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Capitala Finance : Dividend Outlook

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On January 2, 2018, Capitala Finance (CPTA) announced monthly distributions for the first calendar quarter of the year. The payout is unchanged for the second quarter in a row at $0.0833 per month through March 2018.

INTRODUCTION

The BDC Reporter’s current Dividend Outlook for calendar 2018 for CPTA is UNCHANGED.  We last wrote an article on October 2 about the sustainability of the BDC’s dividend shortly after the announcement of the reduction from a monthly level of $0.13, but before the release of the IIIQ 2017 financial results on November 6, 2017. Even though CPTA has now reduced its dividend three times since IVQ 2015, the BDC Reporter’s  dividend rating was principally based upon the premise that the BDC – having just cut the payout – would have set a sensible and achievable level for the next several quarters. Here is an extract from the earlier Dividend Outlook article:

Notwithstanding that CPTA has not yet released its latest financials, the BDC Reporter has changed its new dividend outlook -through December 2018 – to Unchanged.  Likewise – and judging by the stock price in the aftermarket and the new yield of just over 10.0%, the market is also sanguine that CPTA will be able to maintain the $1.0 a share pay-out through next year.

As the quote above suggests, we were partly influenced by the market price of the stock following the announcement, which still traded at $9.950, or a pro-forma yield of 10.0%. Generally speaking, a yield of 10% or less suggests market participants are sanguine about the sustainability of the regular payout.

That Was Then

In the interim, though, CPTA has published the IIIQ 2017 results; held a Conference Call and provided supplementary data. Moreover, as the chart below shows, the market has sharply marked down the stop price from $9.950 to $7.51 at the open on December 3, and a low of $7.280 on December 29, 2017. That was a drop of (27%), and with CPTA now yielding 13.1% suggests the market strongly expects a reduction in the distribution in future periods, notwithstanding the unchanged payments just announced for the first three months of the year.

The BDC Reporter decided this was an opportunity to have an  in-depth look at CPTA’s financial performance, with a focus on the 46 portfolio companies on the books, in order to determine if a change to our rating might be appropriate:

FINANCIAL SNAPSHOT AT 9/30/2017

Here are some of the key data points highlighted on CPTA’s latest Conference Call intro:

As of September 30, 2017, our portfolio consisted of 46 companies with a fair market value of $471.1 million and a cost basis of $454.7 million. First lien debt investments represented 47.0% of the portfolio, second lien debt investments represented 6.5% of the portfolio, subordinated debt investments represented 22.5% of the portfolio, and equity/warrant investments represented 24.0% of the portfolio, based on fair values at September 30, 2017. On a cost basis, equity investments comprised 12.3% of the portfolio at September 30, 2017. The debt portfolio has a weighted average yield, exclusive of the impact of our non-accrual debt investments, of 12.9% at September 30, 2017.

At September 30, 2017, we had debt investments in four portfolio companies on non-accrual status with a fair value and cost basis of $26.8 million and $57.2 million, respectively. At December 31, 2016, the fair value of the non-accrual investments was $17.4 million, with a cost basis of $29.5 million.

Net investment income for the third quarter of 2017 was $4.4 million, or $0.28 per share, compared to $7.4 million, or $0.47 per share, for the same period in 2016.

…Net realized losses totaled $10.3 million, or $0.65 per share, for the third quarter of 2017, compared to net losses of $17.0 million, or $1.08 per share, for the same period in 2016. During the quarter, the Company realized losses on Sierra Hamilton, LLC ($7.1 million), CSM Bakery Solutions, LLC ($1.3 million) and Kelle’s Transport Service, LLC ($3.5 million), partially offset by a $1.5 million gain related to B&W Quality Growers, LLC and $0.1 million in other realized gains. The losses realized on Sierra Hamilton, LLC and Kelle’s Transport Service, LLC were related to restructurings during the third quarter of 2017, did not negatively impact our net asset value, and enabled us to reduce non-accrual balances. The realized loss on CSM Bakery Solutions, LLC did not impact on our net asset value, as the investment was exited at our June 30, 2017 fair value.

Net unrealized appreciation, inclusive of the written call option, totaled $2.8 million, or $0.17 per share, for the third quarter of 2017, compared to appreciation of $7.6 million, or $0.48 per share, for the third quarter of 2016.

Net asset value per share declined by approximately 5%, mostly related to unrealized depreciation from one of our non-performing investment.

WATCH LIST

The BDC Reporter has reviewed CPTA’s portfolio and identified 11 different companies for our Watch List. Obviously, that’s a large proportion (a quarter) of the total list. Of those, as the Company reveals above, 4 are already not generating any income for CPTA: American Exteriors (a window manufacturer); Cedar Electronics Holdings Corp (consumer electronics); On-Site Fuel Services (fuel transport) and Print Direction, Inc. (printing services). In addition, still performing, but written down to zero is $2mn lent to Immersive Media Tactical Solutions. No interest is being received there, only earn out payments up to $2.4mn (see Note 12 on page 12 of the 10-Q). For our purposes, we’re assuming no current income is being earned from any of these five investments.

