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Capitala Finance: We Update Following IVQ 2017 Results

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A few days ago, the BDC Reporter wrote a preview of what investors might expect from Capitala Finance’s (CPTA) IVQ 2017 earnings release. We explained that this was likely to be an important report given that the BDC had announced multiple credit issues in the IIIQ 2017 and slashed its distribution for the second time in a year. Now that CPTA has released its 10-K for the year ended 2017 and held its Conference Call – which we listened in on- we’re updating our initial memo. We are showing both the original text and the update, which is rendered in bold and italics for ease of use. We end with our summary of where CPTA stands in its attempted turnaround:


“CAPITALA FINANCE (CPTA) – REPORTING TUESDAY FEBRUARY 27, 2018 AFTER THE CLOSE – $0.27 E

Actual Vs Expected

Just over a year ago, CPTA was earning $0.47 per share of Net Investment Income. Last quarter – thanks to a flurry of bad debts – the number dropped to $0.28.

This quarter the analysts are expecting $0.27.

Update: Net Investment Per Share was $0.26. 

Much To Do

We noted in an earlier in-depth review of both the portfolio and earnings power published in January 2018, that CPTA will be under pressure for several quarters to come.

First, there is the settling out of the 5 non-performing loans on its 34 company portfolio  – by our way of counting –  and the status of several under-performing companies, which could yet take a bite out of earnings.

The non performing names are Immersive Media, On-Site Fuel Service, American Exteriors, Cedar Electronics and Print Direction.

Here is what we wrote in our earlier article about the non-performing credits in summary. We’ve not updated our research since this was written January 3 2018:

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.

Update: Just by the numbers CPTA has not made much progress – whatever the press release says – on reducing its non-accrual mountain. In September 2017 CPTA said 4 loans were on non-accrual. (We added a fifth – Immersive Media -which has no scheduled interest and pays only “earn-out payments of up to $2.4mn”. This quarter CPTA still has 4 loans on non-accrual and the FMV has dropped from $26.8mn to $25mn. The cost of the non-accruals has reduced from $57.8mn to $50.1mn. However Velum Global Credit has been added to the list while Print Direction has come off, but only because the investment was taken as a (22mn) Realized Loss. Let’s look at the details:

American Exteriors: Remains on non-accrual and has been further written down to $1.8mn from $2.7mn. 

Cedar Electronics: Remains on non accrual and written down further from $8.5mn to $3.5mn. On the Conference Call, CPTA said there was a new management team at the Company and discussions were underway.

Print Direction:  At September 2017 the cost of Print Direction was $22.1mn. This quarter CPTA wrote off the whole enchilada – presumably throwing in some unpaid interest – or ($22.4mn). 

On Site Fuel Service: Remains on non accrual. However the $16.7mn at cost was valued at $11.6mn in the prior quarter and remains unchanged in the December 2017 quarter. This is a Control investment, whose year end 2017 loan maturity has already been extended by a year. CPTA’s ownership level remains unchanged. 

Immersive Media Tactical Solutions: Was carried at zero value and $2mn cost in September 2017. Now sold/liquidated.

Initial conclusion: Our earlier estimate that American Exteriors, Cedar Electronics, Print Direction and Immersive Media might be total write-offs is on the way to being realized with 1 investment sold for zero value (and a $2mn Realized Loss) and with an aggregate value of $5.3mn left. That’s another potential $0.33 per share reduction to NAV. Also as estimated, On Site Fuel Service remains a question mark, and an important one with $16.7mn invested at cost. This is a privately held company to which CPTA is the only BDC lender and news is scarce. Finally, there’s Velum Global – discussed below- which if written off (and we’re not optimistic) could cost another $0.50 a share to NAV. Together – and assuming Good News for On Site Fuel Services- CPTA is at risk of seeing NAV drop $0.83 per share, down to $13.08. 

One Notch Lower

So much for the non-performers. Just as important to CPTA’s future prospects are under-performing  names which are still on accrual that we’ve identified.

At September 30, 2017, that consisted of 6 companies : 3 where we anticipate full recovery is less likely than an eventual loss and 3 where we’re more optimistic.

From Most Worrying Down

Keep an eye out for the status of Velum Global Credit Management. There are questions surrounding a $11.8mn loan outstanding.

Velum is a financial firm that acquires non performing loans. In Brazil. Which should be reason enough to be on anyone’s Watch List.

The borrower’s debt – which was marked very modestly down by CPTA, which is the only BDC lender – matured in December 2017 and bears a juicy 15%,  all in PIK. (Two more red flags).

All CPTA would say back in November 2017 when asked about Velum is that negotiations were underway about extending the facility.

