Gladstone Capital Is Seeing Better Credit, But Growth Is A Concern

| About: Gladstone Capital (GLAD)
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Summary

Credit quality appears to be improving as non-accruals and unrealized losses shrink as a percentage of the portfolio value.

Gladstone deployed more capital earlier in 2014, but announcements of new investments have petered out and may well reflect a challenging competitive lending environment.

Gladstone's shares could trade back up toward 1.1x NAV as lending demand and credit quality improve, but dividend coverage is an issue in the meantime.

Business Development Companies like Gladstone Capital (NASDAQ:GLAD), Full Circle (NASDAQ:FULL), Ares (NASDAQ:ARCC), and Kohlberg Capital (NASDAQ:KCAP) have to strike a balance between growing their portfolio (which drives future dividend growth) and compromising value and credit quality in doing so. Gladstone has made some good progress since my December writeup in terms of credit quality, with non-accruals and unrealized losses both shrinking. While portfolio growth is still a concern (as is management's need to waive fees to protect the dividend), there's an interesting mix of value and income here for more risk-tolerant investors.

Credit Getting Better

It's still early in the reporting season, but many of the banks that have reported so far, including banks with substantial business lending operations like Comerica (NYSE:CMA), have reported ongoing improvements in credit quality. Provisions ticked up a bit this quarter for Comerica, but the non-performing asset ratio was good, as was the net charge-off ratio. So too for the much larger JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC).

Gladstone operates a different sort of model, but has seen ongoing improvements in credit quality as well. Over the last couple of quarters, Gladstone has seen its non-accrual rate (reported as a percentage of cost) fall from 11.9% to 9.5% (and down from 15.7% in FQ2'13) while the unrealized losses on the balance sheet have shrunk from 28% of the portfolio at cost to 18%. While the company does have some sizable non-accruals in Heartland Communications ($5M cost) and Sunshine Media ($29M cost), overall quality seems better.

Looking For Growth

Gladstone's portfolio has grown about 14% since the fiscal fourth quarter of 2013 as the company has moved back to make net investments (as opposed to seeing net repayments). Gross originations climbed to $35 million in the fiscal second quarter and the company saw a slower pace of repayments than expected as terms were extended in several cases.

Since then, though, the portfolio growth seems to have slowed considerably. I don't see any announcements on the company's website since the March 12, 2014 investment in Lignetics and management had previously commented about seeing increasing competition in lending and less value in the syndicated loan market. At the same time, smaller banks are getting more involved in syndication activities as they see a lucrative opportunity to address larger credit opportunities than they normal handle on an independent basis.

Portfolio growth (and portfolio credit performance) ultimately drives Gladstone's dividend-paying capabilities. Investment income rose 5% in the fiscal second quarter, with a 2% decline in interest income, but net investment income declined 2% and Gladstone's management has had to waive fees to support the dividend. That's not sustainable for the long term and management will have to make a difficult decision between accepting lower effective yields (8.5% in the fiscal second quarter), taking on greater credit risk, or lowering its payout.

Gladstone had approximately $55 million in available capital at the end of the last quarter, or about 16% of the current portfolio at cost. Fully deploying that capital would certainly generate more income, but Gladstone isn't the only financial company out there with money to lend that is finding the demand environment to be challenging. Remember, too, that Ares, Full Circle, Main Street, Monroe Capital (NASDAQ:MRCC), et al all are looking to grow their portfolios as well. There are certainly company-specific differences at play (Gladstone avoids housing, leasing, and high-tech industries, for example), the point remains that a lot of capital is available right now and companies across a range of industries are still cautious with their capex/expansion plans given the state of the economy.

Waiting For A Better Environment And A Better Valuation

About 85% of Gladstone's debt portfolio is floating rate (and more than 90% of the portfolio is senior or subordinated debt) and though its funding is weighted towards floating rate instruments (a revolving credit facility that charges LIBOR plus 3.75%), Gladstone should benefit from higher spreads once rates start picking up. Gladstone is likewise leveraged to any improvement in operating conditions for small and mid-sized businesses, as an improving economy should incentivize more capex spending (and more demand for capital).

The entire BDC sector appears to be trading around net asset value, which is a mid-teens discount to its historical norm. Increased competition/capital availability could explain some of that, and Gladstone arguably deserves a discount given its dividend coverage. Even so, I would not rule out the possibility that Gladstone could move back to a 1.1x multiple to NAV if and when the operating environment improves and the company puts more capital to work.

The Bottom Line

At 1.1x NAV, Gladstone should trade closer to $11 than $10, and the company offers an 8% yield in the meantime. Management seems committed to maintaining that payout, though its own intentions may not matter if non-accruals increase and/or portfolio growth proves slower than expected. Gladstone presents some above-average risks today, so readers shouldn't consider this "free money", but risk-tolerant investors might want to look closer at the potential here since credit quality appears to be improving and banks remain generally positive on the prospects for improving loan demand as the year moves on.

Disclosure: The author is long JPM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.