As part of the BDC Reporter's News Of The Day, we reviewed Monroe Capital's (NASDAQ:MRCC) IQ 2017 earnings release, scanned the 10-Q and read the Conference Call transcript, all of which are available here. As usual for BDC analysis, the Q provided additional context and information not found in the press release, as did the Conference Call. Here's the synopsis:
From an earnings standpoint -if that was all that mattered - MRCC had a good quarter. Total Investment Income and Net Investment Income were both up in absolute terms. However, MRCC has been growing its shareholder base faster than earnings, partly through a At The Market equity program. The total number of shares has increased from 13.008mn to 16.712mn in a year. Mostly for that reason, but also due to lower income from a handful of portfolio companies, Net Investment Income Per Share has dropped from $0.44 to $0.36. The Investment Advisor has been preparing for this outcome and has been keeping distributions well below Net Investment Income. That's why Undistributed Net Investment Income is so high at over 3% of capital and still growing ever so slightly, with a balance over $7mn.
The metric which investors tend to be most focused on - and which MRCC itself commented on a couple of times too - is Net Investment Income "coverage" of the $0.35 quarterly distribution. In the quarter, the excess of the former over the latter was just 1 cent ($0.36 vs $0.35). Not helping is that portfolio company Rockdale BlackHawk LLC has cut back on distributions because healthcare industry changes have affected its profitability.
The challenge ahead for MRCC -and for dividend sustainability in the year ahead - is boosting income. Thankfully, the BDC appears to have a plan. The Revolver has been expanded, and there is borrowing capacity from that source to fund new deals. Even more importantly, MRCC has an additional borrowing capacity under the SBIC debenture program. After the quarter end the last amount of equity capital needed to be able to fully draw $55mn in 10 year debt at favorable rates was funded. That suggests MRCC has at least $60mn (the debentures plus the last portion of equity) of funding for new assets. Deploying the capital - if the right deals can be found in a highly competitive market and where the Monroe Group capacity to write a big cheque by aggregating many managed funds together does not really help - will be the main goal, along with booking "regular" middle market loans via the Revolver. Given the cost of borrowing, the additional management and incentive fees and the incremental operating costs involved, this portfolio expansion does not generate as much bottom line benefit as you might expect : 30-40 cents on the investment income dollar. However, that should be enough to generate a margin of safety between Net Investment Income and the distribution.
Which is not to say that will be easy. Besides the generally competitive environment - and as several analysts pointed out on the Conference Call - the BDC's credit challenges have been growing over time. The BDC Credit Reporter, which reviews the portfolio company-by-company, was not surprised to see that the BDC's own internal portfolio rating system has seen an increase in Watch List assets (rating of 3 and below) from $43mn at the end of last year, up to $68mn at the end of the IQ 2017. That's 16.2% of total investments. A year ago, that was $26mn. As management conceded, this is what happens as a portfolio matures: some cracks appear.Theodore Koenig - MRCC's CEO - gave a thoughtful response when asked about the issue of credit. We can't help repeating it here, if only to pass on the analogy to a "roach motel", which we especially appreciated:
One is, as you know, as you ramp a portfolio given the nature of debt and given the fact that we - I don't remember us ever moving something from two to one. The natural migration is that everything comes on as new as two and some things invariably will not perform as well and will move down in ratings. So I think it's - the natural seasoning of a new company, will see some decline in its average risk ratings, so that's part of it. And the other part is that we're actually pretty conservative about how we mark things in terms of risk rating. I always say it's kind of like a roach motel, it's easy to get in and hard to get out. So it's very easy for credit to move down to a three and move from a three to four, but it's very hard for us doing something up from a four, two to three, or a three to a two and so we tend to be very conservative about those movements. And I don't think it's anything more than that.
The Investment Advisor has shown with the example of troubled portfolio company The Picture People that it's ready to turnaround a failing business by acquiring a controlling equity interest; recapitalizing (which typically means reducing debt outstanding) and investing new capital. How successful MRCC will be with such a hands on approach (which may not always be the preferred route) remains to be seen.
Looking ahead, our Dividend Sustainability outlook for MRCC through the IQ of 2018 remains at our highest ranking (between Likely, Possible and Unlikely) but will merit watching.
Like so many of its peers MRCC's stock price has been riding high, hitting a peak of $16.08 a few weeks ago, 11.5x the distribution. A little over a year ago on exactly the same distribution and with an even lower risk profile MRCC traded at a price a full one-third lower. The stock has already moved down (3.5%) from its April 24th peak. Should overall BDC sentiment change and/or concerns grow about dividend sustainability this stock - and so many of its peers- are liable to drop up to 30% even in the absence of a recession. That's the equivalent of more than 3 years of distributions at the current level. So confidence will need to remain high. A glass half empty investor might argue that the normal deterioration in credit metrics is already apparent, and the writing is readable on the wall. A more optimistic investor would argue that the BDC may yet weave around its troubled credits; add additional income and remain as well positioned as ever.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.