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Garrison Capital: IIQ 2017 Preview

BDCs:
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With the second quarter 2017 earnings season upon us, the BDC Reporter is previewing for its News Of The Day subscribers the key issues investors should be looking for in the upcoming filings. We are less interested in projecting the absolute level of earnings which might be reported – already covered by a small army of analysts and earnings sleuths. Instead, we look at potential developments among the long term trends already at play at each BDC which will drive earnings, distributions and the stock price for years to come. Every BDC has its own mix of challenges, failures, problems and opportunities, all of which extend over multiple periods.

We cannot preview every BDC and when earnings begin to be released we may be waylaid. However, in the interim, we are reviewing the BDCs whose performance is most in question as reflected in prior periods performance and the trend in their recent stock prices. We’re always intrigued by BDCs whose stock price is moving up or down in the weeks ahead of earnings on no new “news”, suggesting analysts and investors are looking at the portfolio and the earnings and positioning themselves for some anticipated change. This can be confirmed by the actual disclosures (which are much broader than the earnings per share announced) or contradicted, both of which can strongly affect the stock price.

PREVIEW

We begin with Garrison Capital (GARS), a sub half a billion dollar in assets BDC which came public in the spring of 2013 at $15.00 a share. Unfortunately, GARS has struggled mightily with credit issues almost from the outset. Back in December 2012 – before the IPO – NAV Per Share was $16.54, but has since dropped by March 2017 to $11.90. GARS has racked up -$39.4mn in Realized Losses and has booked -$23.7mn in Unrealized Losses. 4 of 63 portfolio companies were on non-accrual status at March 31, 2017. The BDC Credit Reporter counted 8 Watch List names (including the non-accruals). GARS itself – in its internal credit rating system –  admitted $165mn in investments at fair value, or a whopping 47% of the total, were in Category 3 status (“market rates of expected loss of principal”) and $15mn in its lowest Category 4. As a result, more than half GARS portfolio was valued in its two lowest  credit categories. GARS will be reporting August 8 after the close. See press release.

Here are three items to look out for where GARS is concerned:

  1. CREDIT QUALITY PERFORMANCE: The Investment Advisor has partly blamed the credit issues on a flawed investment process, with insufficient senior manager checks and balances; and has changed its investment decision making progress.

Several quarters more will have to play out before we can determine if the new procedures are working to reduce the number of flawed credits. If investments booked since the changes made a year or more ago start popping up in the Watch List the conclusion will be clear.

In the interim, shareholders will be interested to see what progress GARS is making with its current batch of non-performing and under-performing loans.

Hospitals

Starting with the former, the long saga of its two troubled hospital investments continues and continue to have $5.1mn in value. Will further write-downs be coming or will GARS be able to recoup some of that dead money and be able to re-invest into some new yield bearing investment ? Look specifically for what is happening at Forest Park Medical San Antonio and Walnut Hill Physicians Hospital. $17.6mn of yield assets at cost, bearing rates in the mid-teens, are on non-accrual and hurting GARS earnings.

Internet Shopping

Less important is what’s happening at Speed Commerce. This was a disastrous loan, which GARS and others sought to take-over and run the underlying company, with no success. $5mn invested is already written down to zero.

Oil & Gas

More important is what’s happening or otherwise at one of the BDC’s oil & gas deals: Gasco. $10.4mn invested and previously bearing a 18.5% (!) rate is on non-accrual and written down to $5.3mn.

Of the 4 still performing but troubled Watch List names at March, Rooster Energy seems to be the top trouble spot. Since quarter end the company has filed for Chapter 11 and much controversy has ensued. The $5.1mn loan at cost is presumably now on non-accrual too. That was accruing income at a rate over 20% (!!!) in the last quarter: 12.93% Cash and 8.0% PIK. That means $650K or so of Investment Income is likely to have vanished. Investors will be wondering if $4.2mn of FMV in Rooster is still possible…

Consumer Lending

Continuing losses in GARS idiosyncratic investment in consumer loans may continue. This is valued at $4.8mn and could increase.

There are a few other investments worth looking at, but for brevity purposes we’ll stop here.

