We have just reviewed BlackRock Kelso's (NASDAQ:BKCC) second quarter 2014 results, read the 10-Q and the Conference Call transcript and, much to our surprise, come away with an upgraded valuation. Surprising, because BKCC has been a perennial disappointment over the past few years. We have reduced our Realizable Price (that's the price at which we would be prepared to sell our position) from north of $10.0 in 2012, to $9.5 and, most recently $9.0.
It's not just that BKCC has been paring down their distribution since the end of the Great Recession, while most other peers have managed to stabilize or renew an upward trend. As the Yahoo Finance chart shows, once BKCC began paying a full $0.32 dividend again in late 2009 (in earlier quarters, the Company was paying a partial dividend to harbor cash at a very dangerous time), the trend has been to the downside. With the most recent cut to $0.21 a quarter ($0.84 a year), BKCC's distribution has dropped by one-third. Compare that to Ares Capital (NASDAQ:ARCC), which has gone from $0.35 a quarter to $0.38, with a couple of Special Dividends thrown in.
DIVIDEND POLICY CRITIQUE
We were more put off by the manner in which management and the Board handled the distribution policy. For years BKCC's distributions were in excess of the dividend commitment. For years, management obfuscated and suggested that the situation was temporary and would be remedied by the deployment of unused borrowing debt capital into new loans. However, just running the numbers suggested otherwise, as high bad debts, higher borrowing costs and lower market yields conspired to reduce potential earnings. We wrote an article about the Company back in March 2011 on Seeking Alpha, which included a pro-forma recurring Net Investment Income calculation of $0.87. At the time, the Company was still paying out $1.28 in distributions. Subsequently, and with no clear message as to the reason for the timing, BKCC has cut the distribution twice: first from $0.32 to $0.26, and most recently to $0.21 a quarter.
MR MARKET WALKS AWAY
Mr. Market lost patience with the Company early on. The stock peaked in February 2011 at $12.75, and has dropped a remarkable 30% since then, mostly in a few fateful hours three and a half years ago. YTD 2014 the stock is down 7%, probably due to the second distribution cut in the first quarter. The stock price had another meltdown when that was announced, with the stock dropping 10% in a few weeks in the spring, suggesting many investors were flatfooted by news.
BUSINESS MODEL QUESTIONS
Of course, mismanaging investor expectations has not been the only weakness at BlackRock Kelso. The Great Recession brought out the weakness in the Company's business model of higher risk lending to larger borrowers, often in the form of subordinated debt and investing a high proportion of the BDC's capital in equity stakes. The business model presumably derives from the backgrounds of the two blue chip sponsors of the Company: BlackRock Inc. (a "needs no introduction" asset management firm with over a trillion dollars in assets) and Kelso & Company (a huge private equity player with a distinguished history). Bloodlines notwithstanding, the Great Recession resulted in very high Realized Losses at BKCC in both debt and equity. Mr. Market almost gave up on the firm, which lost 88% of the stock price value at the beginning of the Great Recession.
Unlike that other under-achiever Apollo Investment (NASDAQ:AINV), BlackRock Kelso's senior management team and sponsors have never publicly admitted that anything might be wrong with the Company's strategic direction, even as distributions have dropped by 50%, and Net Asset Value went down about as much at the nadir, and is still 40% off 8 years ago when the new firm went public with much promise.
Another brake on the Company's earnings performance, and reputation, was the seeming inability to grow the investment asset base, even after the Great Recession had ended. At the end of 2009, BKCC had $1.054bn in loan and equity assets at cost. As of June 30 2014 (4.5 years and a boom in leveraged lending later) total assets at cost are lower: at $954mn. In one way, we're happy that net debt to equity is a very safe 0.3 to 1.0, but in another way, we're frustrated that for all their substantial management fees, BKCC cannot utilize their very inexpensive Revolver (2.25% cost) to make decent investments at a 10% + yield, which most other BDCs of their size are able to accomplish.
FOCUSING ON ENERGY
Management will say there are being cautious in a very overheated environment for leveraged lending. We have no argument there, and BKCC must still be licking its credit wounds from the Great Recession (even if they're not acknowledging as much). Safe is good. However, there's no confirmation yet that the new assets being added are any more credit worthy than before. On the Conference Call, management is talking up a greater focus on making senior loans with asset collateral, while still achieving a BDC-like yield of 10% or more. The "collateral" here, though, are energy assets as BKCC joins most every other BDC and Private Equity group in the energy patch.