No available information suggests any of these non-performing companies have been returned to performing status, but the loss of income has already occurred and is reflected in CPTA’s IIIQ 2017 recurring income. From an investor’s standpoint, the most important question going forward is estimating how much of the $26.8mn of fair market value which these investments represent might actually be recovered. We’ll give it to the old college try here:

Non Performers

American Exteriors has been a troubled credit for years and on non-accrual since 2015. CPTA is the only lender to the company and has been advancing additional monies, as recently as the last quarter. The principal investment is $5.4mn in First Lien Debt, with a FMV of 50% or $2.7mn. Unfortunately, given the valuation trends we’ve tracked using Advantage Data’s records, the recoverability of the loan seems in question. Back in the IVQ of 2015 – while on non-accrual – the debt was discounted by (13%). By June 2017 the discount was up to (40%) and was written down further in the latest quarter. Notwithstanding the First Lien status of the debt (we don’t know if there is an even more senior Revolver or other debt ahead of CPTA) we’re assuming a 100% eventual write-off, barring any new information.

Cedar Electronics – like American Exteriors a private company – appears to have at least two tranches of debt: a senior and a subordinated tranche. Unfortunately for CPTA its $21.6mn at cost /$8.5mn at FMV loan is in the junior position. (Non Traded BDC TCW Direct Lending is in the senior slot. It’s debt appears to be still performing and written down only marginally). The valuation trend for the CPTA tranche is down from a (25%) discount when the debt first went on non-accrual in June 2017 and (60%) in September 2017. When this deal was first booked in 2015 – which included both acquisition financing and a dividend recap– there was $97mn in Senior Debt raised, which is senior to CPTA.

We have no idea what the financial performance of Cedar Electronics looks like. We know the owners – a PE group – have brought in a new CEO as recently as December 2017, and (as mentioned above), the senior debt seems to be still performing. However, from CPTA’s standpoint we have no reason to expect a resumption of interest payments any time soon. A complete write-off of the investment – given the trends, the discount and the place in the capital structure – would not be an unreasonable assumption.

On-Site Fuel Services has been on CPTA’s books since 2015 and on non-accrual since 2015. The BDC has been adding capital into the business in order to effect a turnaround – as mentioned in a Conference Call earlier in 2017. What began as investments in Subordinated, Preferred and equity of just over $10mn has increased to $16.6mn. All the equity/Preferred has been written down to zero since 2014. However, the Subordinated Debt – although on non-accrual and twice extended in maturity- is carried at a premium to par. A few quarters ago, before the amount of debt was increased, this was carried at a substantial discount. CPTA seems to believe the turnaround will at least allow repayment of its $11.0mn of debt due in December 2018. For our part we are not assuming any income from the Subordinated Debt but we assume that the capital will get returned down the road. In the short term,though, we expect no contribution and no change in FMV.

Print Direction, Inc. is also a long standing borrower of CPTA’s, dating back to 2012. The initial exposure was only $5.3mn in Subordinated Debt and equity. However, by the time Print Directions defaulted in IIQ 2017, CPTA had invested $22mn in the company, $19mn in the form of First Lien debt. Unfortunately, the valuation – which had been trending downwards for many quarters – was very low at IIIQ 2017, just 20% of cost. To be conservative, we expect no income forthcoming and no recovery on either debt or equity.

Immersive Media Tactical Solutions is a defense contractor and a long standing borrower dating back to 2012, but got into trouble as far back as 2014. Based on the darta – and the full write-down- we expect no income from this source.

Summary Of Non Accruals

The publicly available information suggests 4 of the 5 non-performers (including Immersive Media) might be complete write-offs and generate no further income. The only exception might be On-Site Fuel Services, whose debt might get repaid and might – eventually – return to performing status. On these assumptions, CPTA might still write off – over time- ($15.2mn) of book value, which would bring NAV Per Share from $14.31 down to $13.36. Eventually the $11mn (at cost) of On-Site Fuel Services debt could generate 10%+ in income or $1.1mn annually. That amounts to about $0.07 per share in incremental Net Investment Income Per Share, a possible 6% increase.

WORRY LIST

One step down (or is it up ?) from non-performing companies are those which the BDC Reporter identifies as being more likely to cause an eventual Realized Loss than returning initial capital or better. Unfortunately, CPTA has 3 of these “Worry List” portfolio companies. What happens in this category is even more important because the loans involved are still income producing. Should that stop, the impact on earnings and the ability to pay the distribution will be felt quickly. Here there is $2.4mn in annual investment at risk from potential defaults and $26mn of FMV.

The Big Kahuna is a company called Velum Global Credit Management. CPTA has been lending to this consumer credit purchaser since 2014 and has built up to $11.8mn at cost in First Lien debt outstanding. On a valuation basis there seems to be no problem. CPTA has marked the investment at only a (5%) discount. However, the debt was due December 2017 and at the time of the last Conference Call had not been refinanced. An analyst picked up on the subject in the last Conference Call and was told: “I mean, we’re actively in conversations with them about whether we need to extend that or not. So that’s playing out as we speak.” We noted that the loan is all in PIK form and at a very high rate: 15%. However, through 2015 this used to be a cash pay credit. We’re guessing there’s more to the story, and given that the income at risk is high at $1.77mn annually worthy of more attention. All by itself -if the company failed to pay its interest – Net Investment Income Per Share would drop by 10%, everything else equal.

