Monroe Capital: This 12% Yield Is Still Oversold – Monroe Capital (NASDAQ:MRCC)

Co-produced with Treading Softly

Here at High Dividend Opportunities, we don’t fear staying put when others run, especially if the fundamentals of a company are sound. A few months ago we highlighted a specific lender which had sold off.

Monroe Capital (MRCC) has traded relatively flat since our initial recommendation to re-enter this position. On a price basis, it has traded almost flat while the recent dividend payment added 3% to our returns to date.

ChartData by YCharts

Investors have a renewed opportunity to jump into this position while prices remain low. Before doing so we must ask ourselves what if anything major has changed from our original thesis.

Last time we stated:

The investment we are looking at today undeniably had some real issues crop up in Q3 of 2018. This resulted in a real decline in NAV and has put pressure on their net investment income. Yet while NAV has declined a little under 10%, the share price has declined more than 25%. That is an opportunity for us to take advantage of the oversized sell off that has led to a dividend that is yielding 13%.

The questions we need to ask ourselves are:

1. Is the business model still sound?

2. Will the company be able to work past the issues?

3. Is the dividend likely to be maintained while the company works out these issues?

In this case, the answer to all three questions is a resounding yes!

Source

Brief Overview

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Monroe Capital Corporation (MRCC), is a business development company that we follow. MRCC is a middle-market lender that focuses primarily on secured first-lien and unitranche debt.

Due to some borrowers having credit issues, MRCC had previously seen the price drop. Currently, it’s trading at an 11% discount to NAV. We believe that some of these issues are close to being resolved and MRCC’s price will recover when that happens.

We believe that MRCC is attractive at the current price and investors who do not own the stock should initiate a small position. Note that the stock has a very small market cap of $220 million, and because of this, it has been volatile. The best approach is to buy in small amounts with limit orders and average down on large pullbacks.

MRCC makes loans to small- and medium-sized businesses, which are usually secured by collateral. As of Q3 2019, 89.9% of investments are first-lien, which means they have priority over any other debt the company might have. It has had a steady stream of “net investment income” (‘NII’) covering its dividend, with NII covering the 35 cents quarterly dividend for every quarter since the first quarter of 2014.

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Source: MRCC Q3 Presentation

Where Does NAV sit now?

This last quarter NAV reduced again slightly due to ongoing unresolved issues with borrowers. The dip is less related to the belief of failure to recover and is more related to the marks on the positions. Over time, these non-accruing positions will have varying degrees of recovery based on either final liquidation or the price others would be willing to buy out these positions out.

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Source: MRCC Q3 Presentation

Changes In the Last Quarter

Here is where the rubber meets the road. Two major changes occurred since our last review of MRCC

Two New Borrowers on Non-Accrual

MRCC’s portfolio issues continue to develop. They are actively resolving prior issues but were forced to place two new borrowers into non-accrual status. Management was active in expressing this does not mean they expect a loss of capital invested, but these two borrowers are not expected to return all the interest expected from MRCC’s investment. So instead of continuing to accrue interest, MRCC placed them on non-accrual and let the loans remain as they resolve issues with the borrowers. Payments from these borrowers haven’t stopped, but the expectation of a full return of investment plus interest is in doubt:

We do that every quarter as you know on a name by name basis based on what we know about that individual credit. And so it isn’t necessarily tied directly to whether we’re receiving cash payments from a borrower at any period. It really has a lot more to do with our internal assessment of the likelihood of being able to receive all that accrued interest if it’s not being paid currently at the outcome of a resolution of a deal. Now the reality is that can change. I mean, we could put something on non-accrual status and ends up getting a full recovery, including any unpaid in the accrued interest, but it’s really just a judgment call based on what we know at the time that we’re making that assessment.

Source: MRCC Earning Transcript

Two key points are to be remembered here:

  • Management is being extremely proactive in placing loans into this status.
  • The payments are simply being treated as a return of capital at this time.

What this means is that these payments are not hitting MRCC’s NII like they would’ve if on an accrual basis. While we do not like adding additional loans to the on-going credit issues, management’s proactive efforts in this area is positive.

This leads to our second event.

Reduction of Management Fees

Management had waived fees in prior quarters to ensure that NII was covering the dividend. This ongoing waiving on portions of their fees was not a long-term solution and continues to leave questions if they would be willing to do so long term. Any uncertainty leaves doubt which can lead to continued depressed share prices. MRCC did help ease investor minds by reiterating their commitment to help NII by permanently reducing fees.

This amendment has the effect of reducing our annual base management fee rate on assets in excess of regulatory leverage of 1:1 debt to equity to 1.00% from 1.75% per annum. As with the prior calculation, there is no management fee paid on cash and restricted cash assets. The combination of our reduced management fee structure and our continued incentive fee waiver demonstrates our commitment to maintaining dividend coverage with net investment income and creating value for our shareholders. All of this reflects our confidence in the long-term strength of our business.

Source: MRCC Press Release

This adjustment to management fees will not only assist MRCC in the short term, but also help with long-term growth. From a long-term growth perspective, as MRCC continues to resolve issues and invests more into new investments, it will be able to remove this reduced fee structure.

We view this change as extremely positive. MRCC has depended on potentially fickle fee waivers from management. To date, management has aligned its interests with long-term growth and as such shareholders have benefited from their altruism. A direct fee structure change provides a formal change in stance by management to continue to be shareholder friendly and growth friendly.

Dividend Safety

As income investors and value investors, MRCC’s yield and moderate discount to NAV appeals to us. However, it’s extremely important to ensure while waiting for the discount to NAV to close that our income stream is steady and sound.

MRCC has covered its dividend every quarter successfully. Their NII has stayed right around $0.35 leaving little room for MRCC to reinvest in growth due to their non-accruals.

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Source: MRCC Q3 Presentation

While this situation does not immediately look appealing on the surface, MRCC is making additional investments (due to new less restrictive BDC rules) and working to resolve its non-accruals. MRCC should eventually see direct growth in its NII and the ability to fund additional NAV development. The fair value of the company’s investments on non-accrual status totaled $30.68 million at Sept. 30, 2019, and forms about 4.6% of total assets. We will be watching this metric closely to see how things develop, but at present time the yield and the discount to NAV provide us with some buffer to buy this name.

A Conservative Option for Fixed Income

Monroe Cap 5.75 % Notes (MRCCL) currently yields 5.6% and offers investors a secondary choice for investing in Monroe. MRCCL has traded higher and is currently above PAR after management reduced their fees. A fee reduction not only benefits the common holders but also this baby bond.

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Bondholders are typically more conservative investors and MRCCL has traded strongly positive, showing that overall sentiment on the bonds remains positive – another plus for common holders who have seen little positive price movement.

MRCCL has an interest coverage ratio of 5.4x, meaning MRCC’s total investment income could pay MRCCL’s interest payment 5.4 times over. This makes MRCCL extremely well covered and a very conservative choice for fixed income-oriented investors.

The Wrap Up

MRCC has provided a small amount of alpha and a decent 3% return boost via its dividend. Looking forward, we see a positive future for NAV growth and strong immediate income generation. MRCC, with 12% yield, looks to be a perfect fit for a retirement portfolio and for those investors seeking immediate income and value.

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Disclosure: I am/we are long MRCC, MRCCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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