A 12.88% Dividend Play: Capitala Finance Corp.

|
About: Capitala Finance Corp (CPTA)
by: Bridger Research
Summary

A 12.88% dividend yield might not be sustainable in the near future.

The stock price has underperformed S&P 500 by a wide margin over the last several years.

The key bullish catalyst is a portfolio rebalancing from high-risk assets into senior secured debt.

While we live in times of inverted yield curves, near the record highs of the major U.S. stock market indices and exceptionally low treasury rates compared to historical levels, some investors might look for other non-traditional asset classes to achieve higher returns. Stocks which are yielding +10% dividend returns look attractive at first sight, however, there are always risks associated with the safety of dividends. In this article, we would like to present our readers with a very interesting and well-established business development company or (“BDC”) named Capitala Finance Corp. (CPTA). It has been distributing its shareholders a monthly dividend payment of $0.0833 per share since October 2017. That makes up an attractive 12.88% dividend yield as of September 7, 2019, which might look tempting for high-risk investors. In terms of bullish catalysts, we find the most important one the portfolio rebalancing from equity and mezzanine investments into senior secured debt. Consequently, that might lead to slightly lower returns over the long run, however, it will significantly improve the safety of the dividend payments. Investors have an option to invest in both equities or fixed-income securities of the company, however, in this article, we decided to present our readers with a potential investment into the equity side.

Investment Strategy

(Source: Investor Presentation)

CPTA’s investment strategy is primarily focused on first-lien debt financing to the lower middle-market companies which are generating EBIDTA of $4.5million to $30.0 million annually. For instance, the company has built very important long-term relationships with all the members involved in the lower middle-market ecosystem like the management of companies, intermediaries, financial institutions, etc. Furthermore, most of lower middle-market companies are not publicly traded, therefore we believe that provides a unique edge to generate exceptional returns and strong alpha. As of June 30, 2019, the company reported an investment portfolio with a fair market value of $391.1 million which consists of 41 investments.

(Source: Investor Presentation)

When the company went public on September 30, 2013, equity investments used to represent approximately 35% of the total portfolio. However, over the next several years the company focused on attractively priced lower and traditional middle-market debt investments which were yielding on average between 10%-15%. Management believes that the company will produce a more stable net investment income and a superior return by reducing the size of equity and mezzanine investments compared to debt investments.

Additionally, the management provided even more insight during the most recent earnings release:

“The risk in our debt portfolio is at its lowest point since our initial public offering in 2013, as risk grade 3 assets account for 9.8% of the portfolio, on a fair value basis. First lien debt investments represent 77.7% of the debt portfolio at June 30, 2019, compared to 45.5% at June 30, 2016, on a fair value basis. Future earnings and NAV stability should benefit from this re-balanced portfolio, an effort that began in early 2016.”

(Source: Earnings Release)

In our opinion, the company is on the right track to execute on its portfolio rebalancing strategy and we believe that it will end up as highly accretive for both CPTA’s shareholders and debt holders. For instance, most of the companies in high-growth industries like technology are trading at excessive multiples thus leading to higher fluctuations in the underlying equity valuations. Therefore, we believe that a higher share of equity investments is inadequate at the moment, because of the present late-stage business cycle which is labeled by sharp stock price moves in both directions.

Historical Returns for Shareholders

(Source: Seeking Alpha)

Historically, the company generated a slightly lower average dividend yield(ttm) of 6.96% over the first year of trading in 2014. Consequently, shareholders who invested in the period between 2015 - 2019, achieved solid dividend returns in the average range dividend yield(ttm) of 12% - 16%. Recently, the company declared a monthly dividend payment of $0.0833 per share for September 2019, which makes up a dividend yield of 12.88% as of September 6, 2019. The company used to pay a way higher monthly dividend payment of $0.1567 back at the end of 2014. However, over the last couple of years, the monthly dividend amount has almost halved to $0.0833 and has been consistent at this level since October 2017. One of the biggest reasons for a dividend decline was a sluggish asset allocation with a decent number of NPL’s in the past. We anticipate that the monthly dividend will most likely remain unchanged at $0.0833 for the rest of 2019. The company used to reward its shareholders with a special monthly dividend for most of 2015, however; it has declared no special dividends thereafter.

