MCG Capital: On the Knife's Edge

MCG Capital (MCGC) reported its first quarter 2008 earnings today and held a conference call.

Revenues were up to $43mn from $40.1mn a year ago, but Distributable Net Operating Income was flat at $23mn, and DNOI on a per share basis was down to $0.34. Total assets were up 13% at fair value, but still DNOI was substantially below what management had been indicating just a few weeks before.

To add salt to the wound, MCGC reported that MCGC's largest investment, Broadcom (BRCM), would stop accruing income [all Preferred PIK] for the forseable future. From the second quarter, this is expected to drop Revenues and Operating Income by a massive 12 cents a share per quarter, or 1/3rd ! It's not that Broadcom is dropping in value. It's just not increasing, so accruing any more value in the form of Preferred is not warranted. (On a cash basis this makes no difference).

Last, but not least, the Company cut the dividend to 27 cents from 44 cents from the second quarter, and projected 2008 dividend per share at $1.25 (from $1.76 presumably just days before).

Comments: This is a lot of drama for one earnings release, but we'll focus on what happened to the dividend, because we were projecting just a few weeks ago that MCGC should be able to maintain the $1.76 a share pay-out. This is an extract of our prior conclusion:

2008 Outlook: MCGC's management points out that they've successfully been through 3 credit cycles, which is not to be sneezed at. We're putting our head in the noose and guessing that in 2008 MCGC will complete its Rights Offering, retain its existing lines of credit (maybe adding some new sources) and marginally increase its total assets. Non performing debt and preferred, including Cleartel, will remain high but not get worse. Taxable Earnings will drop, but the dividend will be maintained at or near $1.76.

Most of those predictions are either still up in the air or have come true, except for prediction on the dividend. We believed management's comments during the recent Rights Offering that the dividend was achievable at $1.76 and have been blindsided by the dividend cut. In retrospect, the very fact of a Rights Offering at a meager price per share (well below NAV) placed substantial pressure for a drop in the distribution, so it's our own fault for being gullible. Still, we have more to say about the dividend because on its most recent conference call MCGC used unexpected rationales for the change in in the pay-out, which may give us an inkling of what will happen next.

Explanation One: MCGC says the dividend had to be cut because of the future absence of the Broadcom income. Why shareholders were not be informed of the impending cut-off of the Broadcom preferred during the Rights Offering just a few weeks ago was not explained.

Explanation Number Two: MCGC says it wants to align the dividend more closely with Earnings Per Share, rather than Taxable Income or Distributable Net Operating Income (a MCGC-created metric which was the previous touchstone for the dividend). Given that EPS was at 4 cents a share for the quarter (mostly due to Unrealized Depreciation), management felt was justifcation for reducing the dividend from its 44 cent level. This argument makes no sense to us as GAAP Earnings are highly variable from quarter to quarter (because they include Unrealized items) and are not typically used by BDCs to determine their pay-outs.

Our Explanation: Our guess is that management had to cut the dividend because 1) there are more shares (9.5mn) being added to the 65 mn already issued, which have to be taken into account in the quarters ahead, and 2) with liquidity tight, existing and new senior lenders will be wary of providing finance to be paid out in distributions. The unsecured lenders to MCGC were ready in recent years to allow the Company to book 40% of their revenues in the form of PIK income, borrow the money from their lines of credit, and pay them out as cash dividends to shareholders. Today lenders want to see more fiscal discipline, especially at a time when their unsecured line of credit is up for renewal. Cutting the dividend reduced that obligation by about $37mn in 2008 alone. Even the Broadcom non-accrual announcement seems to fit our thesis that MCGC bent to its unsecured lenders wishes and ceased to accrue non-cash income from its largest source. The silver lining may be that this is what it will take to get the Unsecured Revolver renewed in the weeks ahead. More on this below.

