There has been much hullabaloo surrounding upper middle market Business Development Company (“BDC”) BlackRock Kelso (NASDAQ:BKCC) in the last couple of days. On Tuesday, March 8, at the opening, the company released its fourth quarter earnings report and its annual 10-K filing. After the market close came the conference call. In between the company’s stock price dropped from $12.69 to close at $10.20. That’s a 20% drop, and quite a move for a company that maintained its dividend for a sixth quarter in a row at $0.32. We’ve had a number of emails (OK, just two) here at the BDC Reporter asking about what’s happening to BKCC, so we thought we would have a go at explaining the sudden state of disillusion with BlackRock Kelso.
Of course when a stock drops sellers are not asked to sign a feed-back card as to why they’re getting out (note to the SEC: look into this), so we’ll have to speculate. We’re doing so, though, after reading the earnings release, reading the 10-K and (most interestingly) listening to the conference call. (Which explains why it’s taken us so long to offer up our two cents).
Mind the Gap
Most likely the problem lies with the widening gap between the company’s robust dividend ($1.28 a year) and its current earnings, as reflected in Net Investment Income Per Share, or NIIPS. The latter came in at $0.96 for the year and $0.03 for the quarter. BKCC is the only BDC we’re aware of which does not charge its incentive management fee quarterly, but annually. As a result, at year-end there’s a massive calculation undertaken and this year an equally massive incentive fee charged which leaves the company with very low earnings for the quarter. To management’s credit, there is a disclosure every quarter about the likely incentive fee, which investors can use to assess the likely annual number. Nonetheless, the drastic drop in the quarterly number may have spooked some investors not paying attention.
Or, maybe, investors were spooked by the drop in the annual earnings, both in absolute terms and in per share terms, from 2009. Net Investment Income dropped from $76mn to $$60mn. That’s a 17% drop. The Per Share drop was 29%. Yet, the drop-off compared to 2009 has been known all year, and the gap between what BKCC pays out and the GAAP earnings per share has been a feature for several quarters. We pointed out in mid-2010 that the dividend-earnings gap was growing wider, and earnings seemed unlikely to catch up, especially after two equity raises within six months.
Denial Is a Conference Call With BlackRock Kelso
In any case, this issue was the subject of several questions during the conference call Q&A. Analysts asked in different ways how and when BlackRock Kelso would be able to increase its earnings. Management replied by indicating that they foresaw earnings would catch up with the dividend late in 2011, on the assumption that total net new assets would increase. In the short run, though, management conceded that earnings are likely to soften in the first and second quarter of 2011 due to the higher interest cost on its recently added Term Debt (3% points higher on $175mn is $5.25mn in extra interest cost or 7 cents a year ). Also, business activity has been slower in the current quarter than the busy fourth quarter of 2010, which does not bode well for materially higher income in the IQ of 2011. Other tid-bits: Management indicated relatively high dividend income from equity and preferred investments may not recur at a corresponding level early in 2011, which would depress income somewhat. Likewise, 2010 was boosted by $10mn in fees (more on that later) and $2.7mn in the fourth quarter alone. With less business activity in the first quarter of 2011, fee income may also drop in the short run.
Nonetheless, BKCC’s management reiterated that earnings could still play catch up over time, without committing themselves (very rightly) to a schedule. Management pointed to the under-leveraged status of the company, and the considerable amount of capital available in the form of potential borrowings under its $355mn revolving Credit Facility. Thanks to raising $175mn in Term Debt in January, BKCC has virtually no outstandings under its Credit Facility. It is this capital which should be the source of future earnings growth for BKCC. Fully drawn BKCC would be able to increase assets at cost from just under $1bn to over $1.3bn.
However, it’s hard to know how much of the Credit Facility BKCC can legitimately tap because we don’t know what is the company’s borrowing base. Some BDCs - like Gladstone Investment (NASDAQ:GAIN) as a random example - detail in the SEC filings what the current availability is under their revolving lines of credit. BlackRock is more circumspect and quotes the maximum amount available “subject to compliance ... with borrowing base limitations," without spelling out what those might be. There are concerns about getting too leveraged. If BKCC used all available borrowing capacity its debt to equity would approach 0.8:1.0, which is higher than most BDCs are willing to go.
Back of the Envelope Calculations
Still, we did some pro-forma calculations, and we’ll give you the highlights. BKCC has 72.6mn shares outstanding. At $1.28 a share in dividends that’s potential distributions of $93mn annually. For 2010, Net Investment Income was $60mn. Adjust downward for the higher interest expense going forward, or $5.25mn. If we assume BKCC borrows $300mn of the $355mn Credit Facility (there’ll always be an unused amount in reserve) and that 90% is invested in yield assets at the current all-in yield of 10.9%, and after deducting for interest on the debt and all fees, we come out with incremental earnings available to shareholders of $8.0 mn. Total that with the ongoing earnings and you’ve got a $1.3bn BKCC in assets with earnings of $63mn. Divide that by shares outstanding and earnings per share are $0.87.
That’s nowhere near the $1.28 dividend, and we’ll let everyone do their own calculations because there are a legitimate number of different assumptions that could be used that would give slightly different results up and down. However, BKCC can’t count on higher yields to help them out as their market segment which is currently quite competitive due to the floods of cash available in the larger sized financing market. Costs mostly consist of management fees, which are set by formula. There is a major equity investment that could be realized for $50mn or more and re-invested into yield assets. That’s worth a few cents of higher earnings. Still, that gap seems too wide to be made up.
The Twist in the Tale
Like any good story, though, there’s a twist. Remember those front end fees? For GAAP purposes that income is amortized over the life of the underlying loans. For tax purposes, though, BKCC takes all the fees into income in the year they’re received. The upshot is that Taxable Income is significantly higher than GAAP Income. That explains why BKCC still made spillover income in 2010, which has been deferred into 2011 even though its GAAP earnings fell far short of its distributions. Nor is this fee income likely to go away in the next few years as BKCC leads more deals and deploys its extra capital.
Now we’re looking at three metrics: The dividend rate, GAAP Income and Taxable Income. We don’t understand why BKCC’s management does not just explain that GAAP income will not meet the dividend but taxable income might help get them closer (after all $10mn in fees equals $0.14 in income per share).
We Throw in the Kitchen Sink
There are other moving parts here. BKCC still has a loan portfolio in transition, capable of appreciation or depreciation. The fair market value is still only 89% of original cost, and non-accruing debt at 1.8% of loan assets, which is neither terrible nor great at this stage in the cycle. On the plus side, BKCC’s internal ratings have only $28mn of the total portfolio (3%) in the lowest two categories of risk.
Debt to equity is marvelously low but won’t be if BKCC has to fully lever up to rebuild its earnings. On our pro-forma assumption above of $300mn drawn on the Revolver takes debt to equity to 0.7:1.0, which is the edge of the leverage envelope in the Brave New World of the post-Great Recession.
If all this leaves you confused, that might explain what happened to the stock in the last 48 hours. Investors and analysts will sort it all out in the next few days. We don’t have any pat conclusions down, just these observations. We hope they’re useful in some way.
Disclosure: I am long BKCC.