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Short THL Credit

This is a timely short. THL Credit Inc. (NASDAQ:TCRD) closed on Tuesday at $6.80, about 80% of its second-quarter reported net asset value of $8.49, compared to the high of 81% so far in 2019. This uptick in valuation is opposite of the stock's quality.

While 80% might seem cheap when compared to quality business development companies like Ares Capital Corp. (NASDAQ:ARCC) or Main Street Capital Corp. (NYSE:MAIN), given its questionable credit history, pending credit issues as well as shaky dividend coverage, THL Credit doesn't even come close. Relative to companies in similar situations, the stock is on the expensive side.


The chart below shows the price-book ratios for BlackRock Capital Investment Corp. (NASDAQ:BKCC), PennantPark Investment Corp. (NASDAQ:PNNT) and THL Credit for the past year. All three companies are suffering from credit issues. In the past two months, the price-book ratio for THL headed higher while its most comparable peers' price-book ratios headed lower.

Despite a 5% loss in net asset value was reported in its second-quarter earnings, THL's stock has actually gained 2.6% since then. This price reaction is most likely because the company reported some improvements, including reduction in non-accruals, share repurchases and a permanent fee reduction.

I expect credit issues to continue for THL, however, leading to further net asset value losses. On top of that, the company might see another dividend cut.

These assumptions lead to my price-net asset value target of about 70% to 73%, and potential net asset value losses of 2% to 3%. Combined, I expect a short-term return of about 10%.

I expect this to work out before the next ex-dividend date in mid-December.

Background

THL Credit is an externally managed, non-diversified, closed-end business development company under the Investment Company Act of 1940. As a business development company, THL is required to invest at least 70% of total assets in "qualifying assets," including securities of private or thinly traded public U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments. These companies are also required to pay out 90% of taxable income as dividends to maintain their status as regulated investment companies.

As an externally managed business development company, THL Credit's advisor, THL Credit Advisors LLC, charges 1% base management fees on total assets under management and 17.5% incentive fees on both net interest income exceeding the hurdle rate and on capital gains. It is currently waiving the incentive fees.

THL Credit's investment portfolio is shown below:

Net asset value losses

THL's historical performance is not pretty.

Since the second quarter of 2016, the portfolio has decreased by 33%, net asset value has declined 32% and net asset value per share has fallen by 29%. These were partly offset by share count decreases from repurchases.

I'll walk through the history of one current non-accrual, Charming Charlie.

Charming Charlie was a fashion accessory retailer located in Houston. THL first made a loan to the company back in 2013 for $27 million. The company has gradually marked down the investment since then. By fourth-quarter 2017, the fair value mark for Charming Charlie was 65% of costs (costs were also down to $24 million).

In December 2017, Charming Charlie filed for Chapter 11 bankruptcy. The following April, the retailer emerged from bankruptcy. THL realized losses of $8.3 million related to the restructuring.

Yet THL deployed additional capital and marked the investment at a premium to new cost. In 2018, the company realized another $11.5 million in losses. By second-quarter 2019, loans to Charming Charlie had been marked down to pretty much zero, while just a quarter ago, they were marked at around 50% of cost.

In total, THL recognized losses of $19.8 million, with another $11.3 million of unrealized depreciation since second-quarter 2018. That equates to about $1 per share.

And this is only one example of THL's bad investments.

Current outlook

Charming Charlie and Loadmaster Derrick & Equipment are currently marked as non-accruals.

Charming Charlie has been marked down to almost no value.

Between the three different loans to Loadmaster, total fair value to cost is 54%. Total fair value is about 25 cents per share, or 3% of net asset value.

Martex Fiber and Holland Intermediate are loans on my credit watch list.

Martex Fiber is a textile recycling company in Spartanburg, South Carolina. THL Credit's investment is a subordinated debt of $9.6 million with a 16.5% coupon, of which 4.5% is payment-in-kind. It is marked at 70% of cost.

Headquartered in Fort Worth, Texas, Holland Intermediate is a land services company in the energy industry. THL has a $21 million first-lien loan to the company, which is marked at 85%, down from 90% in the first quarter.

The combined value of these two investments comes to $24.9 million, or 9.4% of second-quarter reported net asset value. These two loans also generate 13 cents in annual net interest income compare to the current dividend of 84 cents.

If Martex is marked down to 65%, which was the fair value to cost level right before Charming Charlie filed for bankruptcy, the implied loss is $0.48 million, or 2 cents per share. If Holland Intermediate was marked down to 65%, the implied loss is about $4.3 million, or 14 cents per share. Combined at 16 cents per share, that's 2% of net asset value.