[As an aside: one of the few advantages of having been around as long as I have and having been involved in both standard buy-out lending and energy lending, is having no illusions. For years most bankers would not touch the energy sector, except through in-house specialized teams. Nor were most of the Private Equity groups buying consumer product companies and such, willing to invest in the sector either. The mantra of both lenders and Private Equity at the time was a focus on stable cash flows, and energy was the poster child for price instability, both during expansions and recessions. Nonetheless, there has been a sea change in sentiment and now both the BDC and the Private Equity sectors (which are linked in so many ways) have greatly increased their exposure to virtually every facet of the energy business. We expect a great deal of money will be made, but a great amount stands to be lost. Loans backed by energy assets are unlikely to be anywhere near as sound in a liquidation than those supported by receivables, inventory or even fixed assets-which used to be what lenders meant when they spoke of being "secured".]
ALL THE ABOVE NOTWITHSTANDING…
With all that said, we sought to review the latest performance with an open mind, and we came away shockingly sanguine about BKCC. Here are the three main reasons. Each of them, though, involves an assumption or two, which bear mentioning, as we shall.
1. Earnings and distributions have been brought into line, and we don't expect any further erosion in the dividend pay-out till the next recession. On an adjusted basis, BKCC earned $0.23 a share (albeit boosted by higher than usual fee income) and is paying out $0.21 a share.
Yield compression appears to have leveled off, and if we get higher long term or floating rates, BKCC's new business should benefit. Even if rates go nowhere (also a strong possibility), BKCC's loan yields should remain flat.
Adding to our confidence, there is still room for the Company to reduce cost of debt capital in the years ahead, which will benefit shareholders. Also, the Company is successfully selling off many of its too-numerous-to-mention equity positions, and the monies therefrom will at least pay off debt (reducing interest expense), or be ultimately redeployed into yield bearing assets. Those two items should support earnings.
Thankfully credit quality appears very sound at the moment (always a jinx), which means there's no pressure on earnings from non-performing loans. Every loan in the portfolio is performing, and the valuation of the portfolio suggests there are no major problem credits waiting in the wings.
As we've said earlier, BKCC is under-leveraged compared to its peers and has plenty of liquidity. Short of a dramatic failure by management to find attractive loan assets to replace what's coming off the books, BKCC has considerable room to grow both portfolio and earnings under most foreseeable conditions. The Analyst Consensus is $0.87 for 2015, which seems fair (or even a little low).
After years of over promising and under-performing (just 90 days ago the Analyst Consensus was $0.93) BKCC might be at an earnings inflection point. If so, the down drift in the distribution should be over and we might even (and now we're just being wildly optimistic) have the prospect of a slightly higher distribution in the future. We'll stick our necks out and project no decrease in the distribution for at least the next two years (barring a recession). We'll follow up every quarter and see how this bold claim is going.
2. 2.Net Asset Value could be headed higher. This quarter, thanks to a big Realized Gain and Unrealized Appreciation in the portfolio, plus a distribution level lower than earnings, BKCC's NAV went up. Going forward, management is leading us to believe (and we have bought in) that we might see further increases in the valuation of some of the equity investments in portfolio. That will boost NAV until those investments are sold. Furthermore, we will continue to have earnings in excess of distributions.
In addition, BKCC does have a stock buy-back program in place with some undefined automatic purchase triggers (and plenty of money to spend). Price swoons as we've seen in the BDC space in recent months could result in buying back stock at below NAV, which will boost the value for the remaining shareholders. As one analyst argued very cogently on the Conference Call, there's a case for much more buying back of stock. Unfortunately, while beneficial to shareholders in the absence of anything else to invest in, buy-backs reduce management fees, and are not popular with BDC external advisers.
The latest NAV is $9.79, up from $9.54 at year-end 2013. We could see NAV going over $10.0. That's still a long way from $16.0 (a number we will never come close to again), but is better than a poke in the eye with a sharp stick.