(Source: Yahoo Finance)

Maybe some of our readers are already excited about the attractive dividend yield, however, the stock price performance has been weak over the last 5 years. According to the figure above, the stock has been largely underperforming S&P 500 since the company went public in late 2013. Therefore, we recommend our more risk-averse readers to also consider baby bonds which our fellow SA Author - A1 Investments described in full details a year ago. Now when we are familiar with both dividend yields and the stock price performance, we can analyze total trailing returns.

(Source: Morningstar)

Based on the figure above, the company has generated a total return of -3.19% over the last 5 years or approximately 800 bps lower than the Asset Management benchmark. After all, we can conclude that even though both dividend yield and the stock price performance numbers might look exaggerated at first glance, the total return numbers are more in line with other asset classes and corresponding benchmarks.

Dividend Sustainability

(Source: 10-K Filing)

According to the financial highlights figure above, the company has been generating enough annual net investment income to cover the dividend payments over the last several years except in 2017. However, net asset value per share has almost halved since the end of 2014, from the initial amount of $18.56 to the most recent amount of $9.55 per share as of June 30, 2019. In general, if NAV is declining that usually leads to lower net investment income and consequently to lower dividends. Management is certainly aware of this problem and has addressed it during the last earnings call.

“Unfortunately, all the good things that we did last quarter sort of it take second to focus and the bad things that happen on the related to NAV. But we do believe that we’re much further along on this rebalancing of the portfolio that started in 2016 and that when you look at assets deployed over the past three years, it really confirms the change in strategy and underwriting and portfolio management of those successful performing assets.“

(Source: Q2 19 Earnings Call)

Now some investors might be slightly concerned whether the current monthly dividend payment of $0.0833 can be sustainable over the next couple of quarters.

(Source: 10-Q Filing)

Recently, the company announced a net investment income of $0.51 per share for the 6 months ended as of June 30, 2019, which is in-line with the distributions declared from NII of $0.50 during the same period. On the other hand, the company generated only a net investment income of $0.46 during the second half of 2018. Therefore, if it fails to meet this amount in the second half of 2019 then that would make up a net investment income of less than $0.97 per share compared to the annual dividend payment of $1.00 per share. One example of the dividend cut was already back in October 2017, when the company lowered a monthly dividend amount from $0.13 to $0.0833 on the back of portfolio de-risking. Additionally, management provided even more insight over the particular dividend cut:

“We are pursuing a more conservative strategy targeting more senior secured and unitranche loans with lower aggregate average yields instead of unsecured and mezzanine loans with higher aggregate yields but with higher associated risk. The management team is focused on investing its liquidity into quality deals, rotating equity realizations into yield, and improving the underperforming portfolio investments, with the objective of future earnings and NAV growth.”

(Source: Press Release, October 2017)

Nevertheless, if management does not realize their established plans of equity divestments for the rest of 2019 while driving investments into high quality senior secured debt securities than we believe that the monthly dividend cut will most likely be inevitable over the next several quarters. Furthermore, we anticipate that the company will try to maintain distributions/net investment income payout ratio of roughly ~100% in the foreseeable future.

Q2 19 EARNINGS RESULTS

(Source: Investor Presentation)

The company reported a net investment income of $0.25 per share or down $0.01 Y/Y, but still in-line with the consensus analysts’ estimate of $0.25 per share. It was also in-line with the current quarterly distribution of $0.25 per share. Net assets value per share came out at $9.55 per share or down $2.33 H/H, driven by a $20.4 million loss on its mezzanine debt investment in AAE Acquisition. Management has projected a fair value price in-line with the sales price of other several investor bankers, however, buyers didn’t want to buy the company within the proposed price range. Furthermore, NAV was negatively impacted by unrealized depreciation on some important investments like a $3.8 million loss of US Well Services’ equity value. However, management is optimistic that it is a temporary loss and once the lockup period ends later in November this year. CPTA will most likely sell the shares of this public company. When it comes down to other equity holdings like Portrait Studios or CableOrganizer Acquisition the company reported a collective $9.2 million of unrealized appreciation as a result of lower valuations driven by the decline in GTM EBITDA.

