We've just reviewed the Kohlberg Capital Corporation's (KCAP) 3Q 2007 Earnings report and listened to the Conference Call. We remain convinced that the Company is on the right track, and does not deserve the pounding which the stock price has taken, down nearly 50% from its high. However, there are some issues to worry about.
Starting with the results: Net Investment Income came in at $6.7mn, up from $5.9mn in the prior quarter, or 37 cents a share, up from 33 cents just a quarter ago. The loan portfolio remains heavily weighted to senior debt, and credit quality remains excellent: NO loans on non-accrual from the 83 in portfolio. In the IIIQ of 2007 KCAP also invested another $5mn in subordinated CLO securities issued by its subsidiary, Katonah Debt Advisors. The $33mn Kohlberg has in these securities accounts for 7.6% of investment assets, but contributes twice that much to total revenues. As the first loss piece, this is the riskiest portion of the Company's portfolio, but KCAP is being paid for the risk, earning 28% of annualized yield in the quarter. No loan in the CLO is in default either.
Overall, KCAP appears to have the right mix of risk and return: a modest 10% yield on the loan portfolio and the much higher return on the CLO securities, with a smidgen of equity co-investments for the occasional capital gain. The Company could write-off all its CLO securities and survive handily, with the dividend dropping by about 7 cents (assuming KCAP ramped up its lower risk assets). Painful, but not a disaster. On today's stock price of $12.76 that's still a yield of 9.4%. The balance sheet, like all BDCs, is strong, with debt only 67% of equity, and interest expense consuming only 23% of Total Revenues.
Net Income did take a hit in the third quarter, as did Net Asset Value ("NAV"), down to $14.77 a share. GAAP required the Company to write down its corporate loan portfolio, CLO securities and investment in Katonah for a total of 63 cents a share. Given that KCAP is a buy and hold investor we don't pay much attention to these losses. Already in the IVQ of 2007, the value of the loan portfolio is swinging the other way. Moreover, Katonah is back in business, accumulating loan assets for 3 funds. We're optimistic that Katonah will be a contributor to the Company's dividend in the years ahead as assets under management grow. Currently, Katonah has $2.1 bn of assets under management ("AUM"), and expects to be at $3bn next year. Over time the 0.5% per annum on assets will bring in millions in fees . We estimate that KCAP could be harvesting $10,000,000 a year (2/3rds of the fees from $3bn of AUM) by 2009, or over 50 cents a share of additional contribution to the $1.48 a year running rate. Even in 2007 Katonah will probably earn over $2.5 mn in Net Income. The market seems to be writing Katonah off, which is a mistake.
The biggest problem for Kohlberg Capital in the short run is that it is nearly fully invested. We estimate the Company can safely borrow another $30mn, which could add 4 cents a share to Net Investment Income Per Share. Management is talking about selling off at par lower yielding assets to invest in the higher yielding opportunities in today's credit marketplace. This might bring in another cent or two of higher NIIPS. However, with the stock price trading below its IPO price and below its NAV, KCAP cannot raise new capital (BDC rule). It could do a rights offering but management is not enthusiastic. The current strategy is to wait for the stock price to increase as it shall and will, as long as nothing untoward happens to the portfolio in the meantime. If non-performing loans should increase sooner rather than later in the loan or CLO securities portfolio, NIIPS could take a dip and KCAP could be frozen out of capital raising for years.
However, given the quality of the existing loan portfolio and the pedigree of the firm, we don't foresee a complete implosion on the credit front. A down and dirty worse case calculation, where half of the current CDO income goes away, and 10% of the Company's $370mn loan portfolio is non-performing still pencils out to an annual dividend of just about $1.0 a year, which still pays out nearly 8% in yield on today's stock price. On the upside, if Katonah kicks in as hoped, KCAP couyld be paying out over $2.0 of annual dividend by 2009, which equates to a stratospheric yield of over 15%!
Disclosure: Author has a long position in KCAP