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Gladstone Investment Thesis

I was quite taken aback upon hearing Mike Mayo, a Wells Fargo analyst, in an interview (paywall) with Bloomberg:

“We’ve done the math and even under pretty negative scenarios, banks have enough capital to pay the dividends.”

How can this be good news? Raising capital to distribute dividend does not create value. Reliable earnings are the wheel that keeps the machine humming.

Last week, Gladstone Investment Corporation (GAIN) issued a proxy statement soliciting shareholders’ vote on a proposal to raise capital through common shares. This comes after the company entered into an agreement with one of its subsidiaries to issue up to $350 million in the form of debt, preferred or common stock.

Gladstone needs cash to support its portfolio companies. In its first press release after lockdown, Gladstone touched on the renewed liquidity needs of its portfolio companies. Nonetheless, this interest in raising capital is also an indication of the company’s troubles regarding its earnings.

Traders should be wary of the short term turbulence in Gladstone’s stock price as the company has lost a major source of revenue that will negatively affect earnings in the next quarter. Specifically, Gladstone lost dividend income from its equity investments. As small and medium companies struggle to manage their cash due to the pandemic, there is little reason to expect that these companies will distribute cash at these difficult times. The suspension of dividend income is thus expected to have continued during April, May and June when the lockdown was in effect.

Moreover, long-term investors should take into consideration the likely decrease in dividend and might consider investing in other dividend-paying stocks.

Gladstone Investment Income

Wall Street analysts’ estimates for net investment income (‘NII’) ranges from $0.15 to $0.20 per share for the quarter ending June 30th, 2020. This is a wider range than in previous quarters, reflecting the risks caused by the COVID-19 outbreak.

As of May 12th, Gladstone had 33,049,463 shares outstanding. Has the company issued any stock in the past couple of weeks? The company’s dealer agreement with one of its affiliates to raise $350 million was only signed 5 days ago on May 22nd, and the vote on the proposal to issue common shares below NAV hasn’t commenced. Still, the company has almost $30 million in its previous ATM program that allows the company to issue common stock. Using this facility, the company might have issued stocks in the past 14 days, but from experience, the company’s use of this facility is limited to small amounts and in a gradual manner that suggests that, if any shares where issued, it would have been in small quantity that would not make much difference in NII estimates below.

Below is an estimate of NII based on NII per share estimates

NII/Share Estimate Total NII
Lower Estimate ($0.15) $4,957,420
Upper Estimate ($0.2) $6,609,893
Consensus ($0.18) $5,948,903

Table created by the Author. NII per share estimates from CNN Money

How do these results compare with previous quarters? Below is a chart showing NII estimates and NII of previous quarters.

Source: Actual NII data from SEC 10-K filings. NII per share estimates from CNN Money

Last quarter’s NII was $14.8 million while the consensus estimate for next quarter is $6 million. On the surface, the estimate appears conservative. The truth is, last quarter is an outlier; NII results were boosted by the reimbursement of incentive fees by Gladstone Management Corporation, which is the external advisor of Gladstone Investment Corporation. For investors looking solely at the bottom line and per share data, the decrease in investment income was concealed by reimbursing the incentive fees. This reimbursement is non-recurrent obviously while the troubles in earnings are likely to have persisted in this quarter as shown in the next paragraphs.

Source SEC 10-K Filings

Gladstone Dividend Income

Gladstone has an equity interest in almost all its portfolio companies. Total equity investments, at cost, amount to $156.4 million. The company aims to invest 25% of its capital in the form of equity securities to achieve capital gains.

Dividend income from Gladstone’s equity investments in the past quarter was zero. This is worrying because the driver behind the suspension, i.e., the lockdown, extended over most of this quarter. It is reasonable to assume that this will continue until small businesses are confident about their finances.The need to preserve cash has never been more important for small and medium business’s survival and while big banks might consider borrowing to distribute a dividend for strategic reasons, small and medium companies are likely to preserve cash in times of economic stress.

Another reason for pessimism about Gladstone’s dividend income is the dividend distributions in other industries. We are already seeing a dividend decrease in many parts of the economy such as with real estate companies.

