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Year In Review: Apollo Investment

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PREAMBLE

With little BDC news to write about and with 2017 coming to a close the BDC Reporter is reviewing many of the BDCs that we wrote about in a series we’ll unimaginatively call “Year In Review“. We aim – with the benefit of hindsight – to determine what we got right and got wrong on these pages, and project what the key challenges are for these BDCs in  2018. As we’ve done all year we’re also sharing with our readers how we invested our own capital, and with what results to date. Here we tackle veteran BDC Apollo Investment (AINV), who we’ve been maintaining a very consistent view about all year. As the article shows, still up in the air is whether we’ve been too cautious, but price action in recent months appears to be bearing us out.

YEAR IN REVIEW

Coverage

We mentioned AINV more than 25 times during 2017, including several in-depth features about the BDC’s earnings, credit quality and business strategy.

The New AINV

Let’s remember that in 2016 the Investment Advisor – not for the first time – installed a new senior management team, announced a new business strategy, waived fees temporarily and sharply reduced the distribution again to $0.15 a quarter per share from $0.20 previously. However, those of us who’ve been investing in the BDC Sector for a long time remember that similar actions have been taken before and that back in 2008, the quarterly distribution was $0.52.

Show Me State

As a result, the BDC Reporter has adopted a more skeptical-than-most approach to AINV’s promise of a more conservative and more successful strategic approach. That was on display in the first major review we undertook on February 6, 2017 when AINV reported its IVQ 2017 results. The message from new CEO James Zelter was that everything was proceeding to plan:

Mr. James Zelter, Apollo Investment’s Chief Executive Officer, commented, “We believe that we have made considerable progress repositioning the portfolio, consistent with the strategy that we outlined last year. We have meaningfully reduced our exposure to structured credit and renewables. In addition, we funded three transactions entered into pursuant to our co-investment exemptive order during the quarter. Since receiving the order, we have entered into eight transactions including several in the March quarter.”

Take The Rough With The Smooth

The BDC Reporter, though, noted that the eventual consequences of the new strategy were likely to be a lower portfolio yield which would impact recurring earnings and cause yet another cut in the distribution. We pointed out that AINV’s laudable policy of selling off its CLO investments and no longer investing in new energy deals would also impact investment income and the portfolio yield as these were high return investments (when they worked out). We predicted that the portfolio yield on income producing investments, which was 10.9% at December 2016 “could drop to 9.8% in a year (or two)”.

[By the way, at September 30 2017, AINV reported a portfolio yield of 10.3%.Excluding PIK income the yield is probably already at 9.8%].

Boosted

We also pointed out that earnings were being temporarily boosted by fee waivers offered by the Investment Advisor following their “annus horribilis”.

Recast AINV’s earnings by adjusting for lower income and higher expenses and the real “running rate” at AINV would be materially lower than what was showing at the end of calendar 2016:

Put those two numbers together and you’ve got over $40mn in potentially lower Net Investment Income for shareholders.

With 220mn shares outstanding, that’s $0.18 a share that’s at risk for shareholders versus a “running rate” Net Investment Income Per Share at December 2016 of $0.68.

That would bring down the annual Net Investment Income Per Share to $0.50 versus a distribution of $0.60.

Crying Wolf

Without even getting into the nitty gritty of earnings quality or individual credit performance, the BDC Reporter warned that chances were high in the next year of a dividend cut:

Although AINV only recently reduced its distribution from $0.20 to $0.15 a quarter (back in September 2016), we have doubts about its sustainability in the short term (i.e. the next 12 months).

The next distribution has already been fixed for the current quarter:

On February 3, 2017, the Board of Directors declared a distribution of $0.15 per share, payable on April 6, 2017 to shareholders of record as of March 21, 2017.

Our analysis suggests, though, that a year from now (or even before) AINV might have to cut the distribution to $0.125 a quarter or lower, a 17% or greater cut.

If that should happen, the stock price might follow, dropping to $5.0 or below.

The market did not share our longer term concerns. When we wrote our article, both the BDC Sector and AINV – which tend to move in lockstep much of the time – were on the final upswing of the February 2016-March 2017 “bull run”. AINV was at $6.06, up 33% from its February 2016 lowest point and 3.4% on the year.

Higher To Go 

On February 25, 2017, in the BDC Market Recap, we noted that AINV was close to a 52 Week High. The BDC Sector, too, was hitting new record highs.

Shortly thereafter, we mentioned AINV again, when the stock hit $6.43 a share in the week ended March 3, 2017.

Credit In Focus

AINV was back in the news on April 4, 2017 when the BDC Reporter – wearing the BDC Credit Reporter hat that we’ve been developing for two years now – alerted readers to a pending loan default and downgrade at Sprint Industrial Holdings. Unfortunately for AINV, Sprint was a portfolio company investment, and the default was a reminder that the BDC still faced credit challenges which could affect both the NAV and earnings.

