The Market Missed The Positive Results Coming With MidCap Financial's Recent Merger

seekingalpha08-27

MidCap Financial completed a merger, resulting in a market drop and an 11% yield, but long-term performance remains promising.The portfolio expanded to $3.1 billion, with plans to rotate assets into ...

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Olena Osypova/iStock via Getty Images MidCap Financial (NASDAQ:MFIC) completed a merger with two other companion Apollo investments in July. In the process of gaining approval from enough shareholders, in particular with the two other funds, an extension became necessary. That delay should have signaled a negative reaction coming afterward, and one did. On the day after the merger, the market tanked on ultra-huge volume. The price also tanked on market weakness several days later. It has failed to fully recover. The yield now equals over 11%. We own a large holding in MidCap having been paid significant rewards. Thus, we continue our coverage of the business, the last article being, With Recent Valuation, MidCap Financial Investment Remains A Buy. Our belief, that $17 in share price is more than valid, continues. Sometimes, like bakers who fail in getting that special recipe correct, markets can and do miss recipes for strong performance. We believe this is the case with MidCap. The Company The company is changing, but a summary at the end of June seems in order. The portfolio's fair value equaled $2.4 billion, being invested in 165 companies from 23 different sectors. The bulk, 92%, was in corporate lending, with only 8% in Merx. The average position was $14 million, or less than a percentage point. The yield averaged 12% with a weighted average spread down 20 basis point quarter over quarter to 601. Finally, pristine 1st lien loans represented 97%. Management hadn't experienced any unusual run on the bank, so to speak, from its investments during the period of a weakening economy. Merx paid off an additional $3 million in June and $7.5 million in July, further lowing its exposure. Now, a look at how the company sits after the merger follows:  Onboarded approximately $596 million in investments. $207 were corporate type loans at 564 basis points. \"$389 million of these assets consists of broadly syndicated loans, high-yield bonds, and structured credit positions.\"   Increased the portfolio size to $3.1 billion. Now in the process of selling non-directly originated assets and redeploying the proceeds. Most of these assets are spread throughout other Apollo funds. Sold $125 million at approximately the cost basis.   $776 million in capital to deploy going forward. $3.1 million per year in expense synergies. Net leverage of 1.13 on the day of closing. 93.8 million shares of stock, up 28.5 million.  The Quarter Next, let's look at the quarterly summary in bullet format. The company reported:  $0.45 net asset income, representing an annual ROE of 11.8%. A net asset value (NAV) of $15.38 slightly lower than the March quarter. A dividend of $0.38 payable in late September. Approximately $1.10 per share in undistributable taxable income at the end of June. [N]on-accruals at 1.8% of the total portfolio at fair value. PIK income of 3.6%, very low, of the total. Weighted average debt interest rate equaling 7% with management reviewing options for lowing expenses. Total expenses at $39 million. Management fees equaling $4.4 million flat quarter over quarter and an incentive fee totaling $5.6 million or 16%.  During the June quarter, MFIC added $285 million in new business commitments across 28 different entities, averaging $10.2 million in returns. On new business for the June quarter, management noted, \"The weighted average spread on our new commitments in the June quarter was 559 basis points. Net leverage on new commitments was 3.3 times, down from 3.9 times last quarter. The weighted average OID for new commitments was approximately 157 basis points. This spread in OID translates into very attractive unlevered asset yield of over 11%, assuming a 5% base rate.\" The Rebalance Begins With the merger complete, the company plans to rotate most of the former assets into higher yielding loans under the MidCap's asset strategy. Additional diversification and other metrics are expected to improve. The rebalance uses Apollo's widespread and large investment reach in providing investment opportunities for MidCap. On this issue, management commented, \"[W]e're extremely lucky to be now just over $3 billion of assets, which itself is roughly only one-tenth of the assets within the MidCap Financial ecosystem. That's in excess of a $30 billion business.\" At this point, it plans to sell the newly acquired foreign assets, excepting those within low liquidity markets. In the Q&A session, it appears that the bulk of the sells will occur in the next few quarters. Again, thus far, $125 million has been sold. The Interest Rate Cut & Other Matters The Fed strongly signaled at the Jackson Hole meeting plans for interest cuts. Lower interest rates could have negative material effects on MidCap earnings with its interest rate bias. Management offered investors the value of the negative effects from lower rates, shown in the next graphic.   