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Apollo Investment: IIQ 2017 Preview

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With the second quarter 2017 earnings season upon us, the BDC Reporter is previewing 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

Apollo Investment (AINV) is one of the oldest BDCs- which went public in 2004 -and one managed by a stellar name in asset management : Apollo Global (APO). However, despite its parent’s reputation for credit investing, AINV has been a poor performer in that department over most of its life as a public BDC. That includes the last several years where the BDC has racked up huge Realized Losses, as well as many Unrealized Losses that has greatly diminished net assets; crushed earnings per share; forced a 25% dividend reduction; temporary fee waivers by the Investment Advisor, and  pushed the stock price down, which at one point was two-thirds off its IPO price of $15.0. Not surprisingly – and not for the first time – the parent has installed new managers and instituted a new business strategy.

We would expect much of the upcoming quarterly review to focus on discussion of the new initiatives which AINV has launched with affiliated entities. However, the BDC Reporter cannot help pointing out that running away from one’s past is very hard to do, even for a Business Development Company. While the new managers might like to look forward, and talk about “legacy investments” or “legacy strategies”, there are numerous remnants from the unsuccessful initiatives of recent years which the new managers will have to contend with.

The market is treating AINV (almost) like its proposed turnaround is complete, with the stock price rising towards its Net Asset Value and its price to distribution going above a 10x multiple. Already optimistic investors may be looking for further validation in the latest results to take the stock price even higher. As we’ll show, the BDC Reporter – apparently a lonely contrarian – believes there are too many legacies from the past for AINV to have any immediate ability to turn the page. In fact, we doubt that the bloodletting in terms of credit write-offs and fast dropping income is done. Furthermore, we question whether AINV can maintain its distribution level at $0.15 a quarter (reduced just 3 quarters ago from $0.20). From our analysis the question appears to be a matter of when rather than whether the distribution will be cut; barring a long list list of things changing course for AINV and its shareholders.

With that inauspicious introduction, let us begin by pointing out some issues investors might want to be looking out for amidst the regular laundry list of numbers that will be coming out:

LEGACY CREDIT PROBLEMS

Like too many BDCs, AINV’s Investment Advisor has chosen to restructure rather than write-off and walk away from its failed investments. In this case, the BDC had made multiple investments in energy as well as in other sectors that did not pay off, but remain on the balance sheet, often under new names and with new balance sheets.

A goodly portion of AINV’s investment income is still derived from companies – under a different alias- which previously were insolvent and had to be “saved”. Investors should be updating themselves on what is happening to the former AMP Solar, which is now Solarplicity. Despite writing off -$36mn, AINV still has $119mn of exposure at FMV and over $150mn at cost, mostly in debt. That debt is paying an 8% yield, but which can (and is probably being) paid in Pay In Kind interest.

Then there’s Glacier Oil & Gas (formerly Miller Energy) with over $50mn of debt and equity, mostly in income producing debt. That, too, is payable in PIK.

Plus, SHD Oil & Gas (formerly Spotted Hawk Development), with $82mn of FMV. On a cost basis that $112mn of Notes bearing rates between 8% and 14%. As you’ll have guessed by now that interest can or will be paid in kind (half of the outstanding does not even have a cash option).

We’d love to report that exchanging debt for equity and restructuring these credits ensures their eventual success, but that’s not a given. When we see the fair market value given most of these investments at the equity level, we note that fair market values have been written down from cost, even after the reset. As we all know, the oil price is far from stabilized and whatever initially ailed these entities is far from over.

Investors will want to also keep an eye on another energy name part of this “legacy” strategy: Pelican Energy.

Outside of energy re-treads, AINV has question marks in other sectors. A structured vehicle called AIVC SPV Holdings is on part non-accrual already, with a cost of $69mn but still $24mn in FMV.

We won’t spend any time on them but the portfolio is still littered with multiple busted investments – most with little or no remaining fair market value or generating any income such as Garden Fresh Restaurant Group (Souplantation to you and me); Magnetation LLC, Gryphon Colleges and Delta Career (the last two part of another ill fated enthusiasm for profit oriented education firms).

AINV like many other BDCs may have dodged a bullet thanks to the recent restructuring of My Alarm Center (several tranches of exposure on its books), but we are keeping an eye on Maxus Carbon (whose low rate of 5.25% is paid all in PIK !); Elements Behavioral Health $11.1mn at cost but also PIK) and the recent $18mn investment in bankrupt Westingouse Electric.

INCOME QUALITY

As readers can tell by our frequent reference to AINV’’s PIK income, we are concerned about both the level and quality of the BDC’s earnings, both in the past and going forward.

