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Medley Capital: Dividend Outlook Updated

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INTRODUCTION

 

We reviewed Medley Capital’s (MCC) earnings press release, 10-Q filing and Conference Call transcript with the aim of determining what changes to make to our Dividend Outlook for 2018, which is for a DECREASE.  We concluded – after extensive analysis of MCC’s balance sheet, earnings and portfolio-  that we affirm our initial view that the BDC’s distribution is highly likely to be reduced at some point in the 2018 calendar year. Our rough estimate of how much is mentioned in our Conclusion below.

CURRENT DIVIDEND STATUS

MCC has been paying a $0.16 quarterly distribution for 4 quarters, since reducing the payout from $0.22 in the IQof 2017. On January 30, 2018 the BDC announced its IQ 2018 distribution would remain unchanged and be paid out in March.

PRINCIPAL REASONS

 

  1. MCC continues to under-earn the distribution. The numbers that pop up in any summary of MCC’s results are clear enough: Net Investment Income Per Share in the IVQ 2017 was $0.13, behind the $0.16 distribution.That’s only half the story,  though, which is more complex. First, judging by the fact that MCC paid an excise tax on under-distributed Taxable Income last year (a very modest tax admittedly) the BDC might have been benefiting from tax-book differences. However, with the costs associated with the January 2018 debt offering and the ever lower quarterly Net Investment Income level, the odds are high that both Taxable Income and GAAP Net Investment Income on a running basis are below the distribution level. In the latest quarter what some investors equate with a reserve – MCC’s “Accumulated Undistributed Net Investment Income” dropped from $9.5mn to $8mn. At that pace the “reserve” will be gone in just over 4 quarters.

 

Furthermore, a goodly portion of the BDC’s Investment Income – and thus its Net Investment Income – remains in non-cash Pay-In-Kind form. In fact, 15% of IVQ 2017 Investment Income was in PIK, or $3.1mn, spread out across multiple portfolio companies. That’s a shockingly high 43% of Net Investment Income. Of course, all this PIK income may yet be collected down the road when the corresponding facilities mature. In the interim, though, with the distribution and operating costs being paid out in cash, the BDC has to effectively borrow or use up its cash to fund the non-cash income. On an annualized basis that’s over $12mn that has to be funded at an effective cost of debt of over 5% where MCC is concerned.

We admit to noticing a number of questionable PIK financings in the portfolio that may never get collected and whose income will have to be reversed out of capital down the road. Investors may want to keep an eye on the $18.8mn of first lien debt to Dynamic Energy Services International, whose entire 15%+ in interest is paid in PIK. The loan is valued modestly off par and is due for repayment in June 2018.

 

Then there’s the still performing $4.1mn Term Loan to DHISCO Electronics Distribution , which pays over 10% all in PIK. The borrower’s multiple other loans are already on Non Accrual and MCC’s equity stakes in the company valued at zero. Also on our list is AAR Intermediate Holding, to which MCC has multiple loans and equity (also written to zero), which includes a Term Loan B whose 9.5% in interest is all in non-cash form.

 

  1. Limited Opportunity To Grow Income. Thanks to another quarter where the number of non-performing companies grew (from 6 to 8) and a further Unrealized Depreciation of portfolio assets – which caused NAV to drop sharply- MCC’s debt to equity is elevated, even when the SBIC debt is generously excluded from the calculations for regulatory purposes. We count Debt to Equity at 0.76 to 1.00, excluding the SBIC debentures. In fact, with the potential of further write-downs among some of the 8 non-accruing loans, and the need to maintain liquidity to fund already committed financings to existing borrowers, MCC seems more likely to shrink its asset base than increase it. Not helping is that the BDC’s SBIC licenses are fully drawn with $150mn outstanding.

