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Gladstone Investment: IIQ 2017 Performance

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The BDC Reporter reviewed the earnings press release of Gladstone Investment (GAIN) and spent considerable time on the 10-Q for its fiscal first quarter, ended in June 2017. As usual we were less concerned with the quarter’s earnings per share and Net Asset Value, and more on identifying new developments that might impact the BDC’s results longer term, both for common shareholders and Term Preferred holders:


NEWS

There are 3 key new developments:

  • Loans/companies on non-accrual increased: In the quarter GAIN added one more portfolio company to its non-accrual list: Precision Southeast. That brings to 3 the number of companies not paying intetrest on some or all their debt outstandings. At cost, this amounts to $25.2mn, an increase from $15.6mn the prior quarter. That represents 7% of all debt assets at cost on non-accrual. The fair value of these non-performing loans is $21.5mn or 6.1% of all debt investments owned. The other two non-accruals are Tread Corporation and Alloy Die Cast.
  • Restructured Mathey Investment and SBS Industries: The former was merged into the latter, with its debt assumed. This has boosted the size of the SBS First Lien Term  debt to $20.0mn.The small equity value in Mathey was also transferred over unchanged. This leaves SBS with a cost of $22.9mn and a FMV of $21.4mn. The BDC Credit Reporter maintains the company on its Watch List notwithstanding the small gap between cost and fair value. The Term Loan bears interest at an above average 14%, suggesting higher risk. Plus, we note that GAIN made a $1.5mn revolver advance to SBS, still undrawn.
  • No new deals were booked. In the quarter Mitchell Rubber Products was sold (for a gain) and new advances were made to existing companies, but no new portfolio companies were added. That brings total portfolio companies down to 33 from 35.

      Under-Performing

           The BDC Credit Reporter counts 16 Under-Performing companies in total, including the 3 non-accruals, and 5 on our Worry list (where the chances of eventual losses seem higher thgan the chances of full recovery), and 8 on our Watch List, where we still expect chances are good for full recovery.

Out Performing

However, GAIN has several equity investments (7) which are valued over cost and might result in an ultimate Realized Gain, like Mitchell Rubber.

Notwithstanding that in aggregate dollars Unrealized Gains outstripped Unrealized Losses in the period, more portfolio companies were written down than up in the period.


ANALYSIS

The combination of lower yielding assets from net repayments and $10mn in non-accruals, plus the issuance of new shares in May will be placing increased pressure on recurring earnings per share. Adding to the pressure is that Investment Income is boosted by fees from the episodic sales of companies. In the latest quarter Total Investment Income was $13.6mn, but $2.9mn was from fees that cannot be counted on to recur religiously in future periods.

As a result, the Investment Advisor will have to work hard to match the $0.17 Net Investment Income Per Share in the quarters ahead. Of course, there may be more company sales (and fees). We would expect that GAIN is out looking for new deals to book ASAP, and the BDC has plenty of liquidity under its Revolver ($111mn at June 2017-see page 29) to grow back its “book”. Also – as has happened in the past – the Investment Advisor may waive one fee or another to maintain both EPS and the distribution.

More non-accruals (a not impossible likelihood) would add to the pressure. On the other hand, GAIN could restructure its 3 non-performing borrowers (typically adding more capital ) in order to boost Investment Income back up.

This is a tightrope which GAIN has balanced on for years so there’s no strong reason to believe the Investment Advisor will not be able to wobble on. Plus, with a buoyant market for middle market M&A future Realized Gains and fees are more likely than not, even if episodic.

We expect GAIN will try to reduce its very high cost of debt capital by refinancing one bof its 3 Preferred issues, but that can’t happen till later in the year. That will reduce dividends on the Preferred, but the savings will be marginal once the cost of paying off the existing issues is factored in. First up might be the Series B Preferred, which can be redeemed from December 2017 and yields 6.75%. GAIN may be able to refinance at 6.0% or lower if all goes well between now and the time of a new issue.

As the 10-Q points out (page 22 amongst other places) GAIN has an unused shelf offering allowing them to raise up to $221mn. No need for equity capital seems to be in the cards in the short run so another Preferred or a Convertible are more likely.


VIEWS

Churlish as it might seem to say after the BDC sells yet another portfolio company for a gain and still has 20% of the portfolio promising potential winners down the road, this was a case of one step forward and one and a half steps back for GAIN. Although the headline numbers that most investors look at are very stable, there’s more movement going on behind the scenes. The increase in non-performing loans is a setback and the Mathey merger into SBS seems to be a sign of credit weakness at the former. In fact, the number of restructured portfolio companies at GAIN is high, suggesting much financial engineering needed, which is always disquieting.

The Investment Advisor has its work cut out in the quarters ahead to keep recurring earnings per share stable. Longer term, though, our generally positive view of GAIN remains unchanged. The BDC  the benefit of plenty of liquidity and much experience in this arena. We are not changing our assumption that GAIN will maintain its current dividend in the year ahead , even if achieved through circuitous means.


INVESTMENT STRATEGY

Common Stock

Although GAIN trades at the slightest discount to NAV, we view the stock as very expensive from a multiple of recurring earnings (14X !). We are staying away at this price level. Our own Fair Market Value for GAIN, even though we are bullish on NAV and the dividend long term is $6.9, which only underscores how “over valued” by our lights this long-in-the-tooth BDC has become in this BDC “bull market” and thanks to its multiple successes selling portfolio companies in recent years. So we are not buying the stock either for our Long Term Income portfolio nor for our Special Situations portfolio.

Baby Bonds

However, we remain Long in all 3 GAIN Term Preferred issues. We’ve been invested in GAIN’s Preferred essentially since Day One and have been very satisfied with the results, except for a slump in prices in early 2016 which was followed by a quick rebound. We undertook our quarterly down and dirty “stress test” of the Preferred (which we’ll discuss at greater length in a separate post) and were confirmed in our confidence for both the short and long term. We expect the Preferred B issue to be redeemed in early 2018, and the other two are at risk in the rest of the year, as early redemption dates are reached.

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