I wouldn't be surprised if THL loses 2% to 3% of net asset value in the next two quarters.

Dividend sustainability

During the same three-year period, THL Credit has had two dividend cuts, first from 34 cents to 27 cents, then down to 21 cents. Currently, the indicated dividend yield is 12.6%.

The company's reported loan portfolio yields 9.8%, while its borrowing costs are about 5.7%. THL also has selling, general and administrative costs of about 1.3% on assets, and a base management fee of 1%. Debt-equity leverage is about 0.80. We get a rough return on equity of 9%.

8.9% = 9.8% + ( 9.8% - 5.7% ) * 0.8 - (1.3% + 1.0% )*(1+0.8)

Today's price-net asset value of 80% translates to a return on price of 11.1%, which is less than the current indicated dividend yield of 12.4%.

This rough estimate includes payment-in-kind income of about 9.2% of total interest income, or about 4 cents per share per year. It does not include potential net interest income or capital gains incentive fees since the company is waiving that through the end of 2019. Incentive fees amount to 17.5% of the portion above the hurdle.

Therefore, it is likely that THL won't be able to sustain its current dividend, but I'm not assuming the company will cut its dividend in the short term. It has shareholders' approval to increase leverage, and can do that by either buying back shares (reduce equity) or making new investments (increase debt). Both cases will lead to higher dividend coverage. I'm just looking at this as a nice option to have.

To provide some prospective, business development companiess tend to be punished harshly for dividend cuts. One recent example is BlackRock, which announced a dividend cut along with its second-quarter earnings. Shares dropped 7% on the day of announcement, and continued to slowly drift down afterward.

Things that sound like great benefits but really aren't

Buybacks

While definitely a shareholder-friendly policy, buybacks don't move the needle much.

THL Credit has about $6.6 million left in its current repurchase plan as of the second quarter, which it expects to fully utilize within the year. Assuming the company can repurchase shares at average price-net asset value ratio of 73%, or at $6.20 per share, it can repurchase roughly 1.06 million shares, or 3%. This would be about 2% accretive to the reported net asset value of $8.49 as of the second quarter.

( $266.8M - $6.6M ) / ( 31.06M - 1.06M) / $8.49 - 1 = 2.1%.

Given the current credit issues, I think the buybacks will, at best, offset future net asset value losses from investments.

Management fee reduction not enough to counter losses

THL lowered the base fee to 1% of assets from 1.5%, and incentive fees to 17.5% from 20%. On current total assets of $485 million, the lower base fees saves about $2.4 million per year. In other words, it adds about 2 cents per quarter to net interest income.

If credit issues continue - please refer to the historical table of THL above - this increase is not enough to cover for net asset value losses at all.

Risks

Activists pushing for strategic reviews

The main risk is activists forcing THL Credit to perform strategic reviews.

THL is small company with $266.8 million in nominal net asset values. Leon Cooperman (Trades, Portfolio) owns 9% of the company and has been jumping on the call every quarter, urging for buybacks or exploring sales of the company. If this were to happen, at 79% price-net asset value, the stock could have a quick pop.

But I think this is a risk that can be mitigated by credit issues. First, an acquisition is not likely until after THL cleans up its troubled loans. Even if the company receives an offer at a higher price-net asset value, it might lose more in net asset value between now and the hypothetical deal's closing, so upside in price terms is not as high.

Let's review how TCAP traded when it announced it was reviewing strategic alternatives.

TCAP, which is now known as Barings BDC Inc. (BBDC), announced strategic reviews along with third-quarter 2017 earnings.

Following the announcement, the stock posted a large drop, lingering lower for a while before starting to recover.

I think this provides insight into how THL might trade if it announces a strategic review. As long as the credit issues and losses are present, a strategic review probably won't prompt the stock price too much, if at all.

Pay dividend and short locate fees

THL Credit pays a quarterly dividend of 21 cents for a yield of 12.6%. I do expect this to work out before the next ex-dividend date, which is expected to be in mid-December. If it doesn't work out before that, then we are facing a 3% headwind in the dividend payout ratio.

Short locate fees and associated costs will also need to be taken into consideration.

Disclosure: The views and analysis expressed in this post are solely my own and do not represent the views, analysis, or opinion of any entity with which I have been or am now affiliated with or employed by. The content of this post is solely for informational purposes. It is critical to perform your own independent analysis and consult with a financial professional prior to making any and all investment decisions.

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This article first appeared on GuruFocus.