3. The balance sheet is very strong. Having faced the abyss in 2008-2009, BKCC's management has done a good job building a balance sheet capable of withstanding the next recession. Gone is the complete reliance on Revolver financing. In fact, Revolver outstandings were very minimal at the end of June thanks to the receipt of proceeds from selling equity stakes and the presence of privately placed Convertible Debt and Secured Debt. We may be disappointed that BKCC has not been growing the loan portfolio. However, the plus side is that the Company could face a 50% drop in asset values and still be within the 200% BDC coverage rules (assets to debt outstanding). Very few BDCs can say as much.
Describing one's valuation matrix is a little like describing one's dreams to loved ones: great fun for the dreamer, less for the listener. Still, for context, we should explain that we place every BDC we track in one of four categories (A through D), depending on our perceived outlook as to the stability of their earnings in the next hypothetical recession. An A rating is garnered by those few BDCs which we believe can face a recession with earnings and NAV essentially untouched. A B rating for a BDC whose earnings/NAV might drop up to 10%, a C rating up to 20% and a D rating for anything greater. The higher the letter rating, the higher multiple we apply to the Realizable Value.
Based on the performance in the Great Recession, BKCC merits a D rating, but we've assumed a less fierce recession in the future and some lessons learned by management and a with a strong balance sheet, we've been rating BKCC a C. Today, though, we are projecting future earnings of $0.90 (sorry Analyst Consensus) and a B rating or 11x multiple. That gives BKCC a $9.9 Realizable Value by our methodology, and close to the current and future NAV.
Our target price is substantially higher than the current price of $8.68 (at the close on Friday), which is only 3% below the YTD low. However, the BDC sector as a whole is only 2.5% off the 2014 low. We expect market conditions to improve. Furthermore, BKCC has traded as high as $9.21 since the latest dividend cut was announced, and $10.35 in the past 12 months.
If achieved, the Realizable Value represents a 14% potential capital appreciation. The current yield (which we expect to be stable) is 9.7%, and would be over 10% if the dividend were increased to our bullish earnings estimate. (Admittedly, that's unlikely). At the Realizable Value BKCC would still be yielding 8.5%.
There are downside risks to consider, besides the cagey relationship between the management of BKCC and its shareholders (which others may consider par for the course in the public company world).
1. Continued inability to maintain or grow the balance sheet: We are assuming BKCC's business model will allow the Company to grow its portfolio, after years of failing to do so. If we are wrong, earnings will be pressured even if everything else goes well. For the external investment adviser it is very hard to recognize to themselves and to the market that their chosen market niche may not be working out, and that investors would be better off getting repaid than funds being re-invested in more loans. Even now we continue to wonder if a BDC can make a sustainable profit in the upper end of the middle market, investing in both debt and equity. Competition from the highly liquid markets is very strong. Here we are giving the Company the benefit of the doubt.
2. Concentration risk: Like many BDCs with dozens of companies in portfolio, BKCC still has a concentration issue with 5 investments out of 44 accounting for 22% of the portfolio. Get a couple of troubled loans amongst the top 5 and all the economics change.
3. . Credit risk: Yes, there are no non-accruals. Yes, most every loan is carried at or above cost. Yes, management is being careful in adding new positions. Nonetheless, we really know nothing about the ability of the portfolio to withstand the next downturn. The EBITDA multiples and such provided in the 10-Q are interesting, but do not really illuminate.
WHAT SCM IS DOING
We're not journalists or analysts with no "skin in the game". We are fund managers with very real-and personal-capital at risk. For several years, we've either not invested in BKCC at all, or shorted the stock. As of Friday, the Company was our (only) short position in the BDC sector. (With prices down across the board, shorting opportunities are hard to identify). We bought in at $8.90, and are sitting on a small Unrealized Gain, despite BKCC's good results, mostly thanks to the miasma in the market.
On Monday morning August 4th, we closed out our short, and took a "long" position in BKCC, as per the above analysis. A 14% potential upside, an above average yield and a stock price 11% below NAV are encouraging metrics, especially with debt to equity so low and no credit troubles on the immediate horizon. We are buying at a stock price nearly 20% off the 2-year highs, and only a few percentage points off price levels seen since the end of the Euro-Zone crisis in late 2011. BKCC may be not "super-cheap", but is a Buy for SCM.
Disclosure: The author is long BKCC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.