Other details were vague.

We’ve found nothing else in the public record.

Bad news on Velum could cause earnings to be lower than anticipated. Most likely, though, is that the debt gets extended.

Update: Brazil headquartered Velum remains on the books, with the same December 2017 maturity but has been written down from $11.2mn to $8.0mn, and added to the Non Accrual pot. Not a good sign. On the Conference Call terse answers were given to any question on Velum, indivating discussions are underway. Unfortunately for CPTA that’s $1.8mn of lost Investment Income on an annual basis. On a quarterly basis and deducting out Velum’s contribution from the given Net Investment Income for the quarter that could be a 10% hit, or $0.02-$0.03 a share lost. We’re not sure if that’s already baked into the numbers, but if not that will bring NIIPS down to $0.23, and below the distribution level. 

Two More

The other two borrowers on our heightened risk list (we call our Worry Names) are Kelle’s Transport Services and Bluestem Brands.

Kelle’s, restructured just last quarter and which involved a Realized Loss to CPTA, has recently changed its name and attracted new capital, according to a January 2018 news report.

That’s probably good news for CPTA, which owns both debt (at very, very low rates) and equity in the refrigerated transport company.

We don’t know if the new majority owner – who specializes in transport businesses – will have repaid or rejigged the company’s debt. More info – presumably – will follow on the Conference Call.

Update: At year end Kelle’s Transport was valued only slightly higher than in September and a small additional amount drawn on the Revolver. However, – as reported above – there may have been subsequent developments. We expect the current debt  ( which yields as little as 1.46%) has been repaid and replaced with another Capitala loan to the new  and renamed Kelle’s. That might allow the equity to add some value. Much more importantly CPTA could boost its investment income materially. More details needed. On the Conference Call no reference was made to a new owner or a new name or a new loan, but CPTA suggested higher trucking rates were helping the business. 

We don’t expect to hear much new about Bluestem Brands (retailer).

The multi-brand retailer  seems to be hanging in there thanks to a turnaround and re-positioning strategy.

Main Street (MAIN) is also a lender – in the same Senior Loan position as CPTA – and has already reported.

MAIN maintained a (28%) discount on the debt in the IVQ 2017, essentially unchanged from the IIIQ 2017.

[CPTA only discounted its Bluestem debt position by 4% in the third quarter, for what that’s worth].

All this data mined from Advantage Data’s terrific database, which gets updated within hours of BDCs reporting.

There’s a good deal of public information available we’ve been keeping up with. Our summary of Bluestem’s performance: doing better but still very highly leveraged and not out of the woods.

Update: As expected, not much has happened on Bluestem Brands with the valuation almost unchanged. Worth noting, though, that MAIN values its own position – apparently in the same tranche unless there’s a first loss arrangement – at a (29%) discount to par. CPTA is at a discount of only (5%). However CPTA’s income exposure (as we like to say) is relatively minor: about $100K a quarter of Investment Income. Moreover, with the position in a senior status any material loss is unlikely here. 

Then There Were Three

Moving to the three borrowers that we’re a little less worried about (we rate these a 3 on our 5 point scale).

Worth looking out for in the IVQ 2017 portfolio valuation will be American Clinical Solutions, LLC.

Last quarter CPTA wrote the 2020 10.5% First Lien Loan to this lab test company, with a cost of $9.5mn, down by (16.5%).

Curiously, non-traded BDC Cion Investments – which has a position in the same facility – wrote down its position only (2%).

Is CPTA being overly conservative to be able to boost NAV in this or a future period or is Cion being too optimistic ? Or something else altogether ?

We’ve not been able to winkle out any recent public info.

Update: There was no material change in the value or the status of American Clinical Solutions, which remains at a (17%) discount. Still, this is a relatively large investment at cost of $9.1mn and with an 11.5% interest rate generates material Investment Income. To be continued.

U.S. Well Services – also in CPTA’s portfolio in both debt and equity (and another recent restructured credit) should be OK.

Several BDCs with both debt and equity positions have already reported debt valuations at par and equity carried at a premium, unchanged from IIIQ 2017.

Then there’s Sierra Hamilton, where CPTA’s $16.2mn in debt was converted into $7mn in equity last year, or 14% of the company.

We expect to see an increase in the valuation there, but still no income.

Most anything involved with oil & gas – even service companies – is getting the benefit of the doubt where valuation (and capital) is concerned these days.

The BDC Reporter – unlike some BDCs – does not forget that this is still a highly cyclical business and dodging a bullet does not mean you’re out of danger.

All energy related borrowers remain on our Watch List regardless of valuation levels.

