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 Still, shares have fallen over 10% from their 52 week high. In the second quarter, the monthly distribution was $0.165, which was up 6% year over year. The company also paid out a special supplemental dividend of $0.275. MAIN will be holding the dividend flat in the third quarter of the year, but management is hiking its monthly payout to $0.17 in the fourth quarter thanks to strong results so far 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 taxable 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 another set of strong results, but shares remain too expensive to buy (financial and operating data available here).
Distributable net investment income was $0.56 per share, which was up from $0.53 a year ago. This net investment income comfortably exceeded its $0.495 in regular distributions, which is why management was able to increase the distribution. Now while net investment income per share was only up 6%, net investment income was up 32%. However, the diluted share count increased 27% year over year to 44 million. This increase in the share count seriously slowed per share metrics.
Because Main Street has to return the majority of its income to shareholders, it needs to issue debt and equity to increase the amount of money it can lend. To maintain a strong balance sheet, this issuance is often done on a roughly 50/50 basis between debt and equity. Year over year, the portfolio grew by 11% due to this issuance. MAIN has a debt to capitalization ratio of only 39%, so the company is very conservative and could choose to fund new loans through a higher proportion of debt.
This conservative financial policy flows through to the dividend policy. As mentioned above, MAIN distributes slightly less than it can, which has been a long standing practice. As a consequence, MAIN has built a rainy day fund from which it can pay dividends if performance were to weaken. This fund is worth roughly $0.80 per share.
With limited leverage, a growing portfolio, strong credit quality, and reserve fund, there is a lot to like about Main Street. As an added bonus, shares yield over 6%, which is a fantastic yield in a low-rate world. Unfortunately, its share price reflects the underlying strength of its business. Book value increased 6% year over year to $21.03, so shares are trading at a 47% premium to book value. At the end of the day, MAIN is really a portfolio of mid-market loans, so this is a dramatic premium especially when considering the fact that other BDCs like Prospect Capital (NASDAQ:PSEC) trade right around book value. Similarly, many US banks like JPMorgan Chase (NYSE:JPM) trade below book value. While MAIN has delivered consistent results, this premium is just too steep.
With shares trading at such a premium, management might also be more inclined to fund new loans with equity rather than debt since its cost of equity is so low. Issuing equity at current prices will also help to increase book value per share. A relatively high level of issuance could also put downward pressure on shares. MAIN is a great company, but a 47% premium to net asset value is simply too steep, especially when investors can buy great financial companies around book value. Given its strong track record, I would be willing to pay 1.25x book value or $26-$27. While BDCs are popular income products and MAIN has a great dividend, investors should wait for a better entry price.
Disclosure: The author is long JPM. 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.