The last year has been a very difficult one for many Business Development Corporations and Apollo Investment Corporation (NASDAQ:AINV) has been especially hard hit. AINV shares have lost over 1/3 of their value. Losses in energy and CLO holdings have contributed to the decline in net asset value. The share price decline has been compounded as the discount to NAV has also widened. AINV now yields 14.4% and trades at a 23% discount to NAV. Fiscal Q4 net investment income of 20 cents per share was barely sufficient to cover the 20 cent quarterly dividend. Many investors fear a dividend cut or further declines in NAV
This contrarian article will present the positive case for AINV. Management fees have been reduced and there is an aggressive share repurchase program. More favorable financial and energy markets could result in a partial reversal of prior write-downs. These positive factors could help improve dividend coverage. Given the depressed price of AINV, it would be quite a pleasant surprise to investors if NAV actually increased in fiscal Q1.
Discount to NAV
Net asset value was $7.28 as of 3/31/2016. At a recent price of $5.64, AINV is trading at a 23% discount to NAV. Out of the Closed-End Fund Advisors database of 52 BDC issues, only 13 trade at a larger discount. Apollo is the largest BDC among this deeply discounted group. The somewhat smaller Fifth Street Finance (NASDAQ:FSC) is also notable for it 42% discount to NAV. Perhaps FSC will be the subject of a future article. FSC is about 60% the size of AINV, as measured by equity market capitalization.
Reduction in management fees
On 3/11/2016, Apollo announced a major reduction in fees for fiscal 2017 which runs through 3/31/2017. The base management fee has been reduced to 1.5% of gross assets. Incentive fees were also lowered to 15%. Fees have only been officially decreased for 1 year, but there are indications that these changes may be more permanent. In response to a question on the fiscal Q4 conference call (See page #8), CEO Jim Zelter suggested that Apollo would continue their long term trend towards lower management fees:
"We have had this question in the past, I think our Board views that because of the contracts or 1-year rolling contracts that's how they chosen to deal with it. Certainly, we are very aware of how the market would react, if we were to reverse the trend that we have been taking so far. So again I think that we are some folks have all also pointed out that why don't you make these things permanent. I think we are comfortable with the trend that we have shown over the last several years and continue to lean into doing what's right by shareholders with regard to this theme".
Share buyback program
Apollo has a very active share repurchase program. As per page 1 of the fiscal Q4 earnings report, the company:
"Repurchased 2,012,126 shares of common stock for an aggregate cost of $10.0 million during the quarter which brings total share repurchases to 10,584,855 shares of common stock for an aggregate cost of $62.4 million since inception of the share repurchase program in August 2015 through May 18, 2016"
How much could this repurchase program add to NAV for the current quarter ending in June? Let's assume that another 2 million shares are repurchased at an average cost of $5.50 per share. The current NAV is $7.28 per share, so the expected gain from repurchasing shares would be about $3.6 million. This is over a penny a share on the $226 million shares outstanding.
AINV is a low risk issue
Total debt holdings comprise 85% of the portfolio. 1st lien and 2nd lien secured debt accounts for 2/3 of portfolio assets. This focus on debt reduces risk as compared to many BDC peers with a higher percentage of equity holdings.
While many investors still think of AINV as having a huge level of exposure to energy, this sector now accounts for only 11.9% of the portfolio assets. The aviation sector (17.0% of assets ) and Business Services (16.1% of assets) account for the largest concentration of holdings.
AINV is much larger than most BDC peers. Out of 52 BDC issues in the BDC Universe database from Closed-End Fund Advisors, Apollo is the 6th largest as measured by market capitalization. Size matters for a BDC. AINV is more diversified and has better access to capital than many smaller BDC peers.
All BDC's are legally prohibited from having balance sheet debt exceed 1X assets. AINV leverage was a comfortable 0.77X as of 3/31/2016. Note that AINV is far less leveraged than a typical bank which has 6X to 10X balance sheet leverage.
Possible gains in energy holdings
As of 3/31/2016, oil and gas represented 11.9% of the portfolio as compared to 12.9% on 12/31/2016. This decline resulted from the disposal of some E&P assets as well as further markdowns of remaining assets. The deeply discounted shares of AINV reflect investor expectations for additional write-offs. However, oil and natural gas prices have rallied substantially since 3/31/2016. This has resulted in a broad rally in energy junk bond prices. If Apollo energy assets were marked fairly on 3/31/2016, then valuation increases are far more likely than decreases.
As CEO Jim Zelter commented during the fiscal Q4 conference call (see page #11):
"So, I think from that perspective kind of the worse is behind us. And now, we have equity upside in a number of different companies. So, to the extent that oil prices recover which you have seen in the June quarter to the extent it continues obviously there maybe some benefit for our shareholders of this portfolio".
Exactly how much could gains from higher oil and natural gas prices add to NAV? Many of the distressed E&P debt issues I follow are up 10%, 20%, 30% or more from March. To be conservative I will assume only a 5% gain for Apollo's energy holdings which would be approximately $17 million. Even such a modest 5% valuation hike would add 8 cents per share to NAV,
Possible gains in CLO holdings
Apollo's CLO holdings have been a source of investor concern, but the CLO market has rallied strongly since the end of fiscal Q4. AINV is discounted for further losses in the CLO portfolio. Current CLO pricing data is very difficult to obtain for these thinly traded issues, but favorable market conditions mean that gains for the June quarter (fiscal Q1) are more likely than losses.
There are several positive factors that should help to improve dividend coverage in fiscal Q1. Favorable financial markets may improve results from the CLO portfolio. Discounted share buybacks are accretive to earnings. Lower management fees leave more cash available to pay dividends. Interest costs have declined as a maturing bond debt issue was replaced by increased usage of a lower cost bank credit line. Chief Financial Officer Greg Hunt commented on the fiscal Q4 conference call:
"As I mentioned in January, we repaid $200 million of 5.75% convertible notes upon their maturity. We used borrowings under our revolving credit facility to repay these notes. The repayment of its higher cost debt benefited earnings during the period."
My Panick Value Research Report is focused on high yield preferred stocks and exchange-traded debt issues. I provide members with continued coverage of all of the high yield issues I write about here. The 14.4% dividend yield and 23% discount to NAV reflect unrealistically low investor expectations for AINV. The stock price has not received any credit for share buybacks, reduced management fees, the rebound in oil prices or more favorable financial markets. Even though fundamentals have improved substantially, AINV is still priced for a dividend cut and further declines in NAV. Given these unrealistically low expectations, even a mediocre earnings report could be a positive catalyst for AINV to trade higher.
Disclosure: I am/we are long AINV, FSC.
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.