Thoughts on MCG Capital's Q3 Earnings

Nov. 3.10 | About: MCG Capital (MCGC)

We just listened to MCG Capital Corporation’s (NASDAQ:MCGC) Q3 2010 conference call (see transcript on Seeking Alpha) and reviewed the earnings report and the additional materials on the website. Several analysts commended the company’s management on a good quarter, but our own feelings are more mixed. Yes, there were a number of positive highlights, and we’ll discuss those first, but there are some downsides too.

Most notably on the plus side, the company raised the dividend to 14 cents a share for the coming quarter. After two years of not paying a dividend at all, MCGC has now paid/announced three in a row, each higher than the prior one. Moreover, management made encouraging noises about the prospect of future dividend increases in the future, to be achieved from maximizing earnings in the current capital structure.

The company’s proprietary metric for measuring its recurring earnings – Distributable Net Operationg Income or DNOI-jumped to $12.4mn or $0.16 per share, from $10.0mn or $0.13 a share the prior quarter. DNOI is at a peak when compared with the past 12 months. New business activity was vigorous during the period, with $69mn in new deals added to the books.

As promised by management, most of the new investments are going into yield assets rather than non-income producing equity investments. Of the debt investments made most are the senior debt variety, with presumably lower risk, mostly being booked in the company’s CLO vehicles which benefit from very inexpensive funding. Balance sheet metrics improved with asset coverage increasing to 233%, and net debt (that’s net of cash) to equity at a respectable levels, and very little debt due in the next year that could cause trouble. At the risk of raining on the parade, there are a few clouds worth mentioning. Top of the list is the continuing credit erosion of the portfolio.

Unlike some other BDCs which took a broom to their troubled investments and cleared them out, MCGC has been nursing its troubled investments and selling them off when an opportunity presents itself. This is a perfectly reasonable strategy, but the problem is that there is still room for negative surprises. This quarter total non-accruals increased, thanks to Jet Plastica’s $19mn Subordinated Note ceasing to make scheduled payments. This brings total non-accruals on debt investments at cost to 18.3%, the highest percentage in 4 quarters. At a time when most lenders loan books are improving, MCGC is headed in the opposite direction.

Moreover, there is a danger than more trouble lurks ahead. Jet Plastica has a senior loan which is still current but could get into trouble. Moreover, looking at this quarter’s marks for Unrealized Depreciation, four companies incurred write-downs (including Jet Plastica) of ($22mn). There were partly offsetting write-ups of other investments but overall Unrealized Depreciation increased by ($13.2mn). Reading between the lines of management’s opening remarks, we’re surmising that the credit bottom has not yet been reached. As for those higher earnings mentioned earlier, some of that was due to the absence of the proxy fighting expenses incurred in the prior quarter. Without that variance DNOI would have been up by only $1mn. Still notable, but less impressive.

Another challenge facing the company is that loan pay-offs are outpacing new deal origination. Net-net the company’s book of business dropped by ($64mn) in the quarter. Management expects to get back into the plus column for net new assets in quarters ahead, which is critical to increase earnings. However, on the conference call, the company guided us to expect a flattening out of DNOI in the fourth quarter as yield assets temporarily drop due to the shrinking portfolio and the higher non-accruals. This might cause a pause in the dividend increases that MCGC has been achieving.

Looking further down the road the biggest challenge facing MCGC is restoring the company’s ability to be viewed by Wall Street as a ” business as usual” BDC able to tap the debt and equity markets at will like Ares Capital (NASDAQ:ARCC) or Apollo Investment (ticker: AINV). Currently the company is working with debt facilities left over from their heyday, but is unable to locate a new Revolving line of credit or term debt or raise new equity. There is no huge rush, but this conference call did not provide any clues that MCGC has made any progress in this area.

Medium term plans consist mostly of taking full advantage of unused SBIC borrowing capacity, and reinvesting CLO monies before the reinvestment period ends in July 2011. The two Unsecured Notes on the balance sheet will be paid off next year and in 2012 from the proceeds of loan repayments. For the gradual shrinking of MCGC to be reversed much progress needs to be made in turning round the bad debt situation and selling off some of the key Control Investments such as their equity investment in Broadview Networks, a telecom company.

Management seemed to offer the possibility that Broadview, and similar investments, might get sold in the quarters ahead. That would reduce concentration risk in the portfolio, increase yield income as proceeds are reinvested in debt instruments and possibly permit MCGC to access new sources of capital.

Otherwise, MCGC might be caught in a kind of unwanted de-leveraging, which will shrink assets and earnings. Ironically, the company’s balance sheet will look very strong, but growth will be stymied.

Disclosure: Long MCGC