The second biggest risk of income loss on our Worry List is Bluestem Brands, Inc,. This is a retailer to lower income demographic consumers which has been having very public financial difficulties. The BDC Reporter has written about the company previously due to multiple BDC exposure. Although all the BDCs with exposure are in the First Lien Debt due in 2020 there are different valuations out there. MRCC, MAIN and HMS Income have written down their loans by (28%) while CPTA only (4%). There may be a completely innocent explanation for this discrepancy, but we don’t know what it is. In any case, our review of the Bluestem Group’s latest results still leaves some doubt as to whether this retailer can forge ahead without a default or restructuring. The value at 9/30/2017 was $3.8mn and $0.360mn in annual investment income was at risk.We expect most of the capital- even in a Worst Case – will be recouped but a temporary interruption of income from the debt is possible.

Finally, CPTA has $15.2mn at cost invested in Kelle’s Transport Service, LLC. The debt to this logistics company was restructured; a Realized Loss taken )$3.5mn)  and the debt returned to accrual status. Here’s the catch. Previously Kelle’s was paying 14% for its debt. Now there are two facilities with one charging 4.0% and one 1.46% !. CPTA was not very forthcoming about Kelle’s future prospects. However, should this restructuring not take $0.26mn of annual income is at risk.

Summary Of Worry List

The only Big Threat to CPTA’s income comes from Velum Global Credit Management. Should something happen to the company the loss of investment income would b sufficient to cause recurring earnings to drop to or below the dividend level. The other two Worry List names are less potentially impactful. If all 3 borrowers defaulted, the potential loss of investment income could drop CPTA’s Net Investment Income Per Share to $0.95, below the $1.0 current dividend level.

Early Warning List

The BDC Reporter keeps track of borrowers who are under-performing more modestly and for which there is more than an even chance of full ultimate pay-off. Nonetheless, investors should be aware of these credits which could deteriorate in the future.  We have identified 3 names. To keep this article from running on too long we’ll just mention them by name: American Clinical Solutions, LLC (FMV $7.6mn); Sierra Hamilton Holdings (just restructured with $7mn in equity only) and U.S. Well Services (also restructured and carried at a premium at the moment).

SPREAD COMPRESSION

Another phenomenon underway which should cause CPTA’s income to drop is the decision by the Investment Advisor (not unreasonably given the multiple dividend cuts and credit losses) to seek refuge in lower risk but lower yielding credits. This is not a process that happens overnight but the CEO of the BDC did indicate that “we will probably lose 150 to 250 basis points on yield. Using a midpoint of 200bps that suggests the portfolio yield could drop from 12.9% to 10.9% over the next three years or so. If we assume about $350mn in performing debt outstanding on CPTA’s balance sheet that could drop Investment Income by $7.0mn, all of which would also come out of Net Investment Income as well. That’s equivalent to 40% of the BDC’s current running rate, or $0.44 a share. Or in other words that could cut Net Investment Income Per Share from $1.12 to $0.68.

ADDITIONAL INCOME

Against the threats to income from bad debts and spread compression management points to 2 sources of potential increased income.

The first is using the BDC’s liquidity- especially the $50mn in cash in its SBIC subsidiary – to invest in new assets. Fully invested – and assuming some of the proceeds go into non-income investments – that could yield at a 10% yield about $5mn a year of Investment Income. Net of management fees and costs that would generate $4mn of Net Investment Income. Beyond that, CPTA could draw on its unused Revolver – repaid by raising expensive unsecured debt in 2017 – to fund additional investments.

Second, the BDC hopes/intends to sell many of its equity stakes and re-invest the proceeds into yield bearing investments. On paper there is $113mn at FMV of equity investments. For our purposes – and being realistic about how many of these investments that might get sold in the next few years – this could result in $50mn in new debt additions. At a 10% yield, CPTA could generate $5.0mn of incremental Investment Income and Net Investment Income from this source.

CONCLUSION

There are many moving parts here, both that might increase or decrease CPTA’s Net Investment Income. The BDC Reporter has little doubt that even the latest $1.0 a year distribution level will eventually have to be cut as the lower risk-lower return strategy begins to impact results. Moreover, anybody scanning down the BDC’s portfolio list will notice the numerous high yielding and higher risk credits (many of which are paying partly or fully In Kind) accumulated over the years. It’s unlikely that CPTA can staunch any further losses even amongst credits that are still performing today.

However, our Dividend Outlook looks out only a year: till the end of 2018. During that period – unless there are a series of hits from defaults by Early Warning and Worry List borrowers – the sources of higher income are likely to outstrip factors that will eventually reduce earnings. By 2019 chances are CPTA will be under much greater pressure to reduce its payout.

However, for 2018 the BDC Reporter is changing our prior Dividend Outlook rating for CPTA from UNCHANGED to AT RISK.

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