MCG Capital: Transition To 'Normal' BDC Status Progresses

| About: MCG Capital (MCGC)

MCG Capital (NASDAQ:MCGC) recently announced its first-quarter 2012 earnings results. It reported net income of 2 cents a share and announced a 14-cents-per-share distribution. MCG Captial closed Friday at $4.27 a share. The company's numbers were adversely impacted by transition costs and certain other one-time events, and it appears that MCG Captial is on track to earn in the neighborhood of 10 cents a share going forward.

MCG Captial is a business development company (BDC) and, as such, distributes a large proportion of its earnings as dividends to its shareholders. The company's current distribution of 14 cents a share will probably not prove sustainable over the long term, and investors should not invest in this stock on the basis of an assumption that dividends at that quarterly rate will continue indefinitely. While management appears to be doing a solid job of turning this company around, the nature of its business (lending to small and midsized businesses and using only a modest amount of leverage) and its current portfolio will probably result in earnings that will support a dividend closer to 10 cents a share going forward. MCG Captial will, however, apparently continue the 14-cents quarterly distribution level at least through October.

The company has been through a difficult transition; it entered the "Panic of 2008" with a sizable portfolio of equity in small companies and a concentration in the competitive local exchange carrier (CLEC) business. This business was adversely affected by a number of developments, including Internet telephony, and MCG Capital has been required to write down the value of these investments on a very large scale. It determined that it would transition to more of a typical BDC mode, focusing its portfolio on debt instruments rather than equity and avoiding excessive concentration in one industry or one company. MCG Capital has now reached the point at which some 88% of its portfolio consists of debt instruments, and the company will likely move further in that direction.

The overwhelming majority of the write-offs are in the past, and MCG Capital has monetized some of the equity investments and is committed to monetizing others. The "whale" in the fish tank has been Broadview, and MCG Capital is still wrestling with the refinancing, sale, and restructuring alternatives in order to exit from this project. From an accounting point of view, MCG Capital's investment has been almost totally written off so that any monetization will be a pleasant surprise on the upside.

The company has a net asset value (NAV) of $5.45 a share and is trading at a discount of more than 20%; unfortunately, that NAV has been steadily declining due to write offs and distributions in excess of income. I think that there is reason to believe that NAV will stabilize north of $5 a share. The write-offs should be pretty much over and MCG Capital is buying back some stock, which, when the buybacks occur at prices below NAV, tends to increase NAV per share. MCG Capital still has a relatively high leverage level, although its large cash reserves insure that debt service is not likely to be a problem in the intermediate or near term, and it appears that the long-term objective is to reduce leverage. Over the next few quarters, MCG Capital should see its expenses decline as the transition is completed and may have some potential to reduce its borrowing costs. Earnings in the area of 10 cents a share should be achievable on a quarterly basis.

MCG Capital has its worst quarters behind it now and, as it emerges from the painful transition, should develop into a solid BDC, paying dividends in the 10 cents neighborhood with modest growth potential. I would recommend buying on dips as part of a diverse BDC portfolio.

Disclosure: I am long MCGC.