Description

MVC Capital is an interesting investment idea that I've followed for many years. It was presented as a turnaround on the VIC board in March of 2005 by Salvo880 at a price of $9.17, a slight discount to NAV at the time. The idea turned out to be a winner, as MVC increased NAV per share from around $10 at the time of the write-up to over $15 at the end of '07, driving the stock price to over $17 by December of that year. I believe it is now a bargain stock once again. At the recent price around $11, the stock trades at a massive discount to the stated NAV of $17.64 as of January 31, 2010. Clearly, the market doesn't believe in the NAV, but it is my contention that even given a reasonable discount to the stated figure, MVC is likely worth at least $15 per share. The stock also currently yields about 4.3%.

MVC is a business development company (BDC) that is oriented towards equity investments in private companies "with secure market positions, predictable profit margins, and stable free cash flow" according to company presentations. The company has delivered impressive historical NAV per share growth, increasing NAV per share from $8.48 at the end of 2003 to $17.64 as of the most recently reported period. The company has also paid out $2.34 per share in cumulative dividends during that period. And unlike many BDCs which increased NAV per share by selling stock at a premium to NAV, most of the increase at MVC has come from the performance of the underlying investment portfolio. MVC is also relatively unlevered, with about $35 million in net debt against an asset base of over $500 million.

I will refer interested readers to the March 2005 write-up for a bit more background on MVC and its investment manager, Michael Tokarz. Suffice it to say that I find the arrangement between the management company and the fund has been very reasonable as compared to many other BDCs, and Tokarz has been a steady and consistent cash buyer of MVC shares, including a recent sizable purchase.

So, let us cut to the chase and examine the only real relevant question regarding an investment thesis for MVC. The company says its portfolio is worth $17.64 per share. The market says its worth a little more than $11. Which one is right?  Before I present my rationale for a number significantly higher than $11, I will first offer some good reasons why one should be skeptical about the $17.64 per share value offered by MVC. First of all, MVC does not employ an external third party valuation service as some other BDCs do, so all valuations are done in-house by MVCs valuation committee. Naturally, one should be skeptical anytime management gets to grade its own test. MVC also provides virtually no transparency into the underlying portfolio holdings beyond company descriptions. The company also doesn't provide financial information, even on an aggregate basis, for its portfolio holdings. I should point out that this isn't at all unusual in the BDC industry, but it's a reason to be skeptical nevertheless. Finally, as a general statement BDCs have terrible incentive structures, with management fees and allowable leverage all predicated on asset values, creating a strong temptation for any BDC management to inflate valuations. But perhaps the biggest issue for many investors that have looked at MVC is that the NAV figure was stable and actually trended up from June 2008 through March 2009, a period of time when the Russell 2000 declined by 38%. It certainly seems highly unlikely that a portfolio full of illiquid equity investments in small and middle market private companies could have gone through that period unscathed.

My thinking on the above concerns are as follows - on the valuation front, I personally don't derive any comfort at all from the presence of the independent valuation services, because in my view it only introduces another potential source of misaligned incentives. Are the valuation services really going to fight hard for lower valuations than the client wants? In any case, most valuation services are used by BDCs to provide input on only a portion of the portfolios, and then often only to offer the vague assurance that the methods used to arrive at the valuations were "not unreasonable." As far as disclosure of financial data on the underlying portfolio companies, MVC says because its investments are generally in privately owned businesses, the owners of those businesses generally do not wish to have financials disclosed for competitive and other reasons and non-disclosures are a standard condition of the investments. I personally think they could and should at least make an effort to provide at least some general or aggregate financial information on the portfolio as a whole, but apparently there are issues that make it difficult for them to do so.

As far as the valuation methodology used by MVC, clearly the company has chosen not to let the broad market extremes of the last couple of years greatly affect the valuations it uses, making the NAV figures from period to period appear far smoother than they would be if mark-to-market assumptions were heavily incorporated. I personally agree somewhat with those who would argue that the significant market declines for equities in late 2008 and early 2009 should have been reflected more in MVC's portfolio valuations. On the other hand, the valuations didn't increase during the 2006-2007 period of strong small cap performance and increasing multiples, either. Much of the value increase for MVC during that period was from realized gains. From what I have gathered, MVC's valuation approach is heavily weighted towards a sort of reasonable multiple to trailing EBITDA at the company level, the underlying portfolio company performance during the 2008-2009 period simply didn't decline that much. It wasn't until the period from March 2009 through September 2009 that some EBITDA erosion started being reflected in the NAV, which declined from $17.29 to $16.57 during a period when publicly traded small-cap equities were on a positive tear. Again, whether one agrees with this approach or not, my intent here is only to explain the numbers and not defend them, and to try to ascertain whether we can have any confidence in the NAV as it is being stated today.

