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Capital Southwest : Earnings Preview – CORRECTED

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Thanks to one of our readers, we’ve corrected and updated the original article:

  1. We corrected the earlier assertion that Media Recovery is non-income producing. Although CSWC’s entire position is in common stock and Preferred, the former does pay a dividend. Of course that makes only more important the BDC Reporter’s suggestion that readers should keep an eye on CSWC’s largest company investment.
  2. Our reader believes – based on deductions worthy of Sherlock Holmes – that the portfolio company placed on CSWC’s internal Watch List is Wastewater Specialties.

INTRODUCTION

With “Earnings Season” right around the corner – and the BDC markets flat in recent days in anticipation – the BDC Reporter is previewing some of the key issues investors will want to be looking for when the actual press releases, 10-Qs (the 10-Ks don’t come till late February and early March) and Conference Calls come out.  Forewarned is forearmed. We begin with Capital Southwest (CSCWC), which is first on the BDC Reporter’s just expanded and improved Earnings Calendar ( see the Tools section). We limit ourselves to 3 top issues investors should be looking out for:

CSWC

1.Recurring Earnings Growth. Last quarter CSCWC reported Net Investment Income Per Share of $0.25 per share. That was up on the prior quarter and on the prior year same time as CSWC has been – by recent BDC standards- growing earnings at warp speed. That’s because – unlike most of its peers – CSWC is under-invested with a debt to equity of just 0.2 to 1.0, versus a target of 0.75 to 1.00 , or even more. Constant growth in the portfolio has allowed the BDC to raise its distribution several quarters in a row. The latest announcement was in November 2017, and the payout was upped to $0.26 from $0.24 for the just ended IVQ 2017 quarter.  Obviously, even though the dividend was pegged one month before the books closed CSWC’s management must have had good reason to raise its dividend by two cents from the quarter before, and above the third quarter’s earnings level.

Nonetheless, there were one time costs associated with the BDC’s first ever issuance of Baby Bonds late in the quarter which may have depressed earnings. Then there were more professional hires adding to expenses, which began to show up last quarter and higher LIBOR borrowing costs potentially too. The market is expecting CSWC to continue marching up its earnings to as much as $1.33 a share by 2019. That’s a 33% increase from the level in the IIIQ 2017 annualized and the reason the stock has traded as high as $17.76 in the past year (a 13.3x multiple of future earnings !).  Since the October 2017 high, though, the stock has traded down to $16.60, but that’s still a respectable 12.5x multiple of future earnings. Investors will be looking out for any signs that recurring earnings – after much fussing with one time expenses – may peak lower than previously expected. That would also mean that the ultimate dividend might end up being less elevated than the market expects and not justify the underwhelming  6.3% yield shareholders are currently receiving while waiting for future distribution hikes. Watch out – even if CSWC is otherwise performing well – if earnings/dividend expectations get permanently trimmed back. The market has already pulled back its highest hopes in advance of the earnings release but could go 10% or more lower if an equivalent decrease in future earnings becomes the New Normal.

2. Status Of Watch List Loan: As a newer lender in the BDC space, CSWC has had very, very few troubled loans to worry about. That’s partly due to the fact that bad loans typically take a few quarters to show up, especially in this easy money environment. However, at the end of last quarter management admitted to having a new name on its internal Watch List. This is the sum of what management said about the under-performing loan:

 We did, however, place one first lien asset for $10 million on our internal watch list this quarter.

This company is a regional provider of industrial cleaning services to industrial and petrochemical companies in South Texas and Southern Louisiana. The performance has deteriorated in recent months in part due to disruptions resulting from Hurricane Harvey.

At this time, we believe the underperformance to be temporary, but they did breach financial covenants for the September period, so as a first lien lender, we will have the ability to address the situation directly with the company.

The BDC Reporter is still figuring out which portfolio company is being referenced, but the status of this loan will be important to update, given the potential impact on earnings and NAV if temporary troubles become more serious. We would also keep an eye out for the value of Deep Water Corrosion Services, in which CSWC has a Preferred investment which is already deeply discounted. There may no impact on income but NAV could be impacted.

3. Status/Value of Media Recovery Inc:   Down the road CSCWC would like to become like Main Street Capital – with a large and diversified portfolio of lower middle market borrowers to which the BDC would both lend and invest equity in. Howeve, for the moment there is only 1 company in the portfolio with a meaningful equity value (but plenty of seeds) and that’s Media Recovery Inc. The company is a left over from CSWC’s former life as an equity-focused entity. (Long story). The issue is that Media Recovery represents a very large portion of the BDC’s total investments: $40mn at FMV on $322mn of portfolio assets. The company does not contribute to income but what happens in the future to Media Recovery will have an outsized effect on CSWC. If the company continues to grow in value and i eventually sold, the proceeds will boost the BDC’s earning capacity (and Taxable Income). On the other hand, if the company stumbles (as happens) the impact on CSWC’s NAV could be substantial. Keeping an eye on where Media Recovery sits will be a recurring theme for some quarters to come, as management has not shown any inclination (nor should they) to divest themselves of the investment. This is a double edged sword.

There are many other issues besides that need to be updated at the next earnings including the status of the BDC (all but written off as a source of capital for the medium term): the portfolio mix between lower middle market lending, upper middle market and the Senior Loan JV; the ramp up of costs expected from hiring new staff and much more. Nonetheless – as BDC quarterly earnings go – we expect this to be a relatively routine quarter, as we’ve indicated in the BDC Earnings Calendar. Still, anything can happen, but our readers will have the advantage of having these crib notes in advance.

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