AINV’s Investment Advisor is not shy to book PIK income (which boosts fees and the P&L) only to later write them off as uncollectible. See page 104 of the 10-K for the disclosure. Note both the “adjustments” of PIK from investments exited or “written off” and how PIK income capitalized last year was 11x PIK income received in cash.

We don’t run a financial model, but reviewing the latest 10-K, we can’t help noticing i) AINV has sold off some of its higher earning CLO assets which contributed substantially to FY 2017 income but won’t be there in FY 2018. We count $13mn of income from those sources. That’s a not inconsiderable 6% of Investment Income and 9% of Net Investment Income.

ii)The estimated taxable income for FY 2017 was $89mn versus GAAP Net Investment Income of $149mn. As a result, nearly half the distributions paid out were return of capital (i.e. shareholders just getting their own capital back).

iii) The Investment Advisor – rather than making permanent cuts to its compensation arrangements – is only waiving some of its fees till March 2018 (just round the corner from a long term investor’s perspective). Once that fillip to earnings is gone even GAAP Net Investment Income on a pro-forma basis will not be sufficient to cover the current distribution.

FUNNY NUMBERS

Just for fun, deduct the $34mn in PIK income and the $13mn in non-recurring CLO income from 2017’s Investment Income and add-back the fee waivers and AINV’s Net Investment Income (everything else being the same) would be $81mn versus the $149mn reported.

BACK TO OUR THEME

All these elements are a reflection of AINV’s prior credit troubles: the PIK income is mostly from restructured prior deals gone bad or going bad; the CLO assets were sold to generate cash and reduce risk and the waiver was chosen to mitigate the impact of the Advisor’s terrible credit underwriting- even if only for a short period.

COST OF CAPITAL

There’s more besides, with the “new” management having to contend with some of the most expensive debt borrowings for a BDC of  its size because of a prior decision to raise long term debt at interest rates between 5% and 6.5%. Now with yields dropping thanks to bad debts and an attempt to reduce the risk profile  earnings are burdened with a very high interest expense bill. In FY 2017 the “annualized interest cost” was 5.6%, higher than the two prior years even as the BDC’s portfolio yield was dropping from 11.0% to 10.3%.

Investors will want to know more about the Investment Advisor’s plans for compensation; and its debt borrowings to ascertain if there’s any chance earnings can be improved over the long term in these two areas. We don’t have much hope regarding either, but we may be surprised.

INVESTMENT CONCENTRATION

After the fiasco of over weighting itself with for profit education and energy investments and taking on more risk than was warranted (viz. Those higher yields), the new managers have promised a more granular portfolio and less sector bets.

Yet, the top 10 investments out of a total of 86 represent nearly half of all assets. The most prominent single “bet” is on AINV’s aircraft leasing subsidiary (Merx Aviation). That’s 18% of the portfolio by itself  and a quarter of the BDC’s net worth. Just as important, with its 12.0% yield from a Revolver lent to Merx and distributions from its equity interest, its a major source of income for AINV: nearly 25% and a third of Net Investment Income.

Of course Merx seems to be performing well. Nonetheless, this is a highly leveraged entity and in a sector which has had its troubles in the past. Investors will want to know as much as possible about how Merx is performing in this and every quarter because its fate will be a huge determinant of AINV’s, especially to the downside.

LOOK UP

It’s easy enough for any manager to walk away from under-performing sectors or investments in the name of diversification. More dificult – but more insidious from a longer term risk perspective – is doing so with a successful operation. However, given its size that’s what needs to be done. AINV should be selling off a good portion of its exposure to a third party to meet its promises of not being caught over-concentrated…again. However that’s unlikely to happen and investors may want to look up from fretting about this quarter’s Net Investment Income Per Share to keep an eye on the long term health and prospects of this critical investment in the AINV pantheon.

CONCLUSION

AINV, its Investment Advisor and many of its investors are looking forward to the fruits of rolling out its new strategies. The BDC Reporter, though, suggests investors should – in this case at least – keep their eyes as much on the various legacies which AINV is burdened with in terms of credit, earnings quality, high cost of debt, investment concentration as on the bright shiny future promised. To use that oft-referred to cliche where AINV is concerned: the BDC is like a huge ship which takes a long time to turn around and which remains in danger of crashing on the rocks of its prior course. Many more quarters will have to pass before the BDC Reporter foresees being able to call the all clear. In the interim, both us and shareholders will have plenty of items to keep a close eye on that the Investment Advisor – understandably enough – may prefer not to discuss too much.

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