November 4, 2011: This is a few days late, but Solar Capital Ltd. (ticker: SLRC) announced third quarter results on November 1st. The Net Investment Income Per Share of $0.57 was exactly in line with expectations, and just marginally below the corresponding result for the prior quarter which had non-recurring fee income.
The BDC Reporter’s Two Cents: There was nothing very dramatic or obvious in Solar Capital’s results-good or bad-to comment on at great length. We had a quick look at the 10-Q, but we’ll undertake a more in-depth review shortly to confirm that suspicion. Here are the main preliminary thoughts:
1. Asset values dropped because Solar Capital (like Apollo Investment, BlackRock Kelso and Ares Capital amongst others) invests in larger company loans, many of which are traded. The Unrealized Depreciation for the period was $75mn, or just over $2.0 a share of paper loss. That’s a 6% write-down of Solar’s portfolio from cost. When it comes time to mark-to-market at the end of the quarter Solar has to use these market prices in valuing its own portfolio, even if assets are being held for the long term. We predicted in our blog of October 11th when we previewed third quarter BDC results that there would be a reduction in asset values. We had a ballpark figure of 8-10% (which we picked by looking at market price reductions in the junk bond and leveraged finance market).
We can’t take these so-called market prices too seriously because on any given day the price can go up or down based on macro factors (i.e. if Greece is misbehaving so might the price). Moreover, as BlackRock Kelso pointed out on their Conference Call the number of deals actually traded is very limited, which affects pricing. We’ve heard from several BDCs that market prices have jumped since September 30th as market optimism has rebounded.
What matters is if there is any material change in the fundamental performance of any of Solar’s portfolio companies. That’s much harder to tell, but the Company says all is well on that front. That’s the argument propounded by Solar’s CEO on Jim Cramer’s CNBC program (he’s a SLRC booster). He seems to comfortable with that line of reasoning, as the link shows. What’s more the analyst community has SLRC earning $2.27 a share this year and $2.48 next year. On today’s price (already up due to the Cramer plug) SLRC is trading at just 8.9x 2012 earnings. Our initial review of the 10-Q shows us that there are 6 companies in portfolio that have reduced enough in value over cost to be placed on our Watch List. However, none of the loans are on non-accrual.
TO BUY OR NOT TO BUY THAT IS THE ETERNAL QUESTION
We don’t disagree with Mr Cramer, or agree for that matter. On one hand, in 2007-2008 increases in Unrealized Depreciation were an early indicator of the trouble that was to follow. Many of the companies which were written down on paper initially ended up defaulting and going into bankruptcy or being restructured. Unrealized Losses became Realized Losses, often with several quarters of delay between the two. The third quarter was the first since the Great Recession where we had such a sharp market pull-back and almost across the board Unrealized Depreciation. On the other hand, this could be a passing cloud, in line with the apparent bounce back in the outlook for U.S. GDP.
WHAT WE WOULD SAY IF WE HAD OUR OWN TV SHOW AND WERE LESS SUCCINCT THAN JIM CRAMER
Our argument, which is nowhere near as helpful and cut and dried as Mr Cramer’s, is that there’s no way to know what’s going to happen next to Solar Capital’s credit worthiness or earnings. Solar has loans and investments in over 40 companies in a wide variety of industries, each in their own economic micro-system. Moreover, the bulk of their investments are in higher risk subordinated loans, which can be valueless if the borrower tanks. Moreover, Solar is continuously adding and selling portfolio companies, so the picture is in constant flux. BDCs do provide a huge degree of transparency to investors. Moreover, Solar’s management has access to the monthly financials of all its portfolio companies, as well as access to each entity’s management, and even they cannot be certain what the next few quarters will bring. You could be pessimistic, sell out today (or fail to invest) and then watch as economic conditions ameliorate, and lose out on both a near 12.0% yield and a 10-30% run up in the stock price. Or, you could get jump in and find out that the economy will point downwards and see several of SLRC’s portfolio companies slip from under-performance to non-accruing to Realized Loss. The stock price, which is close to AV even now, could drop substantially.
2. Net Investment Income Per Share was 57 cents, versus a dividend of 60 cents. Like many of the larger BDCs, Solar Capital has been comfortable allowing a significant gap between the dividend being paid out (which is supposed to be essentially its entire taxable earnings) and actual GAAP earnings (which is a different number). Solar has been in ramp up mode in a relatively benign economic environment since going public. Management’s approach has been to gradually build up the balance sheet and earnings to meet a dividend which has been unchanged for 7 quarters in a row. We’re comfortable that Solar Capital should be able to continue to boost net investment assets given that net debt to equity is still only 0.3 to 1.0. There’s plenty of availability under the Company’s well priced Revolver and there are opportunities to invest in both new deals and primary deals at good rates. Fully invested, and assuming no drag from bad debts, Solar should earn over $0.60 a quarter, which bodes well for a dividend increase next year if economic conditions do not suddenly deteriorate.