 

The result is likely to be less new loan production and thus lower fees. Moreover, as higher risk, higher return loans still on the books are paid off, the proceeds will likely be recycled into the safer, but substantially lower yielding loans the Investment Advisor currently favors. Those loans – judging by what’s been booked to date – pay rates as low as LIBOR + 4.50% and average between 8%-10% all in. With the portfolio turning over at an annualized 22% rate in the IVQ 2017, the impact of those lower yields will soon be felt.

 

Lower loan balances, lower yields on average, lower fee income and no offsetting equity gains to harvest is a recipe for lower Investment Income and Net Investment Income in the quarters ahead.

 

  1. Credit Issues Remain. Every quarter MCC’s Investment Advisor – which brought the BDC to market and has been involved throughout- speaks to the “legacy assets” in the portfolio which were written to a strategy and earnings target which have since been eschewed. Every quarter the Investment Advisor argues that the work-out of the troubled loans involved is almost complete and MCC can benefit from the safer (lower yielding) loans booked in the last 2 years.

 

Unfortunately, every quarter, the BDC continues to struggle with these unloved investments. By our count out of 68 companies in portfolio, there are 13 on our Watch List. Admittedly 8 of those are already Non Performing. However – as we saw above- 5 of those borrowers still have some facilities which are current. Understandably, the BDC Reporter has to have some doubts about the sustainability of income of loans where the borrower is already in default elsewhere.

 

Then there are 2 borrowers, which are still performing but which we’ve added to our Worry List (where we believe the chances of an ultimate loss are greater than that of full recovery). Between the still performing loans of non-performing borrowers and the Worry List borrowers, we count $5mn of Investment Income POTENTIALLY at risk of interruption by default or restructuring. To put that into context annualized Investment Income is about $82mn and Net Investment Income $29mn.

 

If you think we’re being too harsh just look at MCC’s own Investment Performance Rating in the 10-Q. At December 31, 2017, $185mn of investments (mostly loans) were marked as performing “below expectations”. That’s 22% of total portfolio value. Of those, $84mn are in the two lowest categories where some loss of income and/or principal is expected by the BDC. That’s anywhere from $1.5 to $3.4 a share at risk, depending what you include.

 

Ironically, we don’t dispute that MCC’s non-troubled portfolio of 55 companies looks to be in pretty good shape. We’ve looked at each in turn. However, the BDC will still have to cope for several more quarters with a range of under-performance – and potential loss of capital and income – with the fifth of the portfolio still in the Legacy category.

 

CONCLUSION

 

With current earnings already running below the distrbution and likely to drop more as bad debts ; lower yielding new assets and smaller  fees all eroding Investment Income, the sustainability of the $0.64 a year distribution seems highly questionable. MCC can’t grow itself out of trouble and has the added drag of paying for its high PIK income. Just to be official: We affirm our Dividend Outlook of DECREASE.

 

We expect that if a cut does occur MCC may choose the calendar third quarter to make the announcement. We don’t typically seek to estimate what the distribution might be cut to. We’ll make an exception and project that the distribution might have to be cut to  a $0.40 level if current trends prevail.

 

LAST WORD

While we are seeking to project a BDC’s dividend level up to a year ahead, this is not the same as saying that MCC – or any of the other funds we rate – is a Buy or a Sell. The market may have already written down the stock price so much that a dividend cut will have little impact on the return. (That’s been a theme in a recent Seeking Alpha article). Or a cut could still shock the market which might write-down the price. Moreover, we are seeking to estimate a distribution level that is the fruit of multiple factors many of which we have inadequate public information about. Finally, all managers – understandably enough – are required to be cheerleaders for their BDCs and stock prices which makes determining what is really going on very difficult for outsiders like the BDC Reporter. We offer up the Dividend Outlook as one of several issues investors will want to consider when deciding whether to invest or not.

We do note, though, that MCC has dropped sharply in price since the earnings release and is trading just above its All Time Low of $4.41, a (12.5%) drop in two days.  This stock has traded as high as $8.050 in the past 12 months which underscores the importance of getting the call right, avoiding a (45%) price drop.

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