A 6.1% Yielder That Could Trade Higher As It Transitions To An Income-Focused Business Model

| About: MVC Capital (MVC)

Summary

Interest income will increase as this BDC issue replaces equity holdings with income-producing assets and utilizes more leverage.

The 29% trading discount should decrease as MVC transitions to a pure income issue.

Large investment in U.S. Gas & Electric is performing well. A successful IPO could generate a special dividend.

Credit-focused business development companies are very popular with yield-seeking income investors. Issues such as Prospect Capital (NASDAQ:PSEC), Apollo Investment (NASDAQ:AINV) and Medley Capital (NYSE:MCC) make loans to middle market companies and use the interest payments received to fund the large dividends that income investors love. Equity-focused BDC issues are far less popular. Holding private equity can result in a big payoff when a client company eventually goes public, but there is no steady stream of interest payments. As a result, most equity-focused BDC issues pay only minimal or sporadic dividends.

MVC Capital (NYSE:MVC) started out as an equity-focused BDC, but management got tired of having a deeply discounted stock. In 2014, David Williams and his team joined MVC from Fifth Third Bank (NASDAQ:FITB) as the focus shifted from equity to debt. David Williams had founded the bank's successful mezzanine equity unit. FITB and many other banks have reduced their middle market lending due to increased regulatory scrutiny.

As equity investments are cashed out, MVC has been making new investments in debt and other yielding assets. This process should eventually enable MVC to pay a higher dividend and narrow its steep 29% trading discount to net asset value. This article provides 10 reasons to consider MVC.

1. Deep trading discount to net asset value

At a recent price of $8.89, MVC is now trading at a 29% discount to net asset value of $12.45 per share. According to the Closed-End Fund Advisors BDC Universe data, the average BDC trades at only a 6% discount to NAV. MVC is trading at a far larger discount than the average BDC issue even though net asset value has increased for the last two quarters.

2. Transition to a credit-focused BDC will reduce discount

MVC is classified as an equity-focused BDC since client debt holdings comprise only 34% of assets. According to the Closed-End Fund Advisors BDC Universe data, the average discount to NAV is 39% for equity-focused BDC issues. In contrast, the average debt-focused BDC issue trades at only a 1% discount to NAV. Interest payments from debt holdings enable credit-focused BDC to pay large dividends. Income investors favor credit-focused BDC issues and deeply discount equity-focused BDC issues.

3. The MVC transition to yield is already well underway

Although debt comprises only 34% of NAV, equity investments include U.S. Gas & Electric preferred stock currently valued at $89 million (25% of the total portfolio value) as of 1/31/2017. MVC received a $10 million distribution from U.S. Gas & Electric on 3/7/16 and another $2.5 million distribution on 7/28/16. Since the preferred stock pays a dividend, the yielding investments (debt & preferred stock) now comprise 59% of holdings.

4. Solid dividend history

MVC currently pays a quarterly dividend of 13.5 cents and has now made 47 consecutive dividend payments. The dividend history shows that the last change to the quarterly dividend was the 10/15/2015 increase from 12 cents to 13.5 cents.

5. Another special dividend is possible

A special dividend of 17 cents per share was paid on 1/8/2016. As noted in the press release:

"Additionally, due to the realization of capital gains from the sale of certain portfolio companies, the board has also declared a special dividend of $0.17 per share that was earned during the year."

Fiscal Q1 2017 is off to a good start as net asset value increased by 6 cents per share. This was driven by a $9.8 million gain from the sale of AccuMED Corp. that was partially offset by write-downs in other areas. U.S. Gas & Electric may determine whether a special dividend gets paid in 2017. An MVC special dividend could result from a successful U.S. Gas & Electric IPO or a repeat of the windfall dividends received in 2016.

