Main Street Capital: Diving Into Second-Quarter Earnings

Business-development company Main Street Capital (MAIN +0.38%) reported that it earned $0.58 per share in net investment income, covering its distributions to investors during the second quarter. The company also increased its monthly dividend by 3% to $0.19 per share. Here's what investors need to know about its second-quarter earnings report.

Dividends and fees drive results

BDCs typically make money in three ways: interest on loans, dividends from equity investments, and fees earned when loans are closed or prepaid. Interest income thus tends to be stable and predictable, whereas dividend and fee income tends to be more volatile. Dividends vary with its portfolio companies' profits, whereas fees vary with transaction activity.

Because Main Street Capital holds more equity investments than the typical BDC does, a greater portion of its net operating income, also referred to as net investment income, comes from dividends it receives from its portfolio company investments.

Image source: author.

High dividend and fee income as a percentage of net operating income is both a blessing and a curse. On one hand, more income is always better than less, regardless of the source. On the other hand, dividend and fee income tends to be more cyclical and transactional in nature, making it less predictable and reliable. As it stands, approximately half of Main Street Capital's dividend income comes from just five portfolio companies.

Data source: SEC filings. Calculations by author for the first six months of 2017. I-45 SLF is Main Street Capital's joint venture with Capital Southwest, which makes loans to middle-market companies. MSC Adviser is the asset manager of HMS Income Fund, a non-traded BDC.

Lamb Ventures exemplifies the often unpredictable nature of dividend income. It takes a spot among Main Street Capital's biggest dividend payers in the first half of this year because of what appears to be the monetization of certain real estate assets. The operating company, an aftermarket automotive-services chain, generated only $40,000 of the total $875,000 of dividends paid back to Main Street Capital. The rest came from the real estate group.

Image source: Getty Images.

Prepayments lift earnings this quarter

On the conference call, management noted that Main Street Capital earned about $3 million in income that it classified as "non-recurring" during the quarter, primarily because of prepayments on debt investments in its portfolio.

Roughly $1.9 million of this non-recurring income was recorded as interest, with the remaining $1.1 million recorded as fee income. These one-time sources thus added about $0.05 to net investment income on a per-share basis during the quarter. Without these non-recurring items, Main Street Capital would have earned net investment income of $0.53 per share, versus the reported figure of $0.58 per share.

Make of that what you will. Some say that one-time income should be backed out from operating results to get a clearer view of the company's earnings power on an ongoing basis. Others argue that these "non-recurring" sources of income shouldn't be denounced as one-off items, given the frequency with which they appear in Main Street Capital's earnings results. Late last year, I cast a critical eye on one-off dividend income it generated from the timely sale of a portfolio company, but Main Street Capital has earned its dividend ever since. 

Non-recurring income is a fickle thing, because it only matters if people care. If Main Street Capital reported headline net investment income of $0.53 per share this quarter, the stock might have opened down by as much as 5% the next day, as yield investors tend to panic about dividend sustainability when net investment income falls below a BDC's quarterly dividend payouts. For now, Main Street Capital is more than earning its regular dividends with net investment income. But investors should remain focused on the quality of its income streams. Dividend and fee income and non-recurring items are an important source of Main Street Capital's earnings. 

Retail weakness

Three of four loans to retailers were written down this quarter, which isn't surprising, given that the ratings agencies have warned about their recent performance.

Data sources: SEC filings, author calculations.

These retailers make up approximately 2.7% of book value, or $0.61 of book value per Main Street Capital share. They remain on the watch list for future markdowns, given the problems in retail as a whole. (We discussed these credits before Main Street Capital's earnings results this quarter.)

Winners outpace losers

On a net basis, Main Street Capital's winners appreciated more than its losers depreciated. Across its portfolio, the company wrote up its assets by $0.18 per Main Street Capital share during the quarter. Among the big winners were CBT Nuggets and MSC Adviser, which appreciated by $5.3 million and $3.6 million, respectively, or about $0.16 per Main Street Capital share when combined.

Before the earnings results, I wrote about a weird mark in Main Street Capital's portfolio. Main Street carried an equity investment in a company known as Glowpoint at a positive value, even though it marked a debt investment in the company at roughly 66% less than its cost. After the quarter ended, Glowpoint agreed to pay Main Street Capital about $2.55 million to redeem Main Street Capital's stock in the company and pay off an outstanding loan at a fraction of its face value. 

As far as I can tell, the net impact of Glowpoint appears to be about a $0.04 hit to net asset value (NAV) on a per-share basis. Because this happened after the end of the second quarter, Main Street Capital's reported net asset value per share of $22.62 can be reduced to roughly $22.58 per share. That would result in net appreciation of about $0.12 per share this quarter.

High share price remains an asset and liability

When it comes to valuation, Main Street Capital remains in a league of its own. Shares trade for about 172% of book value, 36 percentage points higher than the second-highest-valued BDC, and an astonishing 78 percentage points higher than the average BDC, which trades at approximately 94% of book value.

On one hand, Main Street Capital's high multiple of book value is a huge asset. With each new share issued, Main Street Capital's underlying value increases. In the first six months of the year, stock issuance alone added $0.58 to Main Street Capital's book value on a per-share basis. That's easy money for early investors, who benefit when shares are issued at a lofty premium to book value.

Data source: SEC filings.

On the other hand, its valuation would be difficult to justify if Main Street Capital's underwriting performance deteriorates. Triangle Capital enjoyed a similar multiple as Main Street Capital as recently as 2014, but outsize investment losses have sent shares plummeting. The stock now trades at 117% of book, well below its highs.

Investors new to the industry may not appreciate that Main Street Capital isn't the first BDC to ride the wave of a high valuation in part because of good results and low operating costs. A long list of billion-dollar internally managed BDCs -- Triangle, Allied Capital, American Capital, and Hercules Capital, for example -- enjoyed top-tier premiums to book value that later came back to earth because of underwriting errors, mismanagement, or a combination of both. 

For this reason, high-priced BDCs are something of a confidence game. In effect, Main Street Capital enjoys a high valuation because of its consistent increases in book value and earnings power, which are both largely driven by the company's ability to issue stock at a premium valuation.

So long as the premium exists, Main Street Capital has ample ability to issue new stock and grow book value and earnings power on a per-share basis. If the premium shrinks, however, this easy lever for growth practically disappears.