Nonetheless, investors with short term outlooks should be cheered.

Update: A bit of good news for CPTA: U.S. Well Services increased in value – on the back of its equity stake in the oil services company. The debt was carried at par, which is encouraging given that much of the income therefrom remains in PIK form and reassures us that the accumulating pieces of paper will eventually be collected as cash. The Class A units of the Company’s common stock are now valued at $15mn versus $11mn in September. Nonetheless, U.S. Well Services remains on our Watch List. We’ve been here before. 

Less useful from an immediate Investment Income point of view but encouraging nonetheless, the Sierra Hamilton equity investment increased by $1.5mn in the quarter. This may yet benefit CPTA if this stake can be sold, along with numerous other equity stakes, to offset loss of yield elsewhere by being re-invested into income producing debt instruments. See below. 

Strategic Change

The biggest threat to CPTA’s earnings this quarter – and for the rest of 2018 and even beyond – is of its own making.

With the second round of bad debts that CPTA endured last quarter and which caused its dividend to be reduced twice within a year, the Investment Advisor has said “No Mas”.

According to last quarter’s Conference Call CPTA is going to transition its portfolio to lower risk loans in the future.

Less risk = less investment income.

That  process – if the Investment Advisor follows through with its intentions –  will lower Net Investment Income from the levels of last quarter, but over time.

Here is what we wrote in January 2018 on the subject:

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.

Shareholders will be interested to see what sort of new loans the BDC has booked and at what yield in the quarter.

However, even with the frothy environment for leveraged loans this is a process that will take several quarters to complete. We estimate above a three year horizon.

Update: We didn’t expect much change over a quarter but for the record CPTA’s ” weighted average yield on our debt portfolio was 12.8% at December 31, 2017, compared to 13.2% at December 31, 2016″. New loans made in the IVQ 2017 yielded just 11.2% and were almost exclusively in first lien. The shift to a “safer” portfolio is underway but by the BDC’s own admission by the end of the year 64% of the total portfolio was in first lien. That was up on 2016 but some way from the goal of – presumably – 80% or more at the top of the capital structure. 

Reinforcements

That’s not the end of the story where CPTA’s earnings are involved.

On the positive side, the BDC is actively looking to sell off its performing and out performing equity stakes and converting the proceeds into Realized Gains and then into yielding loans.

That might help reduce the ($38mn) of net Realized Losses on the books and boost income.

Update: Realized Losses are now at ($62mn) , a depressing 25% of all the equity capital raised by CPTA.

Interesting will be to both evaluate what has been sold and what potential remains.

We know – as CPTA told us in a press release – Brunswick Bowling Products was sold in January 2018 and a $2.5mn Realized Gain booked on the equity, and $6.2mn received.

Update: The Brunswick gain was offset – to use the term lightly – by losses elsewhere. Here’s what the press release said : “During the quarter, the Company realized losses related to Print Direction, Inc. ($22.4 million), Portrait Innovations, Inc. ($1.8 million) and Immersive Media Tactical Solutions, LLC ($2.0 million), partially offset by gains related to Brunswick Bowling Products, Inc. ($2.5 million) and other gains totaling $0.3 million”.

Otherwise, we count over $80mn in various non income producing equity and Preferred stakes in portfolio companies that CPTA could monetize.

However that’s also a process which will take years to play out, and much can happen in the interim to the companies involved and the value of those stakes.

Update: On the Conference Call, CPTA reminded an analyst – in answer to a question – that they had sold a bevy of minority equity stakes in the past and might do so again. However, some of the positions might sell off individually and at higher prices, and closer to the FMV. CPTA says there are 4 to 5 major positions that could make an appreciable difference. CEO Alala is in Berlin right now discussing the potential sale of equity stakes in order to re-invest into yield bearing positions.

CONCLUSION 

This is an important earnings release for CPTA – after announcing those massive losses last quarter and critical to regaining some level of investor confidence.

After all, the stock trades at a (50%) discount to book.

Unless something negative has happened at Velum, or credit troubles have developed in credits we’re not aware of, earnings are likely to be close to the analysts estimate.

Update: Velum has gone on non-accrual and that may explain why Net Investment Income Per Share was slightly off the analysts estimate. Or, the impact could be felt next quarter. The only good news: no “new” troubled loans.

Whether that happens or not, the Bigger Question is how the combination of credit issues and strategic repositioning will affect recurring income from debt investments over time.

With many moving parts even the best analyst model cannot adequately project CPTA’s earnings trajectory in the year or two ahead.