There is other evidence in favor of MVC, or at least in favor of the argument that MVC execs themselves believe the NAV is reasonable. First of all, MVC is one of the few publicly traded BDCs that didn't rush to do a secondary offering in 2008 or 2009 to raise additional capital at a big discount to its NAV, and the company doesn't appear to be preparing to offer more shares at recent prices either. Insiders have been steady buyers, and there was particularly aggressive buying in the fall of 2008. Altogether, insiders own over 11% of the stock. Finally, the past behavior of the management company and the board in creating a fair fee structure, working to limit expenses, and delivering significant capital gains in prior years offers some further comfort in my opinion. A recently announced monetization of a large holding for a price in excess of the company's prior holding value offers additional positive evidence. And of course, the current price implies a discount of greater than 40% to NAV and would appear to fully compensate for any systematic tendency to moderately overvalue the portfolio holdings.

With that as my intro, I will provide a quick overview of the portfolio and then wrap up with a few risk factors to consider. As of the most recent 10-K filed for October 31, 2009, there were 32 investments in the portfolio with attributable value, and the total value of portfolio was a little over $500 million. The top ten positions accounted for about 72% of the portfolio, so I will limit my comments to these investments. While I must reiterate that there is little disclosure in the way of financial performance, it appears that most of these top portfolio companies are established, profitable businesses with long operating histories in recession-resistant industries. The top ten positions are shown below: 

Investment                                10/31/09 Value                          % of Port

US Gas & Electric                        $69,092,641                               13.7%              

MVC Automotive Group               $50,143,557                               10.0%

Ohio Medical                             $49,110,425                                 9.8%

Summit Research Labs               $47,597,177                                 9.5%

Dakota Growers Pasta                 $30,811,950                                 6.1%

Vitality Foodservice                     $27,800,020                                 5.5%

SP Industries                             $26,345,073                                 5.2%

Velocitus BV                               $23,200,000                                 4.6%

Custom Alloy                              $22,648,338                                 4.5%

BP Clothing                                $20,965,308                                 4.2% 

U.S. Gas & Electric markets and distributes natural gas to small commercial and residential customers in the state of New York, New Jersey, Michigan, Indiana, and Ohio. This investment was apparently a huge winner for MVC in 2009. As of Oct 31 2008, MVC had investments of $7.9 million in a second lien loan, a senior credit facility of $4.9 million, shares of Series I convertible preferred stock with a cost basis of $0.5 million and a stated value of $5.3 million, and Series J convertible preferred stock with a cost basis of zero and a stated value of $350K. In July 2009, U.S. Gas acquired a company called ESPI that sells electricity to small commercial and retail customers in New York as well. As of October 2009, the senior credit facility at MVC was repaid, and during the year the MVC Valuation committee continually upped the value of the preferred stock, with the biggest jump being in the October quarter, when the value of the U.S. Gas investments jumped by a cumulative $40 million to $69 million total. The second lien loan had a fair value of $8.3 million, and the Series I preferred stock had a value of $58.9 million (versus a cost basis of $500K - your run-of-the-mill 117-bagger) and the Series J preferred was valued at $1.6 million. Based on an internet search, it appears that US Gas & Electric had doubled its revenues for six years in a row through 2008 and began rapidly increasing EBITDA after turning EBITDA-positive in 2006. The company had $106 million in revenue and $8.28 million in EBITDA for 2008, and was expecting to double sales and EBITDA in 2009 prior to the acquisition. In the press release announcing the acquisition, MVC stated that "both companies have recorded compounded annual sales growth of greater than 100% since 2003" so apparently ESPI had been growing quickly as well. MVC is a majority owner of U.S. Gas & Electric. U.S. Gas & Electric also had a little brush with the SEC back in 2003 and 2004 prior to MVC's involvement - interested readers can look it up on the SEC website as well as read about it in this article on the company from early 2009.

http://www.sbnonline.com/Local/Article/17071/459/0/Recharged.aspx

MVC Automotive is a control investment of MVC that owns and operates nine Ford dealerships located in Austria, Belgium, and the Netherlands. As of October 2009, MVC owned equity interest in the company valued at $46.5 million, which reflected an increase in the stated valuation by $5 million during 2009. There was also a bridge loan worth $3.6 million. I don't have further detail on this investment except to note that Ford reported very strong European sales this year thanks to the government scrapping incentives.

Ohio Medical is a 45-year old company that operates leading brands in niche medical markets like medical vacuum and gas delivery and systems under the names Ohio Medical, Airco, Ohmeda, and now Amvex. The company has done a number of tuck-in type acquisitions in recent years.  At October 31, 2009, the company held stock worth $9.1 million (cost basis $17 million) and convertible stock worth $40 million (cost basis $30 million). MVC reduced the value of the common stock by $8.1 million in 2009 but not the convertible stock due to PIK distributions. Ohio Medical is also listed as a control investment.

Summit Research Labs is another 40-year old company that manufacturers antiperspirant actives and is a contract manufacturer of skin and hair care products for private label beauty products. The company also has an R&D center and packaging capabilities, such that it is capable of offering the contract R&D, testing, manufacturing, and packaging new personal care products for its customers. MVC owns common stock with a stated value of $38 million on a $16 million cost basis, as well as a 14% second lien loan worth $8.9 million. MVC increased the value of the common stock by $5 million during 2009. Summit is also classified as a control investment.