Lost Hope

The market appears to have “written off” the chances of much recovery, having pushed down GARS stock price to close to $8.0 a share, a nearly $3 a share lower than the last book value, and suggesting approximately $50mn in further losses are expected, if you’re an NAV focused analyst.

  1. Amount Of Distribution Cut: The BDC Reporter weeks and weeks ago projected the distribution would have to be cut from its $0.28 a quarter level. Already last quarter earnings were not covering the distribution.

Given what the stock price is doing Mr Market agrees. The question will be less if GARS cuts its distribution (we rate the chances of maintenance at the current level as very low) but how much GARS will cut its pay-out.

This is more art than science and has as much to do with public relations as reflecting what its financial models might say. Will GARS cut the distribution a lot to reflect even potential income losses from Watch List names, or will the cut be kept relatively small not to alarm and depress shareholders ?

The market knows the cut is most likely coming but a judgement about its suitability will be reflected in the stock price in the hours and weeks after the announcement.

Guesswork

We are guessing a cut will occur to $0.20-$0.22 a quarter. A bigger slash of the pay-out may indicate to the market that problems are more serious or a surfeit of conservativeness. A smaller cut may be read as a “they’ve turned the corner” or “they’re burying their heads in the sand”. The number itself will not tell the story, but will depend on the overall portfolio picture and what other changes – if any – GARS might make, one of which we’ll discuss next.

  1. Leverage Target. This is a good segue into the third issue: what GARS is going to do about its asset coverage.  At March 2017, GARS was close to its regulatory limit of 200% assets to debt, even after not counting its SBIC borrowings. With expected further drops in book value, the Investment Advisor is likely to have to shrink the portfolio (and certainly not grow outside of the SBIC).

A key issue is what management signals will be the policy going forward. If GARS gets more conservative going forward and increases coverage to 220% or 240% (more in line with its peers) from 212% last quarter, the result will be less yield bearing assets and even lower earnings and potentially an even bigger dividend cut than some investors may have expected.

Or, the Investment Advisor could decide to continue to steer close to the wind to maintain its distribution and shareholder support.

Ironically, the BDC Reporter would prefer to see a more conservative balance sheet approach given the BDC’s weak credit underwriting record which might spare shareholders a disaster down the road if asset values were to drop sharply and the coverage rules broken. Better a smaller distribution than none at all, or one 80% paid in the form of more shares as could be the outcome if all went wrong.

CONCLUSION: This is a very important earnings release for GARS, although the issues discussed above have been in operation for many quarters and will continue for many more. How the Investment Advisor addresses both the status of the current portfolio and the structure of its balance sheet and risk taking going forward will be as important as whatever new distribution level might be announced. The goal for GARS  – easy for us to say but very hard to implement – is to be able to find the level which will ensure the market is convinced no further cut is coming for the foreseeable future.

FULL DISCLOSURE: We have no position in GARS. Even though the BDC is reaching our Fair Market Value price, we are hesitant – barring a major price panic – to invest in the stock given the fundamental uncertainty about the Investment Advisor’s ability to maintain adequate credit quality over the long term. Nevertheless, we maintain an open mind and a combination of a yet lower price and some evidence that GARS has a reasonable plan to “turn the corner” keeps the BDC on our Potential Buy List.

From an investment strategy point of view we don’t have enough confidence to front run the earnings and buy GARS – even at a sub $8 price. We are choosing to see if the market – which continues to rationally price the BDC’s prospects – loses its nerve at some point and drops the GARS price too far. However, in this bullish environment – as we discuss weekly in our market recaps – even under-performing and dividend cutting BDCs still attract relatively high prices. In this case GARS has managed to drop nearly 50% in price in just over 4 years but continues to have shareholders hopeful for a turnaround in its fortunes. The coming dividend cut may shake some of those investors out but will that cause GARS to be end up in our “bargain basement bin”. We have our doubts but we wait, watch and analyze. If we were to hit the Buy button, we would be taking a position in our Special Situations portfolio which we reserve for our more “Speculative” investments, and which are relatively short term in nature.

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