MidCap June Quarter Presentation The slide communicated, in the bottom portion, the effect of lower interest rates. On the right, each 150 basis points drop lowers quarterly earnings by $0.05 cents per quarter. On the left, the company notes that the average floor for investments at which the payments are no longer lowered from interest rate changes is approximately 1.15%. In the worst case, lowering rates to that range equals $0.13 per quarter. The lower earnings seem steep and could have a material effect on the dividend and earnings. Fortunately, the story doesn't end. There are positive factors, higher leverage by 0.1 plus (2nd quarter leverage at 1.37 approximately 0.1 lower than the mid-range target) plus lower costs and investments made under the new materially higher return fee rules. Also, in the slide presentation offered for explaining the merger, the company noted that a synergy in expenses equals of about $3 million per year or $0.03 per share per year in savings. With respect to leverage changes in Looking Into Apollo's Successful Financial Progress, we wrote: \"The above table seems to suggest that 0.10x changes minus the Fed rate changes yields approximately $0.05 in quarterly earnings. The December quarter opened at a leverage of 1.24x, 0.10x higher than last quarters average. The company plans additional leverage increases during December.\" Regarding the added earnings from a new fee schedule instituted last year, we wrote in MidCap Financial Investment Corporation Posed For Oversized Dividend Growth,  \"We noted in other articles the likely long-term effects from the new lower fee model announced last quarter, but still dormant until January. From Apollo Investment Previews Its New Make (MidCap Financial Investment) And Model (The Tanner Powell):  \"So as you assume some reduction in yield and some reduction in leverage from where we were now, you're talking about an increase of the ROE from the low 8s to the low 9s, 10% increase in ROE, sort of like as a base case.\" A 10% improvement in ROE yields approximately $0.04 per quarter (0.1 * $0.35). The lower incentive fee, 20% to 17.5% adds a penny per quarter.\"  For the last two items, an essential fact reminds investors that the company is approximately 1.5 times larger, and earnings might increase by significant amounts. A table summarizing the net changes seems in order.   Changes in NAVII (Per Quarter) * Lower Rate (Max.-Worse Case) Cost Synergies Reaching Mid-Range Leverage New Investment Strategy Net Change   Amount -$0.13 +$0.01 $0.05-$0.07 $0.04-$0.06 $0.0 Net   Click to enlarge * Zero percent interest rate basis. Within the accuracy of estimates, net negative changes going forward seem balanced, netting each other out. The official answer from the company came when Kenneth Lee of RBC Capital asked, \"And just one follow up if I may. Any updated outlook on potential ROE or ROE accretion just going forward? Thanks.\" Tanner Powell, CEO, answered, \"No, we are not going to update that guidance. Obviously, we're looking at the potential for lower base rates, but as we outlined in our prepared remarks, as well as which referenced our November materials, we see significant synergies to improve both ROI -- ROE and NII.\" Our gut feeling suggests that the exchange between the positives and the negatives will be very lumpy. Also, we don't expect the Fed to cut rates to zero at any point in time. The cuts will be measured and slow. The reinvestment strategy for MidCap won't happen over-night. Some, though a smaller portion, might take years even until the assets reach full maturity. Finding investments for the $800 million of opportunities seems more than doable with the huge size of Apollo as a primary source. It will be lumpy, sometimes stronger than expected, sometimes weaker. Chart Time Included next is a day chart generated using TradeStation Securities.   TradeStation Securities From the chart, the second tank or fall came during the major market crash on the same day. MidCap recovered from that fall with the continued-up draft in the market. But investors should take notice of the first price tank, which came from the merger. The price hasn't yet recovered, not even close. In general, the market is nervous about the coming results. We expect the price to fall backward after the next ex-day being September 10th. Net Conclusions & Risks When considering conclusions and risks, the word lumpy, very lumpy, has significant meaning. Although the long-term earnings suggest that $0.45 is more than possible even under zero-over-night interest rates, the interim period could experience periods of softness. For example, if the company sold $125 million in foreign assets and didn't reinvest it for an entire quarter, a drop in income per share might be 3% of $70 million, the June quarter number, or $2 million. This lowers the investment income to $27 million from $29 million, or 7%. The June quarter would have been approximately $0.42. In addition, the likely 50 basis point drop-in rates might drop earnings by another $0.02 per quarter per the above slide. In the worst case, a $0.40 quarter might occur, still above the paid dividend. Still, the $125 million isn't likely to be earningsless for a complete quarter.  The big risk for BDCs with exposure to floating rate loans is lower interest rates, and it is coming. How low isn't known. Also, any recession might affect the non-accrual status for more investments. Yet, we continue our buy rating but advise patience. A better opportunity is likely after the next ex-date, September 10th. We believe that the price will fall into the high $12s or low $13 shortly thereafter. Still, this is a compelling investment. The market appears to have mis-mixed the ingredients once again.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2462166553"}