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CM Finance: Why We’re Concerned- Corrected Version

BDCs:
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With the week-end here – and with BDC earnings season almost completed – the BDC Reporter is busy updating its database of financial records, and undertaking triage among the nearly three dozen new earnings releases filed in the past fortnight. For the moment, we’re looking for the BDCs which cause us the greatest concern or where we see the greatest opportunity, in light of the latest information. In the former category falls CM Finance (CMFN), as we’ll explain.


NEWS

First a brief recap of the BDC’s fiscal first quarter results: Net Investment Income Per Share was $0.22. See the attachment.

NAV decreased slightly from $12.41 to $ 12.39. [An earlier version had incorrect NAV numbers]

From October 1, when restructured Bird Electric – which had been partly written off by over ($7mn) in the quarter just ended- was returned to accruing status, no more investments were on non-accrual.

Debt To Equity was at 0.75: 1.00.

Unlike the prior quarter, the BDC did not waive any fees in the period to achieve its Net Investment Income.

Management – on its Conference Call – predicted the next quarter would result in a higher Net Investment Income Per Share. Here is the full quote:

.. we expect to earn in excess of our dividend during the December quarter. And we are on track to cover the dividend for both fourth quarter and the full calendar year 2017.

CMFN announced a calendar fourth quarter distribution of $0.25, unchanged from the prior period.

Management is confident about its prospects in the just begun fiscal year :

Our run rate portfolio yield as well as our current portfolio size give confidence as we look into 2018


ANALYSIS

Digging into the 10-Q, there are a number of additional factors which need to be taken into account:

First, 10% of Net Investment Income consists of Payment-In-Kind versus zero last year.

On an adjusted basis  Cash Net Investment Income Per Share is close to $0.20.

Note, though, that the Investment Adviser will not receive $221,883 in deferred Incentive Fees until the income therefrom is received in cash.

Second, although Bird Electric has been returned to accrual status this quarter, the income is likely to be in non-cash form for the foreseeable future.

Third, the Company – with debt to equity of 0.75: 1.00 – is reaching the top of its targeted  range of 0.65-0.85.

Fourth, the BDC’s own risk rating table shows investments in its two riskiest categories have grown in value from $14.3mn at June 2017 to $27.0mn.

Fifth, the BDC continues to have a way above average exposure to energy for a BDC: 16% of assets between Oil & Gas and Oilfield Services.


VIEWS

We wrote about CMFN at the time of its fiscal year end 2017, which ended in June.

At that point, the BDC Reporter was skeptical about the ability of the BDC to maintain its newly established $1.0 a year distribution for the next 12 months.

Notwithstanding the announcement of the unchanged distribution for the quarter ended December 2017,the promise of higher earnings in the current quarter and the optimism of management, we continue to believe the dividend is At Risk of being reduced within the next 6-9 months.

The key risk is credit, and specifically what happens to a couple of borrowers in a very small 23 company portfolio where bad news from as little as 1 borrower can materially affect earnings.

We worry about the risk of defaults or restructurings at PR Wireless, to which CMFN has loaned $15.5mn at an interest rate just over 10%. PR Wireless is a mobile operator, whose geographic coverage is the much battered island of Puerto Rico. CMFN continues to carry the loan at par, but our research indicates that may turn out to be optimistic.

Even more concerning is $21.8mn in second lien exposure to healthcare company Trident USA Health Services. This credit has been a question mark for several quarters and was written down again this quarter. We believe the change in the two lowest credit categories flagged above is moving Trident down from Category 3 to Category 4.

Trident generates over $2.25mn in annual investment income for CMFN.

If both these loans should default in the future, CMFN faces both the loss of substantial income and book value, given that PR Wireless faces the destruction wreaked by the hurricane and Trident is in a junior position.

The potential income loss is over $3.85mn, or 14% of Investment Income (using the latest quarterly results and annualizing) and 30% of Net Investment Income.

With the recurring earnings per share already below the distribution level, CMFN might be forced into cutting its distribution by a third or more in this hypothetical scenario.

Moreover, should losses occur on either one of these loans, debt to equity is likely to increase- and with CMFN at its leverage limits – that might require the sale of some other assets to keep the BDC metrics in line, with further impact on the earnings capability of the BDC.

For example, the write-off or write down of 50% of the value of these two borrowers would reduce book value and bring debt to equity right up to the 0.85:1.00 maximum limit.

We’ve not heard any definitive Bad News from PR Wireless (written down by the rating agencies both before and after the hurricane and waiting for a merger with a competitor which may – or may not – be the solution to its ills) or Trident USA. If we do, though, we’ll immediately move our Dividend Outlook to the most negative setting: “Decrease”.

Caveat

If CMFN’s credit portfolio holds up, the risk of a major dividend cut – similar to those which have just roiled TCAP and ABDC- will be postponed.

Longer term – and in this regard the BDC Reporter admits to being more conservative than most – we are concerned about possible negative news from any of the energy investments which CMFN has booked and chosen to hold onto over the years.

“Fool me once etc.”

Moreover, the small number of credits in portfolio – and recurring earnings already running below the distribution – makes the BDC very vulnerable to any credit hiccup.

The credit profile of CMFN – regardless of its actual underwriting – is on on the higher risk side. Besides concentration risk and energy exposure risk, note that 45% of all investments are in second lien. That’s a category of debt getting very much beaten up from a credit standpoint of late, with many BDCs reducing their exposure.

What Does Mr Market Have To Say ?

The BDC Reporter always like to look how it’s own view contrasts or otherwise with Mr Market.

Judging by the stock price drop from $10.70 in the spring to $8.70 today, just 4% off a 52 Week Low set a few days ago- and with a yield  of 11.4%, we’d say Mr Market has expressed a level of doubt too about CMFN’s prospects.

However, if there were to be a 33% drop if things don’t go well, CMFN could still drop substantially more in price as happened to ABDC, and to other BDCs which surprised to the downside.

Very roughly, we would suggest the downside here is a drop to a dividend of $0.67 and a stock price of $5.0. That’s a potential (43%) drop from the current level.

Rhetorical Query

If we are right – and this is more of a matter of odds than anything else – we ask if a 11.4% yield in a BDC which has already cut its distribution a few quarters ago; with a tiny portfolio by BDC standards and a concentration in energy and a negative credit trend is worth the potential downside that might play out in the year or two ahead with some combination of bad debts ?


INVESTMENT APPROACH

Common Stock

We have been posing ourselves the question above in one form or another ever since we began deep diving into CMFN’s portfolio and business model.

The answer has been – and remains – the same: No.

We have no position in CMFN and do not expect to even list the BDC among our Prospects.

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