MCG CAPITAL CORP MCGC
November 15, 2012 - 10:03am EST by
brook1001
2012 2013
Price: 4.09 EPS $0.50 $0.55
Shares Out. (in M): 73 P/E 8.0x 7.4x
Market Cap (in $M): 298 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • BDC
  • Management Change
  • restructuring
  • Buybacks
  • Insider Buying
  • Discount to book
  • Analyst Coverage
  • Dividend yield

Description

MCGC is an extremely attractive asymmetric investment with 50%+ upside and very well protected downside.  MCGC is a completely bombed-out and unloved BDC.  It has a terrible track record, but the market is missing its dramatic transformation in the last year. The CEO/CFO were fired.  Troubled legacy investments were written off.   It cut headcount by 50%.  It started buying back stock at 80% of book value.  And, the new CEO started buying stock personally at higher prices than today’s level.  I am no fan of the BDC business model, but if there were ever a time to buy a BDC, this is it.

Description

  • MCGC is a 1940 Act Business Development company.  It is in the business of making ~$20mm senior secured + sub debt loans at 4-5x leverage with blended 11% coupons for “middle market” LBOs.   It does not pay corporate income taxes and it dividends out all of its net income.
  • MCGC has a disastrous past and nha855 posted a good short-case write-up of the company on VIC in early 2011.  Today, I believe MCGC has hit the reset button with several dramatic management, strategy and portfolio changes.  But, the taint from the past is causing it to be mispriced today.
  • Short history is MCGC made terrible investments leading up to the credit crisis and blew itself up.  Book value declined from over $13 per share in 2007 to $5.20 currently.  Its investment portfolio has declined from $1.5bn in 2007 to $450mm today, and along the way it has had losses of over $500mm(!). 
  • Chief among its many bad investments, MCGC had a $160mm investment in the now bankrupt CLEC Broadview Networks.  This investment was finally written off in 2Q’12, after writing it down multiple times in the last 3 years.  MCGC’s book value was previously overstated because they weren’t fessing up to the loss, which was the main thrust of the spot-on short thesis posted on VIC in 2011.

Hitting the Reset Button

  • MCGC has undergone a massive re-positioning in the last year.
  • It fired the CEO and the CFO in late 2011/early 2012.  Richard (Rick) Neu, a director, stepped into the CEO role.  He was previously the CFO of Charter One (a $40bn bank), i.e. a real bank, so he brought a lot of horse power and a no-BS approach to cleaning up MCGC.
  • MCGC wrote-off its remaining legacy troubled investments.
  • In late 2011 it announced a huge restructuring, including cutting the work force by half and cutting opex by two-thirds.  2012 is a transition year with large restructuring expenses and MCGC should be at its new run rate expense level in Q1’13.
  • It has let its legacy credit facilities run-off.   Now, MCGC is relying solely on $150 mm of 10-yr fixed rate debt from the Small Business Administration with a 4.3% coupon.  This is an incredibly attractive source of funding.  MCGC has applied for another $75mm of SBA funding which would be a catalyst for the stock (see more below).
  • It announced a $35mm share buyback in January and has bought back $22bn of stock (7% of the market cap) at ~80% of book value.
  • The CEO personally bought almost $1mm of stock in August at ~4.60, so 10%+ higher than the current price.
  • It announced its plan to return to a simpler/safer business model with a granular portfolio of senior/sub investments and to exit equity investments. Equity investments are down from 30% of the portfolio to 9% currently.
  • Last month, after 1 year in the CEO role, Rick dropped the CEO title and is remaining as Chairman, and the COO was elevated to CEO.  I believe this transition, along with his insider buying, signals that he feels the reset has been accomplished.

Valuation and Upside Potential

  • MCGC trades at 79% of BV and at a 12% current dividend yield.  The dividend level has bottomed and has room to grow.  BDC comps trade at 1.0x BV and a 10% dividend yield.  MCGC trades at a discount because of its tainted past.  Once they have a few more quarters to show that they have indeed hit the reset button, I believe it will get a peer-like valuation.
  • There is only one sell side analyst who covers the stock. He has had a “Sell” rating but upgraded it to “Hold” this morning based on the cheap valuation.  Basically he thinks it deserves a valuation discount because of its tainted past and recommends that investors pay up for higher quality BDCs.  I think this is a backward looking view and a good example of why the stock is mis-priced currently.
  • Management is guiding to a 45-55c dividend for 2013 and has announced a 12.5c dividend for Q4, or the mid-point of its guidance.  As part of the restructuring they cut the dividend from a 17c quarterly rate. 
  • I think they are on track to pay a sustainable 55-60c dividend including upside from securing a new credit facility (more on that below).  If you apply the average BDC dividend yield of 10% to a 60c dividend, you get a price of $6.00.  Add 50c in dividends over the next year and you get $6.50 of value for 59% upside. 
  • I think the downside is well protected because book value is relatively safe, the balance sheet is relatively liquid and unlevered, and importantly, management has signaled their desire to continue to buy back stock if it trades below book value.
  • Another point of downside protection: in 2011 when MCGC was contemplating its future, it discussed selling out to a large BDC, Ares (ARCC).  Ares typically trades above book value, so acquiring MCGC below book makes sense.  My understanding is that MCGC decided it could get more value staying independent, but I believe selling to Ares remains an option if MCGC can’t create value on its own.