6. Banks also prefer credit BDCs

Like income investors, banks have a preference for credit-focused BDCs. This was evident when MVC obtained a $50 million bank credit line with a three-year term in December 2015. Low cost access to capital is an important aspect of MVC's transition to a credit-based BDC business model. We could possibly see further reductions in the cost of capital by refinancing the MVCB baby bonds. This 7.25% coupon issue matures on 1/15/2023, but is currently callable at par.

7. U.S. Gas & Electric investment is performing well

The oversized U.S. Gas & Electric investment has been performing well. As noted on the 10/4/2016 conference call:

"We recently learned this company has increased its trailing 12 months EBITDA for this 20th consecutive month. As we noted in our formal remarks U.S. Gas remains an outsized investment for MVC, and we continue to review both our near-and long-term options to effectively monetize this investment.... We are currently in discussions regarding seeking to extract more value from this investment in addition to potentially selling the Company outright. We are also contemplating a partial sale of U.S. Gas that will allow us to continue to profit from its performance."

8. Fee waivers and reductions are a good thing

MVC management demonstrated good faith towards investors by waiving some fees in fiscal 2016.

9. Winter 2017 weather conditions were favorable

The profitability of U.S. Gas & Electric is weather-dependent. This is also true for other retail energy providers such as Genie Energy Ltd. (NYSE:GNE) and Spark Energy (NASDAQ:SPKE). Retail energy providers typically buy electricity and natural gas at wholesale prices to hedge for the expected demand from their retail customers. Most retail customers purchase fixed rate contracts for their electricity and natural gas. The REP business was unprofitable in 2014 when a polar vortex resulted in a prolonged period of unusually cold weather. Spot market prices spiked as retail demand for natural gas and electric heat soared beyond expectations. The REP companies got caught short and profits suffered.

An unusually mild winter can also hurt profitability for U.S. Gas & Electric. Too much mild weather would result in lower revenues and possibly over-hedging. The winter of 2017 had a mix of mild and cold periods. This is positive for U.S. Gas & Electric.

10. MVC is substantially under-leveraged

As of 1/30/2017, MVC had portfolio company investments of $355 million and net assets of $281 million. Cash and cash equivalents were $33 million. See page #64 of the fiscal Q1 2017 10-Q filing. The $33 million cash hoard is high for a small BDC. All BDCs are legally restricted from having a debt to equity ratio that exceeds 1:1. For most credit-focused BDC issues, debt is kept at about 75% to 80% of equity. 1/30/2017 debt of $137 million (see page #3 of the 10-Q filing) is only 49% of net assets. Increasing balance sheet leverage to a more typical credit-focused BDC level of 75-80% would put more capital to work earning interest income.

What are the major risks?

MVC has a concentrated position in U.S. Gas & Electric. Its margins can be adversely impacted by prolonged extreme cold such as the polar vortex winter of 2014. Conversely, an extremely hot summer could also hurt electricity margins. Like all financials, MVC is vulnerable to a broad market sell-off or economic slowdown. MVC typically trades about 40K shares daily. Limit orders and patience are recommended when trading.

Conclusions

MVC is currently trading at a 29% discount to NAV and, based on BDC peer averages, should narrow that discount to the 0-15% range as the transition to a credit-focused BDC model continues. Including the U.S. Gas & Electric preferred stock, only about two-thirds of MVC assets are now yielding. MVC is also substantially under-leveraged as shown in item #10. More interest income due to increased balance sheet leverage and a greater focus on yielding assets should support a higher dividend level over time.

The large discount to NAV is unusual given that net asset value has now increased for two consecutive quarters. MVC provides a stable 6.1% yield while waiting for the transition to progress. The key U.S. Gas & Electric investment has been performing well. An IPO of this over-sized position is possible and could result in a special dividend.

Note: My Panick Value Research Report is focused on high-yield preferred stocks, exchange traded debt issues and other undervalued high-yield opportunities. Members receive an advance look at all my articles as well as continued coverage. This MVC article was announced to members on 3/1/2017 with MVC trading at $8.76. Please read our outstanding subscriber reviews here.

Disclosure: I am/we are long MVC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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