The loss of dividend income is significant and will have a material impact on the company’s earnings for this quarter. The dividend income for the nine months ending December 31st, 2019 was $9.4 million.

Total Investment Income Estimates

The estimates of total investment income for this quarter implies a rebound in dividend payments or an increase in debt income, both of which are unlikely. As explained above, small- and medium-sized businesses will not be eager to distribute their cash this quarter.

Source: Seeking Alpha

Income from debt investments is a function of the following variables.

  1. New investments made by Gladstone management
  2. London Interbank Offered Rate (LIBOR)
  3. The default rate of Gladstone portfolio

Firstly, the company haven’t added any new investments to its portfolio since March 2020 when it invested in Maids International.

Secondly, almost all Gladstone debt investments are tied to LIBOR with interest floors. This means that as LIBOR decreases, so does interest income, up to a point where the interest rate reaches a floor level agreed upon between Gladstone and the portfolio company at the time of underwriting.

The LIBOR rate had decreased so much that all debt instruments owned by Gladstone reached the floor rate. This is due to Fed monetary easing. There are no signs the Fed will shift its policy anytime soon.

Finally, regarding defaults, 4 out of 26 debt portfolio companies were defaulting on all or part of their debt obligations as of March 31st, 2020. The dollar value of debt on default is $63.5 million. The effect of the lockdown will be manifested more in the quarter ending June 30th 2020. But how much would be the default rate? Luckily the calculation of Gladstone’s monthly interest income is straight forward. This allows us to estimate different interest income for a range of hypothetical default rates. Below is a schedule to demonstrate interest income for different default rate scenarios.

Default rate Interest income
15% (current level) $12,044,000
20% $10,343,000
30% $8,331,000

Authors estimates using data from the 10-K form

The S&P Global statistics show an increase in the level of defaults compared to last year, suggesting a higher probability that the number of defaults in Gladstone’s portfolio will increase.

Source: S&P Global

Gladstone Capital Structure

Source: SEC 10-K

How much debt can Gladstone have?

As a business development company, Gladstone has limits on the amount of borrowing it can do. This cap was raised to 150% from 200% asset coverage ratio is 2019, as part of regulations aimed to facilitate investment in small- and medium-sized companies.

Total borrowing Maximum borrowing
$183,456,000 $359,329,152

The leverage limits are tied to fair valuations of company assets. These valuations depend on the good faith of the company’s management and built on a judgment which might not reflect the true value as shown in this previous analysis. Gladstone is aware of the possibility of a writedown of its assets. A margin of safety for Gladstone asset coverage is needed to ensure the company does not risk its RIC or BDC status.

Summary

Gladstone’s last quarter’s NII was boosted by huge non-recurrent reimbursement of incentive fees from the company’s external advisor. Investors looking at NII per share alone might have missed the fact that Gladstone equity investments did not return any dividends in the three months ending March 31st, 2020. Small businesses are opting to preserve cash in times of uncertainty. The increased level of defaults, as well as the decrease in LIBOR as a result of Fed monetary easing, mean it is likely that that the company will miss its earnings estimate. This pressure on earnings also means an increase in risks regarding dividend distributions.

My advice for traders is to stay away because the room for price appreciation is small or even non-existent. For long term investors who were able to scoop GAIN at market lows late March and early April, my advice is to hold on to the stock. The low prices should act as a cushion against the risks laid out in this analysis and previous article regarding Gladstone.

As the company prepares new rounds of borrowings, shareholders should keep an eye on asset coverage ratio and any risks involving losing RIC status. Moreover, investors should keep an eye on risks of dilution if the company decide to raise equity.

Investors should also watch interest expenditure and the risk of breaking covenants involving borrowings. In 2010, GSC Investment Corp., a BDC, went bankrupt not only because its earnings decreased (albeit that played a role), but because it broke its revolving credit facility’s covenants as a result of writedowns and increased borrowings.

Finally, in times of uncertainty, it is important to follow the default rates, each quarter, to assess the damage caused by the lockdown and the slow economic recovery. Increasing defaults is a sign that it is time to exit the investment and look for another one.

If you are a shareholder and don’t have the time to follow all the variables layed in this article, click the follow button above and you will receive notifications of my updates on Gladstone Investment Corporation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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