Why I Trimmed My Position In Main Street Capital

Why I Trimmed My Position In Main Street Capital

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As mentioned in previous articles, I’m expecting many Business Development Companies (“BDCs”) to report net asset value “NAV” increases, adequate dividend coverage, and reaffirming current dividends. However, I’m also expecting some BDCs to cut dividends in August 2020. This article discusses Main Street Capital (MAIN) which recently released preliminary Q2 2020 results. Please see the end of this article for details.

Clearly, the potential for additional or renewed lockdowns related to COVID-19 is a concern driving markets lower, including BDCs that peaked on June 8 (including MAIN at $35.82) are now yielding over 13% (see list below).

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Source: Yahoo Finance

It’s important to note that yields below take into account special/supplemental dividends for 2020. 2549371 1596470599395802

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For Q1 2020, MAIN reported between my base and best-case projections with NII per share of $0.57. Distributable net investment income was $0.61 per share for the quarter compared to regular dividends of $0.62.

Dwayne L. Hyzak, CEO: “The current economic environment resulting from the unprecedented effects of the COVID-19 pandemic beginning during the first quarter has proved to be very challenging. The momentum we had built during the second half of 2019 and had started to realize in our lower middle market origination activities was interrupted by these unexpected events and significant challenges. Our first quarter results reflect the negative impact of the adverse economic effects of the COVID-19 pandemic on market conditions and the overall economy. Despite our challenging first quarter results, we believe that we are well positioned to weather the current market conditions and provide a very favorable outcome for all of our stakeholders, and we remain committed to maintaining a stable dividend payment level going forward.”

Source: MAIN Earnings Release

I’m expecting lower amounts of dividend income from equity investments over the coming quarters due to COVID-19 related issues.

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Similar to other BDCs, MAINs net asset value (“NAV”) per share declined by $3.18 or 13.3% (from $23.91 to $20.73) due to unrealized losses which will likely be partially reversed over the coming quarters:

As part of our valuation process, we definitely would have been looking at the impacts of COVID-19 across the portfolio both in the lower middle market and our private loan middle market portfolios and I think that as you would probably expect, the impact of COVID-19 was very significant and that’s reflected in the markets. I think the impact of credit spreads was most impactful on the middle market and private loan portfolios and specifically in the private loan portfolio, we think there’s a significant portion that unrealized appreciation that as spreads recover and we’ve already seen some recovery here in the first part of the second quarter, we should see some of that depreciation come back to us in terms of flipping back into unrealized appreciation.”

Source: MAIN Earnings Call

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Source: MAIN Earnings Release

As of March 31, 2020, there were 10 investments on non-accrual status (previously eight investments) that decreased to 1.3% of the total investment portfolio at fair value (previously 1.4%) but increased to 5.3% at cost (previously 4.8%).

More importantly based upon our historical experiences over the last two decades as the industry leading partner for lower market companies and their management teams, we expect that our very unique debt and equity investment offering combined with our ability to be a long-term permanent partner to these companies will result in a significant increase in our lower middle market opportunities as the economy begins to recover. Over 90% of our lower middle market investments were either deemed as essential businesses or able to continue to operate on a full or limited basis during these uncertain times, which we expect will mitigate some of the detriment of these businesses would have otherwise incurred.

Source: MAIN Earnings Call

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Source: MAIN Earnings Release

There was another decline in yield from its lower middle market (“LMM”), middle market (“MM”), and Private Loan (“PL”) portfolios as shown in the following table.

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Historically, the company has grown its per-share economics year-over-year which is the primary driver for higher returns to shareholders. However, growth has started to slow over the last few quarters and declined recently (see table below) due to slower portfolio growth and lower portfolio yields as discussed in previous reports.

