Apollo's Verdict Is In, Analysts Seem To Have Missed It
Summary
- In the very worst case, the risk of a dividend cut for Apollo seems remote.
- We lowered our earnings potential range from $0.60-$0.70 to $0.50-$0.65.
- When the dust settles on the market, Apollo might be a good buy.
We discuss our reasoning for why the sharp stock price drop of Apollo Investment Corporation (AINV) is creating a more profitable buying opportunity. When markets fail to understand a company's vision and progress, it usually creates bargains especially during sharp market corrections.
The Analysts' Misunderstandings
A particular question and answer sequence during Apollo's last conference illustrates both analysts and market misconception regarding Apollo's vision and progress. It begins with Casey Alexander of Compass Point, "Looking at where LIBOR is going forward, even with the expansion as a balance sheet, it seems to me that you guys, you really need everything to go right to cover the dividend and comfortably cover the dividend... ?"
Greg Hunt of Apollo answered, "I think no. Your adjusted number is probably a little bit low... but call it in the $0.43 to $0.45 range. Our average leverage for the quarter was lower than where we're at right now. So that drives another $0.03 or so cents to our NII... I wouldn't say we're just creaking over it... We also feel like though, fully employed at this level -- right now LIBOR has almost hit the worst possible point for us because it goes down much more, our floors kick in, it goes up, we make more money."
A second sequence further clouded matters. The conversation begins with Rick Shane of JP Morgan, "I think they're two divergent trends here... you guys have done a good job moving in the right direction there and taking advantage of the higher leverage at the same time NAV continues to decline. How do you reconcile those two trends?"
Tanner Powell, Apollo's President & CIO, answered, "[O]n average that portfolio [non-core] is 5.6%. [O]ur focus is sort of twofold is maximizing the return on those assets in order to ensure that NAV, doesn't decline all that much, but at the same time, focus on getting that capital back because it can be reinvest that sort of double the return... but if we got 85% of our cash back tomorrow, you would have another reduction in NAV of $40 to $50 million, and you'd have a significant increase in earnings."
In our view, the two conversations illustrate common misunderstandings about Apollo.
The Real Truth
Analysts seem concerned about the lower LIBOR and Fed Funds rates believing that it can't effectively counter the two negative factors. The Fed Fund rate issue results from Apollo's vision to hold primarily floating rate investments tied to the Fed Fund target rate. Apollo consistently responds that both issues are protected with floors. The Federal Reserve still seems reluctant to cut rates further, but that changed in the current market environment. The Fed did cut rates on Tuesday March 3rd. Apollo did state that "recurring interest income declined due to the decline in LIBOR and lower spread on new investments compared to investments sold or repaid..." But later in the call reminded the analysts that continued declines from lower LIBOR are limited with that rate bumping up against its floor.
The following slide from the last quarter's presentation states the risk from Fed Fund rate cuts.
When the Fed Funds rate drops to 1% or lower, Apollo's investment risk hits zero. With Fed Funds now at approximately 1.5%, a 500 basis point drop to 1% roughly lowers quarterly earnings $0.06 - $0.07. LIBOR rate risk might be minimized having basically reached its floor.
Key Results from The Quarter
Net asset value (NAV) dropped in total by $0.54 to $18.27, essentially all from non-core assets. A continued write down in non-accruals was from one investment, Spotted Hawk. This write down is from weakness in commodity prices (crude oil). Again, misunderstanding seems vibrantly alive. When asked why income from assets continued to grow while NAV declines, Apollo's Powell simply responds that much of the non-core portfolio hasn't produced income. Continuing, the company adds that balance of the portfolio including the newly acquired investments is producing, nicely.
The Net Investment Income (NII) for the quarter was $0.54. The company announced a $0.45 dividend again significantly lower than the income.
Thus far during the March quarter, the company refrained from purchasing stock. The price was too close to the asset value.
Apollo increased its average leverage from 1.13 to 1.27.
The company continues to migrate slowly toward 1st lien assets shown in the next slide, reducing exposure by $60 million.
A Model Update for December & March
In our last update on Apollo, we developed a simple model to predict future earnings based on Fed Fund rates, percentage of 1st lien investments and leverage. Without sufficient understanding relating to LIBOR rates, it was excluded. We expected the one additional cut to lower December earnings by $0.03. Average leverage during the quarter was 1.27 times, up from an average of 1.13 times during the September quarter or 0.14. An increase in earnings of $0.05 minus the $0.03 from the rate cut or $0.02 or $0.03 might have been expected from the leakage increase. It was $0.01 leading us to believe that the lower LIBOR rate and slightly higher 1st lien percentage negatively affected the quarter by $0.01 or $0.02. Without a good understanding on the effect of the LIBOR rate, we thought that the earnings for higher leverages could reach $0.70 under ideal conditions. We now are lowering our absolute high to $0.65.