More On Liquidity: MCGC has a patchwork of financings. As of today all the different sources necessary to maintain the Company in business in its present form (let alone expand) are not assured. Yes, MCGC renewed its Three Pillars $250mn Secured facility a week ago. What's more, the soon to be expired Merrill Lynch line is down to outstandings of only $60mn (4% of total assets). There are 2 prospective new lenders (one of whom may be announced in days) who will almost certainly be able to refinance the warehouse line that Merrill provided. Plus, MCGC has suddenly become an enthusiastic SBIC lender which provides a source of funding for small, new deals.

We've not been unduly concerned about MCGC's ability to extend Three Pillars and find new lenders to take out Merill because the underlying assets pledged for those purposes are abundant (principally senior and subordinated loans to a broad spectrum of companies) , the loans are performing and there is little non-cash income involved.

Worry About The Unsecured: However, the assets being offered to the unsecured lender for renewing the $130mn Revolver in June are far less attractive, consisting principally of MCGC's Control Investments, many of which are non-performing or generate principally non-cash income. Here is what the language in the press release says:

Our revolving unsecured credit facility provides for aggregate borrowings of up to $130 million, subject to certain requirements including but not limited to maintaining certain levels of performing assets which are not pledged as collateral to other debt facilities. The amount outstanding under this facility as of May 7, 2008 is $68.0 million. This facility has a 364-day term which matures on June 4, 2008. We currently have a signed term sheet and are working actively with our existing lenders and certain potential new lenders on the renewal of this facility until June 2009. While we are confident at this time that we will be able to renew this facility, there can be no assurance that we will be able to renew this facility. In the event that we are unable to renew this facility at a reasonable size our liquidity will be reduced significantly.

We've looked at the non-pledged assets available to the unsecured lenders, and have noted how many are non-performing in the year-end 2007 results in our earlier article. With Broadcom going on non-accrual, Cleartel (MCGC's second biggest investment at cost) still needing infusions of cash, and the Company continuing to write down more investments in the first quarter, nothing has changed. We expect MCGC will be able to keep some unsecured revolver, but may be cut back to $100mn or $75mn. Pricing will go up.

Worst Case: If worse comes to worse, the unsecured line will not be renewed. MCGC will seek to cherry-pick whatever best assets are in this unpledged pool to place with its secured lenders to refi its banks. Moreover, it will continue its efforts to sell a portion of Broadcom or other investments. We expect MCGC would survive but in a shrunken form, with total assets dropping below the $1.55bn at cost at March 31, 2008. New business would involve mostly the SBIC and the recirculation of loans paid off in some of the long term secured financings.

Better Case: There would still an upside. As we've said before should Broadcom eventually be monetized in some form and Cleartel be straightened out, the Company will greatly benefit. Moreover, if the non-performing and under-performing Control Investments get back on their feet, MCGC's income and value could increase substantially. We'll keep mum about quantifying this too much until we see the 10-Q, but there are hundreds of millions of dollars at stake. Our back of the envelope calculation is that there are $450mn in questionable assets (including Broadview). If all go "bad", MCGC will be left with $1.1bn of "good" assets and debt of $720mn. Net Asset value would be $380mn, and on 75mn shares the NAV per share would be just over $5. However, if everything turns out all right in the long run (give it 2-3 years), add $6 to that, or $11 a share. Just adding back Broadview alone gets us to a NAV of $7.5. That's over the $6.5 stock price at which MCGC closed today.

This is not a stock for the faint of heart. MCGC's management has made an ill-advised attempt to be a Control Investor, which has included a few huge bad bets (Broadview,Cleartel) that are weighing the Company down, and could bring it to the verge of a liquidity crisis. However, though the fat lady may be standing in the wings, she has not yet sung, so there's more grand opera to look forward to.

Disclosure: Author is long MCGC.

Comments

[joe_no_say]

It's Broadview, not Broadcom.

[NicholasMarshi]

Yes, it is Broadview and not Broadcom. I realized that after draft 3 and tried to change the name wherever it occurred. Clearly I did not edit carefully enough. Sorry


On May 12 04:27 PM joe_no_say wrote:

> It's Broadview, not Broadcom.

[shhaz]

Thanks, good summary.