The market was not concerned by the news, with AINV closing at $6.560. The BDC Sector had hit its highest point just 4 calendar days before.

Another Bite At The Apple

We didn’t undertake any in-depth reporting on AINV because there was little other news until the full fiscal year results were out, in an article on May 19, 2017. As before, we were not yet convinced – as per the Investment Advisor’s narrative – that the turnaround at AINV was settled.

We couldn’t help pointing out that the vaunted improvement in the quarter in the number of non-performing loans was not achieved by “turning round” credits:

Yes, AINV has reduced the total dollars of non-performing loans (see page 20 of the Presentation) but largely by booking Realized Losses (another $42mn in FY 2017, after -$203mn in the two prior fiscal years under the prior/management strategy) and “restructuring” many of the companies involved….we’d like to point out that the absolute level of Non Accruals remaining is still very high after so much red ink spilt. As the Presentation shows, there are 7 companies still on non-accrual, with a cost of $183mn and a fair market value of $69mn, or 7% and 3% at Cost and FMV. Making loans is easy, getting your capital back is hard, as AINV is constantly finding.”

By our – admittedly conservative count – there were still 21 portfolio companies worthy of being on a Watch List, versus 20 the prior quarter.

We also pointed out that AINV had “restructured” several companies and kept them on their books, but success was far from guaranteed.

Love Those Leases

On a more fundamental basis, we contrasted the new management’s of having a more diversified portfolio than in the past, with the reality showing up in the 10-K.

Stepping away from immediate credit sore spots, the BDC Credit Reporter points out that despite AINV’s stated goal of having a more diversified portfolio (deal concentration has been identified as on of its key problems) old habits die hard for an Apollo organization which has been successful -in other contexts – by taking big risks in a small number of deals. AINV continues to place nearly a fifth of the BDC’s assets in aircraft leasing through one wholly owned, highly leveraged company, Merx Aviation. That’s been a successful venture in recent times, but we do suggest anyone interested in getting a full picture of AINV scroll down to Merx’s financial statements which -thanks to regulations – AINV is required to file with the 10-K. The balance sheet shows the lessor has $867mn in total assets, and $637mn in debt and $847mn in total liabilities. On AINV’s portfolio, Merx is carried at $48.8mn, way over the $19mn invested at cost. However, we couldn’t help noting that this value has dropped from $82mn in the prior quarter and $94mn a year ago. Whatever the value, and whatever the income generated, the BDC Reporter can’t help worrying about any BDC that makes such an outsized debt, even if one spread over dozens of aircraft.

A little less disconcerting but worth mentioning in this context is a $135mn position in U.S. Security Associates (versus the $30mn or less AINV targets for any single position) and that big exposure mentioned above to Solarplicity.

Paper Income & Temporary Credits

Finally, the BDC Reporter returned to the question mark about AINV’s earnings quality, referencing both the very large proportion of Pay In Kind Income booked in the period – often from “restructured” borrowers whose long term viability must be in question- and the continuing waiver of fees that only temporarily boost earnings. Again, we were doubtful that AINV’s earnings and dividend could be sustained, but sought to offer readers as balanced an assessment as we could. Here is our conclusion from the article:

As usual, we know this may not be what existing AINV shareholders want to hear. However, we ask you not to “shoot the messenger”. We also readily admit there are many, many moving parts here and the very determined team under CEO Zelter may be able to skirt some of the issues we’ve raised or outcomes from troubled loans might be better than we anticipate or the Investment Advisor might make some long term compensation concessions to shareholders. (That last one might be the most shocking of all) . Clearly that’s what the market was anticipating till very recently and still remains more optimistic than the BDC Reporter.

From our perspective, investors in AINV are taking on substantial “equity risk” for a modest potential upside and that $0.60 a year dividend. Past is not always prologue and Mr Zelter’s stewardship should not be too tarred by the history of AINV. Nonetheless, remember that over its history the BDC has managed to lose to Realized and Unrealized Losses half the equity capital raised from investors through 4 different strategic changes of heart.   We know the expression “Fool Me Once, Shame On You. Fool Me Twice, Shame On Me”. However, should investors get “fooled” four times they will have themselves, and a BDC market where shareholders come and go relatively quickly, to blame…

This will take till June 2018- the first quarter when the Incentive Fee comes back into play- to play out. The BDC Reporter will stay abreast of the situation and will either eat crow or otherwise a little over  year from now.

By that point AINV had reached its 52 Week High of $6.82 on May 1st and the price was in decline, closing on May 19 of $6.26.