(Source: 10-Q Filing)

In terms of portfolio construction, 77.4% of CPTA’s portfolio represents debt investments while 19.1% consists of equity and warrants investments. The company’s debt investment portfolio had a weighted average annualized yield of 12.2% as of June 30, 2019, or up 300 bps over the first half of 2019. Management also managed to drive down the percentage of the debt investment portfolio, which is bearing a fixed rate of interest from an initial 41.4% as of December 31 to 27.2% as of June 30, 2019.

CAPITAL STRUCTURE

(Source: Investor Presentation)

According to the figure above, the company doesn’t have any kind of significant maturities well into 2021 and 2022, therefore it has enough liquidity at its hand in the meantime. We are confident that as the company moves away from high-risk equity and mezzanine investments into lower-risk senior secured debt investments it will support the higher leverage level compared to its peers at the moment. As of June 30, 2019, the company reported a total and regulatory leverage ratio of 1.80x and 0.86x, respectively. Even though the company increased its total leverage ratio by 0.20x over the first half in 2019, we are still confident that it will not have any kind of negative impact on the dividend payouts or NAV value in the near term.

(Source: 10-Q Filing)

Based on the figure above, 30.6% of the SBA Debentures will mature on March 1, 2021, while 40% will mature on March 1, 2022. Consequently, we are confident over the fact that CPTA will be able to drive down total leverage over the next couple of years. It will be driven by a newer portfolio construction mix of lower-risk debt investments combined with the maturity of the SBA Debentures in 2021-2022.

Risks

(Source: Investor Presentation)

Everyone who is involved in the fixed income market understands the significance of the interest rate changes on the underlying price of fixed-income securities. Additionally, interest rate sensitivity is an important risk metric these days, given the fact, there is a constant pressure on the FED to raise or cut interest rates from both President Trump and by the overall macroeconomic performance of the U.S. economy. According to the figure above, a potential positive 300 bps and negative 300 bps interest rate change would increase/decrease net income per share by $0.41 and -$0.15, respectively. This points out that CPTA’s portfolio structure is more tilted towards a potential interest rate increase and is adequately hedged on the downside. Following the most recent dovish comments from Fed Chair Powell, investors anticipate a potential 25 bps rate cut on the next FOMC meeting on September 17-18, 2019. In the case of the potential cut, CPTA would be negatively impacted by a decrease in net income per share of approximately -$0.05, thus leading to a potential monthly dividend cut for the rest of 2019. Consequently, in our opinion, a potential period of aggressive interest rate cuts represent one of the major risks for CPTA’s equity valuation and its dividend sustainability over the next couple of years.

We are concerned over the uncertainty of LIBOR as CPTA has LIBOR-indexed, floating-rate debt securities in its portfolio. LIBOR has been manipulated by several member banks in the past, therefore regulatory changes regarding the calculation of LIBOR or some other restrictions might follow up soon. In the worst-case scenario, regulators might even phase out LIBOR by the end of 2021. That might hurt the company’s investment portfolio of debt securities because all the regulatory changes in the market of LIBOR-based securities might lead to lower valuations.

Summary

We recommend to our readers to monitor this BDC in the near future because the company is changing its portfolio allocation. Furthermore, management has been successful so far when it comes down to portfolio rebalancing and its overall risk reduction. Even though the company has supported its dividend payments by generating adequate net investment income over the last several quarters, we believe that a dividend payment of 100% presents a huge risk of future dividend sustainability. In terms of major risks, investors should be aware of the fact that the company has already cut its dividend several times in the past. Additionally, we believe that the present investment portfolio construction is more suitable in the rising interest rate environment. Therefore, in the case of a highly dovish monetary policy in the near future, it might strongly pressure the generation of net investment income and its dividend sustainability.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This article does not constitute a bid or an invitation to bid for the purchase or sale of the financial instruments in question. Neither is it intended to provide any kind of personal investment advice, therefore readers should conduct their own due diligence. Investing in financial instruments may always be associated with risk. Please contact your personal financial or investment advisor for any additional questions or materials regarding this article. We shall not be liable for any type of damage or loss arising from the use of the information contained in this article.