July 30, 2013: Very little new news on the BDC front this morning: just 2 items.
1. Mid-sized Business Development MCG Capital reported second quarter 2013 results. The $0.11 of Net Operating Income Per Share was in line with the Analyst Consensus. In fact, most everything about the quarter's performance was as we expected.
The Company continued to have the loans financed by it's securitized loan (known affectionately as the 2006-1 Trust) pay off at breakneck pace. The Trust had a balance of $83mn at the beginning of the quarter and $55mn at the end. Subsequently the balance dropped to $29mn. Management expects to end the year with $20-$25mn of 2006-1 Trust obligations left. We wouldn't be surprised to see the Trust paid off. In any case, on a projected loan portfolio of $500mn by year end, according to management, it's an academic issue.
Otherwise, the Company's gross yield remained high (thanks to an ever greater proportion of SBIC, smaller borrower loans). At 12.5%, the Company is achieving the kind of yield (assuming decent credit metrics) a mid-sized BDC needs to remain viable, up from 11.5% last year. Still, there is a lot of PIK income and accrued dividend income therein, and very little cash repayment thereof. Worth watching.
We are impressed by the very real reduction in Operating Expenses at the Company, which are now running at about a 2% of assets rate, which is much better than the all-in cost of most externally managed BDCs. However, we were surprised to see the actual headcount has dropped only marginally: from 27 to 21.
Thankfully, not much happened on the credit front in the quarter. (We are waiting on the 10-Q to dive into the details). The Company sold a couple of equity assets for small gains, more in the form of tidying up than anything else.
DIVIDEND: The dividend for the third quarter is unchanged at $0.125. A portion of the pay-out will be treated as return of capital.
FROM DELEVERAGING TO LEVERAGING UP: The most encouraging feature of the second quarter results was the level of new loan activity achieved by the Company. With $71mn in new loans (including 4 new borrowers), MCGC is finally back in balance sheet expansion mode. That's a very necessary element for the future, both to cover the dividend and to continue management's make-over of the Company from a big equity risk taking semi sponsor group to a conservative diversified lower middle market lender.
The key question is where will future capital come from. The press release has already warned shareholders that the Company expects to be fully invested by year's end. The SBIC borrowings are already capped out at $150mn . (of course, if the SBIC program gets an increase to $350mn that would be a fillip). The Trust will soon be a memory. There is a $20mn Revolver undrawn, but that's more of a back-up line.
Can a company like MCG Capital, with a very troubled past, raise new equity ? Most likely, we'd say (which we wouldn't have said just a few quarters ago). The stock price is now above the Net Asset Value, and the turnaround is almost complete. Look for an equity raise in the next few weeks.
In combination or separately, the Company could realistically expect to raise Unsecured Notes, like every other BDC has. They will have to pay up (6.75%-7.0%), but with a high yield lending model and a fixed, low cost operation, the numbers would work. With $368mn in equity, and SBIC debt not counting against the BDC debt to equity rules, MCGC could readily raise $100mn.
BACK OF THE ENVELOPE PROJECTION: Looking down the road, assuming the Company deploys it's $90mn+ in cash, and borrows long term, but maintains the current yield (which is less under pressure in the lower middle market), we project Net Investment Income Per Share could ultimately increase to $0.15 per quarter from $0.11 now. That's a 36% increase, and does not include any assumption about an increased SBIC line or the impact of a Revolver (if they go that way instead, which would cost less). No wonder the stock price is pushing up against it's 52 week high. At a 10x-11x multiple, MCGC could be worth $6.0-$6.6 a share.
OUR POSITION: We have been in and out of the stock several times in recent years. We do own a position in MCGC in our Funds, but not as much as we should given today's results. We placed an increased order this morning. The increase in earnings may or may not come to pass (bad debts could still bite in the future, or MCGC may not be able to raise new money, or the cost discipline of recent quarters could weaken). However, with no non-SBIC debt and $500mn in potential assets even before any new capital, we like the risk profile here.
2. BDC Buzz and the FOMC Announcement. Frequent poster about the BDC industry "BDC Buzz" has written an interesting article, with a very useful accompanying chart, seeking to project what might happen to BDC prices when taper talk resumes.
Very delicately BDC Buzz suggests investors in BDCs might want to take advantage of a sell-off in the sector (and all yield producing sectors ) to buy.
We agree because we've noticed the same price pattern. BDCs dropped with Bernanke's May comments but bounced back better than High Yield Bonds, Treasuries and Mortgage REITs. However, we also know Mr Market never does the same thing twice. The very fact that BDC Buzz is showing us all the chart, and that we agree is proof enough that "next time it will be different".
Generally speaking,though, we remain bullish on most BDC stocks and welcome any pullback as a prospective buying opportunity.
Disclosure: I am long MCGC.