Main Street Capital: The Health of Its Big Dividend Yield

Image source: Getty Images.

Some people say a lot. Some say very little. Companies can exhibit similar tendencies.

Main Street Capital (MAIN 0.19%) doesn't file all that frequently with the Securities and Exchange Commission, and its press releases can be few and far between, so keeping up with the company between quarterly reports can be harder than keeping up with some of its peers.

Sept. 30 has come and gone, and with the books closed on the company's third quarter, I thought it to be a good time to review events in the third quarter and the first nine months of the year.

A winner in every quarter

Main Street Capital is a business development company (BDC), which is a special type of financial company that makes money by lending to and investing in small businesses in the United States. Most investments come in the form of debt, while a smaller portion takes the form of equity. The debt investments provide routine interest income, where equity offers upside (or downside) in the form of capital gains or losses.

Main Street Capital has sold a company at a significant realized gain in each of the first three quarters of 2016.

Data source: Company investor relations and SEC filings.

The most recent exit of Travis Acquisition was detailed in an Oct. 6 press release, though the acquirer noted in its own press release that the transaction closed on Sept. 30, the last day of Main Street Capital's third quarter.

It is great to see a BDC sell portfolio companies at a gain, especially when the sales price is in excess of its most recent valuations. In an ideal world, all BDCs would generate gains on their equity investments in excess of their losses, and, most importantly, turn those gains into cash by selling their stakes to someone else.

Of course, BDCs control when they realize gains, and they also control when they realize losses. 

What about the losers?

Winners are frequently balanced with losers, and all BDCs will have losers. The only way to bat 1.000 is to buy risk-free U.S. Treasuries and hold them to maturity.

The most difficult question to answer for any BDC is just how much of its capital losers will consume over the long haul. For Main Street, there are some losers to worry about, namely the companies in its portfolio that are most exposed to energy prices. After all, its realized gains in 2016 have come from companies outside the energy industry. Realized losses from its energy-exposed investments could very easily offset its non-energy gains, and then some.

Direct exposure is relatively easy to measure -- it reports that energy-related companies (oil and gas production and equipment and services companies) made up about 7.7% of assets at the end of the last quarter.

Much more difficult to quantify is its indirect energy exposure. Located in Houston, Main Street has naturally invested in companies that operate in areas where energy companies are important drivers of the local economy. Energy is to Houston and surrounding areas what Wal-Mart is to Bentonville, Arkansas. Though Bentonville's best car mechanic may not collect a paycheck from Wal-Mart, its performance certainly has an impact on local demand for his services. You get the point.

I've been keeping an eye on some of its indirect exposure by keeping tabs on the dividends Main Street Capital earns from its portfolio companies. Operating earnings from recurring sources of income weakened over the last year, and the company is increasingly relying on dividends from its investments to pay dividends to its shareholders.

Some portfolio companies that do not have a direct link to oil prices -- they aren't in the business of drilling for oil -- have indirect exposure to oil prices, and have been writing smaller dividend checks to Main Street in recent quarters.

Main Street's three-part health exam

When Main Street Capital reports earnings on Nov. 4, there are a few trends investors should pay particularly close attention to. The first is the most obvious: How does Main Street Capital's operating income compare to its current dividends it pays investors? Dividend coverage has deteriorated, and it's walking a very fine line on covering its routine dividends to shareholders with recurring operating income.

Second, how much of the company's recurring earnings are non-cash in nature? Notably, non-cash payment in kind (PIK) interest nearly doubled in the first six months of 2016 from the first six months of 2015, and now makes up about 5.5% of its operating income. PIK income is interest or dividend income that is paid in additional debt or equity securities rather than cash. Stressed borrowers often elect (when allowed) to "pay" interest to their creditors by rolling the interest into the loan. Cash is always preferably to PIK. 

Finally, Main Street Capital's dividend income earned from its equity investments is an excellent barometer for the health of the companies in which it owns an equity stake. Fluctuations in dividend income earned from its equity investments will likely foreshadow gains or losses in its investment portfolio.

As with any high-yield stock in the financial industry, I believe investors' time and energy are best spent trying to rule out risks to the downside rather than painting rosy pictures of what the upside could be. If you can rule out the risks, the upside will roll in as monthly dividends.

Main Street's quantity of operating earnings (net investment income) and the quality of its earnings (cash vs. non-cash income) should take a front seat, particularly as dividend coverage has been trending in the wrong direction.