Why is Book Value safe?

  • This is a critical question given MCGC’s past and, frankly, the industry’s historical lack of credibility.  Reference David Einhorn’s famous short of Allied Capital and the book he wrote about it.
  • There is no way to know for sure that they are marking the book correctly, but we can triangulate based on several factors to derive reasonable comfort:
    1. Look where we are in the credit cycle. From a macro view, virtually every bad loan from the credit crisis has been written off already.  The pendulum has swung hard in the other direction.  Corporate loan charge-offs at banks are at cyclical lows.   The high yield market is booming.
    2. Mirroring the macro, MCGC has already written off ~33% of its portfolio since 2007.  Q3 was the first quarter since 2007 where they actually recorded a tiny gain. 
    3. Non accruing loans of 7% (at cost; 4% on a current value basis) are at the lowest level since 2007 and are down from a peak of 20% in 2009.
    4. 28% of assets (50% of equity) are in cash, which speaks to how de-risked the balance sheet is.
    5. To get to the current stock price, it would imply an 18% write-down on investments which seems totally unjustified.  Furthermore, giving credit for 1 year of dividends, you’d need a 26% write-down on investments to justify the current price.
    6. New management has cleaned house, started buying back stock, and has bought stock personally.
  • Given all of these factors, I would be very surprised if there were still some hidden loan quality issues.

 Capital Structure and Liquidity

  • MCGC is relatively unlevered and liquid, which gives it flexibility to increase its earnings and dividend power.
  • Its debt to equity ratio is 66% with $99mm from a securitization facility which is slowly running off as loans funded in the facility mature, and $150mm of 10-yr fixed rate borrowing from the SBA at 4.3%.  BDC’s are limited to a 1-1 ratio of debt to equity, excluding SBIC debt. On this basis, MCGC only has 26% debt to equity.
  • Importantly, most of the borrowings from the SBA facility are sitting in cash ($115m of the $150mm) waiting to be deployed into new loans.  In addition, MCGC has $66mm of unrestricted cash.  In total, MCGC has cash equal to 28% of its assets and 48% of its book value which is ready to be deployed into new loans.
  •  In Q3 MCGC applied for another $75mm loan from the SBA.  If they are approved, it would be a positive catalyst for the stock.  Again, this would be 10 year fixed rate debt, and the current coupons are ~3%.  MCGC believes they could invest the proceeds at 11%, earning a 8% spread which is ~8c of EPS and dividend power.
  • Management has also indicated that they will look to establish bank credit facilities overtime.

 Economic Model

  • Below is a summary of MCGC’s current balance sheet and income statement and management’s targets post restructuring.  I believe MCGC will be operating at its run rate target by the end of 2013. 
  • The target assumes they put a significant amount of cash to work in new loans, which is consistent with management’s commentary that the new loan pipeline for the next two quarters is very strong, and they have a very low level of scheduled maturities.

 

($ millions)   Current   Target          
Summary Balance Sheet                
Investments           445           591          
Cash             184             25          
Other               10             10          
  Total Assets           638           626          
                     
Debt             249           258          
Other               11             11          
Equity             379           368 (Assumes they complete they buyback)  
  L + E             638           626          
                     
Debt-to-Equity   66%   70% (70% target)      
                     
      Q3'12 Annualized   Target          
Summary Income Statement                
Interest & Fee Income           48             74          
  Yield     10.9%   12.5% (Fees were unusually low in Q3)    
            (Target is 12-13% with 11% loan yield and 2% fees)
                     
Interest Expense               9               9          
  % of Debt   3.5%   3.5%          
                     
Cash Opex             19             10 (Explicitly guided to $10mm run rate in 2013)
  % of Investments   4.4%   1.7%          
                     
Normalized Losses             -               12          
  % of Investments   0.0%   2.0% (Guidance is 2-3% normalized)    
                     
NOI               20             43          
  ROE     5.3%   11.7%          
                     
Shares               73             71 (Assumes they complete the buyback)  
EPS      $    0.28    $    0.60          

   

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Approval for 2nd SBA loan license of $75mm = 8c to EPS/Dividend
Putting cash to work in new loans
Continuing to buyback stock below book value
Growing the dividend
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