Dakota Growers is the third largest manufacturer of dry pasta in North America, and a leader in private label sales. Dakota Growers actually files with the SEC and puts out a nice annual report on its website every year. According to their fiscal 2008 annual report (FY ending in July), the company produced $280 million in revenue, $9.3 million in net income, and $0.88 per common share in EPS. In FY 2009, the company did $297 million in revenue, $17.7 million in net income, and EPS of $1.70 per share, and raised its dividend from 16 cents per share to 20 cents. The company has very modest debt, with only $25 million or so in debt versus $72 million in shareholder equity. Dakota actually conducted a Dutch auction tender of its stock back in May 2007, buying back 3.92 million shares at $10 apiece.  At October 31, 2009 MVC held just over 1 million shares valued at $15 million, and convertible preferred stock valued at $15.8 million. MVC increased the value of the preferred by $5.1 million and the common by $4.9 million during 2009. This company looks like it could be readying itself for a public offering.

MVC recently announced the sale of its Vitality Foodservice investment to Nestle for a price that was higher than its previously reported fair value, which is a nice validation of the company's valuation practices. The sale did not include a small European operation which MVC will continue to own.

SP Industries is a manufacturer of specialty glassware and equipment serving the pharmaceutical, biotechnology, scientific, educational, industrial, and OEM markets. The company sells it products to virtually all the large pharmaceutical and biotech companies worldwide as well as industrial, academic, and government organizations. SP is a portfolio company of Riverlake Partners, a private equity firm. MVC got involved with SP Industries through a previous portfolio investment, Genevac, which was acquired by SP Industries in January 2008 with additional capital from MVC and Riverlake. MVC's investment in SP Industries is in the form of a first lien loan in the amount of $0.9 million and a $25.4 million second lien loan.

Velocitius is a Netherlands-based company that manages wind farms in Germany. MVC holds an equity investment in Velocitius with a cost basis of $11.4 million and a fair value of $23.2 million at October 31, 2009. The fair value was increased by $2.2 million during 2009. MVC lists the company as a control investment. I have been able to find no additional information on the business.

Custom Alloy has been around since 1968, and produces on-demand specialized pipes, tubes, and fittings that are not widely available from other sources, many of which are custom-made or built to customer specs. MVC's investment in Custom Alloy consists of an unsecured 14% loan of $12.6 million, and preferred stock valued at $10 million with a cost basis of $10 million. In 2008, MVC had written up the value of the preferred to almost $28 million, but in the back half of 2009 they wrote it back down again to its original cost.

BP Holdings designs, manufactures, markets and distributes the Baby Phat line of women's clothing.  Baby Phat is a recognized urban apparel brand in the women's category. MVC's investment in BP is in two second lien loans valued at $21 million as of October 31, 2009.

Overall, I'd say that the investments above don't make me terribly nervous. Remember also that 35% of the portfolio is invested in debt securities, which should at least offer the possibility of some recovery if the companies aren't able to service the debt.

As far as risk factors are concerned, MVC doesn't have the kind of high leverage at the BDC level or (because of the heavy equity emphasis) at the portfolio company level that most debt-oriented BDCs carry. However, MVC would be clearly harmed if debt markets deteriorated again simply because some of its portfolio companies will likely need occasional access to new capital and MVC would need to draw additional credit itself if it wished to be the source of that capital. MVC's own credit facility is coming due in April 2010, and the company has yet to announce an extension. With only $35 million in net debt and $500 million in asset value, I've no doubt that the company will have no trouble getting the extension - the only questions are what kind of interest rate and duration they can get. I believe once MVC does announce its credit facility extension, it will be a material positive for the stock. Other than that, MVC appears to be reasonably low risk.

In terms of explaining why the stock is so cheap, I will only note that MVC isn't very promotional and hasn't done quarterly conference calls or many road shows, etc. Because the investment portfolio is weighted towards equities versus debt investments, the company doesn't have a big dividend yield as compared to the more traditional high-yield debt BDCs, and is therefore does not appeal to the typical high-yield oriented retail investor in BDCs.

As far as what MVC might be worth, my own best guess is that even if one wants to be very conservative, a 15% discount to NAV is more than enough given the strong historical track record, which would imply a stock price of $15.  After bottoming out at $16.46 per share in July 2009, NAV has since been on the rise, and most recently was reported at $17.64 for January 31st.  I expect that NAV will continue to rise over time as MVC successfully monetizes additional investments.

Catalyst

• The announcement of an extension to the current credit facility expiring in April 2010
• Continuing increases in NAV to reflect portfolio company growth
• Repayments of debt securities creating cash for new investments.
• Additional monetizations of investments over time at premiums to carrying value, validating NAV.
• Share repurchase once MVC secures a long-term credit facility is a distinct possibility