Non Accreting

In June, the BDC Reporter tackled another sore point: AINV’s high cost of debt due to its heavy reliance on long term Unsecured Notes.  Returning to a theme we’ve mentioned before, we argued that the debt capital raised by issuing the Notes was non-accretive to AINV’s shareholders after interest expense, front end costs, compensation fees and operating costs are considered, as well as bad debts incurred on assets acquired with the monies. Then we reminded readers that when non-cash income and equity investments purchased with the proceeds from the Notes are figured in, the picture is even bleaker.

We argued that AINV should be focused on “right sizing” its balance sheet (i.e. shrinking) and paying off the egregiously priced Unsecured Notes to improve earnings over time. However, we doubted that the Investment Advisor would take such actions for reasons that are discussed in the article.

A First Step On A Long Journey

[In that case, we were proved (partly) wrong a few weeks later when AINV redeemed $150mn of Senior Unsecured Notes, with the ticker AIY on October 15, and which we covered in an article when the pay-off was first announced on August 31. However – as the IIIQ 10-Q shows – AINV still has $516mn in other expensive Unsecured Notes, which accounts for more than two-thirds of their borrowings. Depressingly for AINV shareholders the latest 10-Q shows the annualized interest cost at AINV running at 6.11%, higher than the year before and one of the highest average rates in the BDC Sector. Even with the redemption of AIY, we don’t expect that interest expense bill to drop too much as the Revolver is priced off LIBOR and that base rate is increasing regularly].

Unrelenting

AINV reported June 2017 results in the summer  – a subject we tackled – in a August 11, 2017 article. Once again, we delved into the SEC filings and – once again – we came away more skeptical than the market. We won’t review all the details because anyone who has read to this point will be familiar with the BDC Reporter’s major concerns, none of which were alleviated by the most recent developments. As we had all year, the BDC Reporter was at variance with the market – which was valuing the stock at $6.29 and only marginally below book value. Our view was that AINV was over-valued for the risks involved as we summed up at the time, leaving to readers to agree or disagree:

Taken as a whole, the BDC Reporter believes investors in the common stock are being asked to take too many “equity risks” at the current price level, which is why we believe the stock is over-valued. The new CEO may yet be able to steer through all these challenges and maintain the distribution at $0.15. However, our assessment is that at some point in 2018 – barring a drastic change in approach – AINV will be forced to admit that the pay-out cannot be sustained and implement another 20%-33% reduction in the dividend. Of course, with the market currently assuming everything is awesome at the BDC, such a move is likely to cause a sharp revaluation of the stock.  Just to throw out some price ranges, that could see AINV’s stock drop to $4.0 or below. For a stock paying $0.60 a year in distributions, the possibility of a $2.50 or more in price drop seems inappropriate risk-reward. We would be happy to be proved wrong but we point investors to AINV’s long term track record and ask why this time should be so much different ?

Otherwise Engaged

We’ve not published any in-depth review of AINV since then. However, the BDC Reporter could not help noting the continuing decline in the stock price  to $5.94 in a post on September 28, 2017.
When we launched our Dividend Outlook Table (a Premium feature) in December, AINV’s payout sustainability through December 2018 was listed as AT RISK. We continue to believe that there is a chance of a dividend cut – if the Investment Advisor chooses not to renew its fee waivers and/or if more credit problems erode recurring income – as early as the second quarter of the year.
UPDATE
Since September 28, AINV has continued to drop in price – extending a downward slide that began in May. As this chart shows, the stock reached a 52 Week Low as recently as December 27 at $5.650, a (6%) drop since late September and (20%) from the May 2017 high. On the other hand, AINV is only down (3%) on a YTD basis, so investors who bought this time last year have made a small gain on a Total Return basis while the BDC Reporter has been sitting on the sidelines fretting about all the issues mentioned above and more besides.
OUTLOOK
We cannot be sure if AINV’s slow price meltdown reflects Mr Market finally beginning to worry about the long term fundamentals – and a dividend cut – or just a year-end selloff which will be reversed in early 2018.
Trying to guess at what the market is going to do in the short term is a fruitless exercise – at least for the BDC Reporter.
From our standpoint – peering into 2018 – the risks of ever lower earnings; more credit losses and a dividend cut that might cause the stock price to drop 20%-30% is too high for the promise of a 10.5% current yield that might drop to just 7.0% if the payout gets hacked again to a $0.40 level.
Moreover, without sufficient progress during 2017 on reducing investment concentration and expensive debt, longer term fundamental risks remain too high for our blood.
This talented management team may yet “turn around” AINV but the risk-reward is not appropriate.

INVESTMENT APPROACH

Common Stock

We have no position in AINV.

Fixed Income

We have no position in the remaining Baby Bond with the ticker AIY.

That’s more of a reflection of the high price – AIY typically trades at over $26.00 a share- and the possible redemption coming in July 2018 (Premium subscribers can check out the details on the Fixed Income Table). 

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