How Apollo Investment Can Sustain Its Dividend

Tomorrow, Apollo Investment (AINV 0.47%) will release its latest quarterly results. The key to making smart investment decisions on stocks reporting earnings is to anticipate how they'll do before they announce results, leaving you fully prepared to respond quickly to whatever inevitable surprises arise. That way, you'll be less likely to make an uninformed, kneejerk reaction to news that turns out to be exactly the wrong move.

Apollo Investment is a business development company, taking advantage of favorable tax laws to avoid corporate-level taxation on its portfolio of investments. To reap those tax benefits, Apollo has to pay out the bulk of its income to shareholders as dividends, and investors have come to rely on its high yields. But will the good times continue for the BDC? Let's take an early look at what's been happening with Apollo Investment over the past quarter and what we're likely to see in its quarterly report.

Stats on Apollo Investment

Source: Yahoo! Finance.

How will Apollo's earnings fare this quarter?
Analysts haven't made any changes to their views on Apollo Investment's earnings prospects recently, keeping their views unchanged both for the March quarter and for the 2014 fiscal year. The stock has also had somewhat muted movements lately, rising just 5% since mid-February.

Apollo and other business development companies have attracted the attention of yield-hungry investors who have suffered from falling income from more traditional income-producing investments. By making investments in small companies that typically don't have access to broader sources of financial capital, Apollo and its peers are able to generate impressive returns. Rival Prospect Capital (PSEC 0.55%) has produced even higher double-digit yields from its willingness to make both debt and equity investments in its portfolio companies. But even for Apollo and peer Ares Capital (ARCC 0.54%), both of which largely restrict themselves to debt and secured loans, attractive yields have appealed greatly to investors.

But Apollo's business model isn't without risk. The BDC has more than $1 billion in debt on its balance sheet, most of which is secured by its investment portfolio. As a result, Apollo's portfolio is effectively leveraged, albeit not nearly as extensively as companies like mortgage REITs that rely largely on leverage to boost income levels from mortgage-backed securities. Apollo takes steps to protect itself from losses from its investments, but leverage boosts the potential impact of any problems on shareholders. Both Ares and Prospect also have similar levels of debt on their respective balance sheets.

Perhaps most troubling is the potential that Congress will see BDCs as an abusive tax-avoidance measure and take away their tax benefits. In late March, Goldman Sachs filed for an IPO of its Liberty Harbor Capital BDC, specifically citing "reduced reporting and other burdens" as part of its decision to use the BDC structure. As the government looks for ways to raise tax revenue, Goldman's move doesn't cast a favorable light on BDCs, despite their legitimate function in providing capital financing to smaller companies without access to traditional capital markets.

In Apollo's report, look for comments from management on how the BDC plans to deploy the capital it raised from a secondary offering earlier this month. Although the company said it planned to use the $163 million in proceeds to reduce debt under its credit facility, investors may prefer it if Apollo finds more lucrative uses for the cash to better support its healthy dividend.

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