This post will be dedicated to a single company that has lost over 90% of its value since I started accumulating shares: MCG Capital (MCGC).
Everyone knows that the financial markets have been battered, but while many firms have rebounded more than 20% since November, MCGC has not. Since I've recommended this security to others, and this is the most battered holding in my portfolio, I've had significant doubts regarding my judgment.
Knowledge is power, so digging for data is my only savior on this one. And believe it, or not, I'm buying more shares. Why?
First, let me start with the risks that seem to convince other analysts that this company may not make it. With the recession in full bloom, the companies that MCGC has investments in will feel pressure. Indeed, over 10% of MCGC's portfolio is in companies that don't appear profitable. Most of the firm's investments are leveraged to some degree and with the credit crunch still in force, renewing credit lines that are coming due might prove difficult and/or expensive.
OK, I admit that these positions are not arguable. However, the devil is in the details. The company has gone to some length to reduce the second issue since the first issue is probably not fixable. A few months ago, the company had lines in excess of $150 million expiring. These lines have, by in large, been handled and less than $20 million will expire in the next 12 months. The risk that the firm’s $600 million in debt will force the company under in the near term is not significant.
Analysts suggest that the credit crunch will not allow the firm to originate new business and thus not grow. Agreed, the company must sit back for a while and service the existing portfolio and originations will lag. However, layoffs have already occurred in response to the slowdown these savings are increasing existing profits.
The company could struggle if the portfolio companies do not pay their interest, dividends, and fees to MCGC. However, current situations don't appear too dire. Let's look at the numbers.
The current stock price is $0.65 providing a market cap of just under $50 million. I'm going to work everything back into a share price comparison so the point appears vivid. The company has a Net Asset Value of $9.39 per share. Hypothetically, the company could liquidate today for 9 bucks and every shareholder would get $8.35 more than the current share price. OK, don't run to the bank yet, because some investments may not be marketable and need to be considered. The net value of the investments less leveraged borrowings is $8.45 per share. Since the investment pool is not leveraged too much let's exclude the whole mess and assume that no further investments will be made and the current investments will not be sold. What's left is a firm with $64 million in cash or $0.84 per share. In other words, the cash in this company after settling out the rest of the balance sheet is almost 30% higher than the current stock price.
It gets better. The current investment portfolio appears somewhat stable aside from the recession and associated risks. Holdings such as Cleartel have already been put on non-accrual status and don't figure into recent earnings. Considering such, the firm will earn over $70 million in cash net of expenses in 2009 if nothing else happens. In other words, absence any investing or other cash activities, the company's cash will grow by more than $0.90 per share each year. If the investment portfolio continues to be hammered by the mark to market rules of FASB, portfolio losses will overcome the cash earnings and dividends will not materialize.
The broader markets are well off the lows in November and while I don't expect a rocket back to 2007 levels, we are certainly nearing (or at) the bottom of this recession's impact on valuations. MCGC will be reporting earnings for Q4 and there will probably be another net loss due to portfolio mark downs. But this same portfolio is the generator of the cash and is, indeed, still performing.
Let's assume that valuations continue to slide through Q1, they can't really slide much further with small gains appearing everywhere else. Since MCGC is a BDC by charter, it must pay out 80% of net earnings. Failure to do so will bring the IRS in to hammer earnings with taxes, so I don't see this status changing.
Let's take a very conservative approach and assume that 2009 has just enough valuation pressure to keep dividends low. We're still talking about something like $0.30 in distributions in 2009 and full earnings in 2010 which would look something like $0.70.
If you’ve followed this so far, here’s the skinny. Forget the huge fall in the stock price since 2007. If one purchases the stock today at $0.65, I’m suggesting that each share will probably receive at least $1.00 in dividends over the next 24 months. Such an occurrence would be a 77% return for two years.
This ship may be sinking, but I just can’t peel my eyes off these good looking deck chairs.
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