With the stock at $7.16 – near its All Time Low – and at a multiple of IVQ 2017’s estimated earnings annualized of just 6.6x, investors seem to be assuming the ultimate resting place for the BDC’s recurring earnings per share are between $0.70-$0.75.

That’s roughly 30% lower than the $027 IVQ 2017 estimate annualized.

Uncertainty is what creates price volatility and CPTA has plenty of that to offer both on Tuesday when its results are published and for several quarters to come.

Update: Here’s our attempt at a back-of-the-envelope calculation of future Net Investment Income for CPTA once most of the dust settles and ASSUMING no new loans added to non accrual and no recovery from all the non-performers except On Site Fuel. At December 31, 2017 the BDC had $410mn in debt investments. However, only $360mn were performing. There were $122mn at FMV of equity investments – also mostly non income producing (total Dividend Income in all of 2017 was only $1.2mn). We assume – based on looking at the portfolio list and based on the inference made on the most recent Conference Calls that CPTA is working hard to sell what it can that $40mn in proceeds will be raised from that source. That would bring yielding assets to $400mn. Based on yields on recently booked loans we’re assuming the portfolio yield – when CPTA cleans house and re-invests more into senior debt – will drop to 11.0%. That’s $44mn in annual Investment Income or $11mn per quarter. 

In the past quarter, CPTA achieved $11.6mn in Investment Income. That was ($0.6mn) or (6%) down from the prior quarter and a whopping (22%) drop from March 2017. Our pro-forma suggests another (5%) drop forthcoming. The number would be higher if not for the $1.1mn a quarter of Investment Income to be generated from converting equity takes into loans during the course of 2018. Still, all that loss of income would come off the Net Investment Income line as CPTA is already not earning Incentive Fees and management fees would be unchanged. That would bring Net Investment Income from $4.2mn to $3.6mn or $0.23 per share per quarter. 

Of course, it’s more complicated than that. CPTA might be able to boost earnings by investing some of its $31mn in cash, or drawing on its Revolver, although total debt to equity is already high at 1.34 to 1.00 ! (Thanks to not having to count $168mn of SBIC debt). Or recoveries could be greater than we’ve assumed above. 

Earnings Quality

On the downside, the risk – despite some stabilization this quarter – is for more borrowers to slip from performing to under-performing and ultimately to non-performing. We’ve looked at the portfolio in-depth a couple of times. To our knowledge – which is limited by the opaque nature of private company reporting – there are no obvious candidates at the moment to worry about. HOWEVER, we remain worried about the overall risk profile of the portfolio. Let’s throw some numbers at you. CPTA has 47 companies in portfolio. One has been repaid since year end (Brunswick Bowling) and 9 are on our Watch List (4 Non Accruing and 5 others). That leaves 37. Of those 6 are very small Non Meaningful positions. That leaves 31 Performing companies in which CPTA has made sizeable investments.

We calculate that 19 of those companies have loans or investments of above average risk, by our standards. This is what we call our Earnings Quality Test. We note any company whose debt yields 12% or above or where the interest rate is very low (usually a bad sign) or where most of the income is in PIK form. We don’t know much about how these companies are performing but poor Earnings Quality marks could result in credit problems down the road.

Let us illustrate with one example picked at random: CPTA has a $8.374mn Subordinated Debt loan to Vology (see page F-7 of the 10-K). The investment is valued at par. The debt bears an interest rate of LIBOR + 14% and 4.0% Pay In Kind. Technically this is a Performing Loan and all is OK but anyone who’s been involved in lending for more than a minute knows that most healthy borrowers do not pay that sort of interest. We have to assume the risks are very elevated. Imagine similar economics in 60% of CPTA’s performing portfolio. What are the chances that the new Credit Manager brought in by Capitala will be able to replace all those kind of investments with much lower yielding and lower risk assets before any more blow up ? We don’t know and everyone has to make their own evaluation, but that’s one of the risks investors in CPTA are taking on besides 4 loans on non-accrual and a lower Net Investment Income Per Share.


CONCLUSION

If you expected CPTA to magically fix its troubled portfolio in a quarter you’ll have been disappointed. One non-performing loan was written off, another added and the Watch List remained largely the same. Energy investments perked up in value and many equity stakes remain to be harvested, if that can be achieved. Recurring earnings are down as is Net Asset Value. More drops in book value are likely as potentially is lower income in the quarters ahead. The future for CPTA will depend largely on how management works through the 4 company non-performing portfolio and copes with both under-performing and higher risk performing loans on the books and their success at monetizing their numerous non-income producing equity stakes. This is a turnaround still in its earliest phases given that management needs to address both specific non-performing assets and restock the portfolio with very different kind of loans than before.

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