MCG Capital: Light At The End Of The Tunnel?

| About: MCG Capital (MCGC)

MCG Capital (NASDAQ:MCGC), a business development company, released its earnings report for the fourth quarter (ending December 31, 2011) on March 1. Based on the report and the conference call, it appears that MCGC is well along the way in its transition away from equity investments and toward a more traditional BDC role as a lender to small and mid cap companies. Can we see the proverbial "light at the end of the tunnel" through the fog of financial disclosure? More importantly, can we be sure that whatever light we may see is daylight rather than a parabolic mirror reflecting our search lights or, worse yet, the headlights of a diesel locomotive heading in our direction?

MCGC made some truly disastrous investments in the equity of certain companies, most notably Broadview Networks. Recent quarterly financial reports from MCGC have been dominated by losses due to the write down of these investments. In the most recent quarter, the Broadview position was written down by $18.3 million and the position in Jet Plastica was written down by $21.9 million.

The good news going forward is that the Broadview position is now carried on the books for some $11 million and the Jet Plastica position is now carried at some $9 million so that, as a simple matter of mathematics, the next round of write offs of these two will have to be much smaller than the last. The bad news is that all of these write offs have reduced net asset value (NYSE:NAV) per share to $5.65, which undermines this author's thesis that the stock is undervalued because it is so "cheap" in comparison to book value (MCGC closed Friday at $4.31 so there is still is significant discount).

If most of the risk of future write downs is in the equity portion of the portfolio, we can get a handle on its potential. At the end of the last quarter, the book value of the equity holdings was some $112 million but it appears that after the close of the quarter, MCGC received $24.7 million for one of those positions reducing the total to $87 million. Management plans to monetize equity and produce another $50 million this year; assuming they succeed this leaves $37 million in equity positions (including the $11 million Broadview cigar butt). If they eat the $11 million as a loss and write off half of the remaining $26 million, the total write off would be $24 million or 32 cents a share. There is no assurance that things will play out this way and, of course, they may have to write off some debt instruments also. But the debt portfolio seems to be behaving reasonably well and more and more of the debt instruments are the products of the new, more careful management.

The company committed to pay dividends of 14 cents a share for the next two quarters and, given that they project a net operating income of 50-60 cents a share for 2013, an annual dividend of 56 cents a share is a reasonable, but not entirely safe, assumption. At the current price of $4.31, this produces a yield of 13%.

Assuming management can execute and assuming that there are not any more big negative surprises on the balance sheet, this could be a position that would return double digit yields on the current price and could produce appreciation toward $5 and perhaps slightly above if management executes. It is certainly worth examination if, in one of the market squalls that will inevitably develop, the price dips below $4. At the current price, I would still recommend it as an element in a BDC portfolio becausebit offers significant upside. However, investors should realize that, unfortunately, the easy money in the post 2008-09 market recovery in the BDC sector has already been made (I bought a lot of this stock at 85 cents a share in early 2009).

Disclosure: I am long MCGC.