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Source: MAIN Earnings Release

MAIN Preliminary Estimate of Second Quarter 2020 Results

On July 20, 2020, MAIN released the following preliminary estimates but was not announced on Seeking Alpha:

  • Net investment income (“NII”) is $0.47 to $0.48
  • Distributable net investment income (“DNII”), which is NII before non-cash, share-based compensation expense, is $0.51 to $0.52 per share
  • Net asset value (“NAV”) per share as of June 30, 2020 is $20.80 to $20.90
  • Non-accrual debt investments as a percentage of Main Street’s total investment portfolio as of June 30, 2020 is 1.9% on a fair value basis and 6.3% on a cost basis
  • Debt to equity of 0.83x while its net debt (total debt less cash and cash equivalents) to equity leverage ratio is estimated to be 0.78x
  • Regulatory based net debt (which subtracts its SBIC debentures and cash and cash equivalents from its total debt) to equity leverage ratio is estimated to be 0.55x

Other details included in the announcement:

As of June 30, 2020, Main Street had total liquidity of approximately $530 million through a combination of cash, undrawn capacity under its revolving credit facility and remaining capacity under its Small Business Investment Company (“SBIC”) debentures. Main Street’s total debt to equity leverage ratio is estimated to be 0.83x while its net debt (total debt less cash and cash equivalents) to equity leverage ratio is estimated to be 0.78x, unchanged from March 31, 2020. Main Street’s regulatory based net debt (which subtracts its SBIC debentures and cash and cash equivalents from its total debt) to equity leverage ratio is estimated to be 0.55x, also unchanged from March 31, 2020

On July 23, 2020, MAIN priced a public offering of $125 million notes at a premium to par of approximately 102.67% of the principal amount per Note, resulting in estimated gross proceeds of approximately $128.3 million and a yield-to-maturity of approximately 4.42%.

MAIN Summary and My Plan

I have temporarily downgraded MAIN’s dividend coverage as there’s a chance that its conservative management proactively reduce its regular dividend to preserve liquidity (see discussion below) and over earn the dividend similar to GBDC in April 2020. Also, as mentioned earlier, the company will likely have lower dividend income and being using lower amounts of leverage which will put pressure on earnings over the coming quarters. MAIN has a conservative policy toward dividends and only pays 90% to 95% expected DNII.

Previously MAIN was continually increasing its monthly regular dividend supported by its many advantages over other BDCs, including the lower cost of capital and the lowest operational cost structure. Also, MAIN has an excellent history of portfolio credit quality that delivers a consistent stream of recurring interest income, the potential for increased earnings through its asset management business, the ability to use higher leverage through its SBIC licenses and management with conservative dividend policy.

Historically, the semi-annual/supplemental dividend was covered through over-earning the regular dividend and realized capital gains. However, as predicted in previous articles, the company is suspending its semi-annual/supplemental dividend:

This week our Board declared our third quarter 2020 regular monthly dividends of $0.205 per share payable in each of July, August and September an amount that is unchanged from our monthly dividends for the second quarter. As discussed in our mid April press release, due to the challenges and uncertainly created by COVID19 and our desire to maintain a conservative approach to our dividends and to preserve liquidity to support an active and opportunistic approach to new investments, based upon our recommendations, our Board agreed to suspend our semiannual supplemental dividend indefinitely. We believe the suspension is prudent and in the best interest of all of our stakeholders and in support of our commitment to maintain a stable dividend payment level going forward through our recurrent monthly dividends.”

Source: MAIN Earnings Call

The company typically announces dividends two to four days before it reports quarterly results. Last month, I trimmed my position in MAIN and will hopefully be buying back at lower levels if/when available. However, if the company reaffirms its dividend this week the stock will likely rally higher.

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Source: Fidelity

The sky is not falling and many BDCs have carefully built portfolios to withstand an economic recession. In March 2020, I purchased 14 higher-quality BDCs and now collecting dividends and:

  • Waiting for BDCs to report Q2 results (see dates below),
  • Watching for preliminary result announcements (as discussed above),
  • Gathering information (portfolio and capital structure updates),
  • Updating projected changes to NAV and dividend coverage for each BDC,
  • Planning for future purchases as there are many higher quality BDCs with attractive pricing at these levels (better than MAIN).

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Disclosure: I am/we are long MAIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seeking Alpha

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