The following table included in both our past article and within this one helps understand past effects on earnings from changes in leverage.
| Apollo Financial Result History | September 18 | December 18 | March 19 | June 19 | September 19 |
| Net Investment Income | $0.45 | $0.45 | $0.47 | $0.50 | $0.53 |
| Rate of Change | 0 | $0.02 | $0.03 | $0.03 | |
| Average Net Leverage | 0.68 | 0.74 | 0.83 | 0.93 | 1.13 |
| Rate of Change | 0.06 | 0.09 | 0.10 | 0.20 | |
| 1st/2nd Ratio | 2.1 | 2.7 | 2.9 | 3.3 | 4.35 |
| Total 1st & 2nd Lien % | 84% | 88% | 88% | 89% | 91% |
| Average Yield* | 9.7% | 9.6% | 9.6% | 9.2% | 8.9%** |
| Net Asset Value | $19.40 | $19.03 | $19.06 | $19 | $18.7 |
| Rate Cuts | 1 |
It appears from the above table that each 0.10 change in leverage increases quarterly earnings by $0.03. Since, the company will likely increase its average leverage by 0.16 (1.27 to 1.43), the difference between the average and quarterly ending leverage, earnings in the March quarter might increase by $0.05. With the most recent Fed rate cut occurring late in the March quarter, it isn't likely to reduce earnings until the June quarter.
A Possible Worst Case Quarter
We developed the following table to summarize the worst case result.
| Worst Case Quarter | December Quarter | Fed Funds Rate Cuts (Maximum 1/2%) | LIBOR Rates | Leverage Increase from 1.27 to 1.5 ** | Conversion to core 1st Lien (86% to 100%) | Total Earnings |
| Earnings & Adjustments | $0.54 | -$0.06 | Nil * | $0.07 | *** Neutral + | $0.55 |
* According to Apollo management, the LIBOR was close to the floor.
** Past results suggest that each 0.10 increases quarterly earnings by $0.03.
*** The difficulty with understanding the effect with conversion to all 1st lien core requires a balancing act between the low average yielding non-core with the higher yielding 2nd lien core. The company is exiting both replacing these with middle yielding 1st lien core investments. Non-core investments earn 7.4% or 2.0% lower than the 1st lien average and are 12% of the total. 2nd lien investments earn approximately 2.5% more than 1st lien and represent approximately 6% of the total. We extracted this information from two slides: Portfolio Highlights included below and Corporate Lending Portfolio Detail included above. 
With Apollo exiting both sometimes at different rates, the net effect is impossible to exactly predict. But for last quarter, it exited $62 million in 2nd lien and non-core repayments totaled $46 million. The long-term effect from this transition remains neutral to a slight positive bias. The base case floor earnings calculates out at $0.55 at the middle of the target leverage of 1.50. We are still somewhat uncomfortable with the LIBOR floor issue. A long-term floor likely ranges between $0.50-$0.55. With Fed rates at 1.5%, the floor probably resides above $0.55. If the company increases leverage to 1.6 within the targeted range, earnings could range between $0.60-$0.70. We aren't predicting this range. With better insight into the LIBOR rate effect, we are lowing our targets from the $0.60-$0.70 range to $0.50-$0.65. Our new lower target is still significantly higher than the current dividend.
Risks
We still believe risks exist with lower LIBOR rates. We also wonder what might happen in a soft investment market. In soft markets, asset value tend to drop even when the investment continues its yield. With the high leverages, would it be possible that the company might be forced to sell valuable, paying assets to control leverage? Finally, the recent market implosion is driving all business development corporations (BDCs) south and in some cases, deeply south.
An Extra Dividend Coming?
With all the uncertainly, we doubt that Apollo will pay an extra dividend any time soon. With the market crashing, we do expect additional share buybacks.
An Investor's Takeaway
We believe that Apollo can cover the $0.45 dividend, perhaps for a long-time barring an economic nuclear explosion. At a future time, we believe that the company will increase the dividend. Under this belief, the stock is cheap, maybe dirt cheap. With this recent market volatility, it seems prudent to wait until later in March. Also, with the ex-dividend date near March 20th, dividend seeking investors might consider purchasing a few days earlier.
This article was written by
Analyst’s Disclosure: I am/we are long AINV. 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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Comments (8)
www.apolloic.com/...It's important and it is positive. Mark
