. In the first quarter, the monthly distribution was $0.165, which was up 10% year over year. MAIN will be holding the dividend steady in the second quarter of the year, though strong first quarter results that were announced Thursday afternoon open the door to another increase later this year.
For those who are unaware, a BDC lends to mid-sized companies to facilitate their growth and then distributes at least 90% of earnings to shareholders to maintain an advantageous tax status. Net investment income is what pays for the distribution, so it is the key figure when evaluating a BDC. If a company's distribution is higher than NII consistently, that is a warning sign that the distribution may be cut. Conversely, if NII continues to exceed the distribution, there may be room to increase the dividend. This quarter, MAIN delivered good news (financial and operating data available here).
Distributable net investment income was up 21% year over year to $21.6 million or $0.54 per share. Because of an increase in the share count, the per-share growth was only 4%, which is still solid growth for a BDC. The average share count rose to 39.9 million from 34.7 million last year. Because a BDC returns virtually all of its earnings to shareholders, it needs to raise capital to expand its lending. To maintain its balance sheet's integrity, MAIN uses both equity and debt to fund new loans. Year over year, the portfolio increased by 1.6% to $1.38 billion. MAIN also maintains a very conservative leverage ratio of 1.7x, and MAIN can use more debt to fund new deals without adding to much risk to the company's financial strength.,
During the quarter, book value per share increased by $0.25 to $20.14. Now, unlike most firms in the space, MAIN is trading at a significant premium to book value. Based on Thursday's close, shares are trading at a 53% premium to book value. For comparison, leading BDC, Prospect Capital (NASDAQ:PSEC), is trading at a 5% discount to its book value. Now, PSEC is facing SEC scrutiny over how it accounts for controlled investments (it has not been consolidating them on its balance sheet and income statement). This revelation has put downward pressure on shares. However, it is worth noting that MAIN carries $365 million in controlled investments and could be subject to the same scrutiny. While this is mostly an accounting issue that has no real impact on cash flow, SEC inquiries are never good news for bulls.
MAIN's conservative lending approach and prudent balance sheet management have delivered slow and steady results for investors. In this quarter, MAIN once again generated more net investment income than it has paid out. Over its life, MAIN has built a reserve that totals $1.16 per share. This excess taxable income it carries amounts to a solid rainy day fund that will allow MAIN to maintain its distribution even if there is temporary downturn or rough patch. MAIN yields a solid 6.4%, and I expect another $0.005 monthly dividend increase before the end of the year. This would increase the annualized payout from $1.98 to $2.04.
For investors looking for a conservative dividend payer that can offer modest dividend growth, MAIN is a good choice. However, investors have to pay up quite a bit to buy MAIN. Its premium to book value is a very large 53%, meaning it would be 35% cheaper for you to build its portfolio yourself than buy MAIN shares. Of course, an individual investor cannot build MAIN's portfolio of private loans, but it puts the valuation in perspective, especially when peers like PSEC, which offers a 13% yield, trade at a discount to book. MAIN is fine income stock, but it is richly valued. As a consequence, I would not be a buyer here. I would rather see a pullback below $27 before I would consider MAIN. MAIN works for investors seeking some income, but those seeking capital appreciation should look elsewhere. Even with the SEC overhang, I think PSEC is a more attractive value than MAIN.
Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.