First Eagle Alternative Capital BDC, Inc. (FCRD) (formerly known as THL Credit, Inc.) is one of the worst performers this year. Revenue decreased 38.37% and 21.58% in Q2 and Q1, respectively, on a YoY basis (YoY means compared to the same period last year).

The recent decimal performance is part of a broader revenue downward trajectory that extends long before COVID. The discount to NAV and the decrease in stock price reflect FCRD’s deteriorating fundamentals stemming from a low-quality portfolio.

While defaults and write-offs will likely have a material impact on FCRD’s common stock, the company’s interest coverage and positive cash flows make it unlikely that FCRD will go bankrupt or default on its loans, opening an opportunity to lock in a high yield on its publicly-traded bonds.

FCRD currently has two baby-bonds that trade on the NYSE, making them accessible to individual traders. The opportunities in these bonds are discussed below, along with an assessment of FCRD’s dividend and stock price prospects.

Dividend sustainability

When the pandemic hit, FCRD reacted by selling underperforming loans, realizing a loss of $26 million on $42 worth of loans that were unloaded during the quarter. In the two and a half years ending June 30, 2020, FCRD realized approximately $100 million in losses. There only exist a few BDCs that performed worse.

FCRD manages $417 million of assets, valued at cost ($331 million marked at fair value). Out of these, $68 million or 16% are defaulting, and another 3% are at risk of default, according to company estimates.

Below is a list of non-performing loans.

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Source: Table created by the author. Data from company financial statements.

Payout ratio

FCRD cut its quarterly dividend by 50% this year to $0.1 per share. Still, this yields ~$16% annually, based on a share price of $2.52, which is not too bad in a world where the 10-year treasury bonds yield 0.8%. The question is, is this dividend sustainable? The weakness of the portfolio put dividend sustainability into doubt, but how can we be “sure” that we’re not exacerbating the risk? The answer lies in the excessive payout ratio.

In the six months ending June 30, 2020, FCRD distributed more dividends than it earned. The payout ratio stood at 138%. This can’t go on forever, and the company will have to either cut dividend distributions or find a way to increase income.

One way to increase income is by expanding investments. If the company is to bring down the payout ratio to 100%, it will need about $55 million in additional investments, based on a 10% average yield.

Recent management change

On January 31, 2020, First Eagle Investment Management, a multibillion asset manager bought THL Credit, FCRD’s previous adviser from Thomas H. Lee Partners.

The transaction resulted in a change in the name of the company and a change in the corporate structure of the adviser, but not FCRD’s management team. FCRD is still managed by Chris Flynn, Jim Fellows, and Terry Olson.

An alternative way to invest in FCRD

The choice of investing in FCRD is personal. Each one of us has unique financial circumstances, financial goals, and risk tolerance. FCRD is trading at a 55% discount to NAV based on $2.48 per share, and the stock might go up. Still, the downsides risks are staring one in the face. The company has a disappointing track record that reflects on management. Perceived risks might suppress the stock, leaving it trading at a large discount to NAV for prolonged periods. Current unsustainable dividend policy can force the management to lower dividends, sending the stock even lower, resulting in a loss of your capital. Not to mention economic risk, the recession, and market changes that many portfolio companies are facing.

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One way to protect yourself from these risks while benefiting from the discount on the company is to invest in its baby-bonds.

1. The 6.125% Notes due 2023 (FCRW)

  • Maturity: October 30, 2023
  • Interest Payment: Quarterly
  • Yield to Maturity: 6.76%
  • Record Dates: The 15th of each of March, June, September, and December

2. The 6.75% Notes due 2022 (FCRZ)

  • Maturity: December 30, 2022
  • Interest Payment: Quarterly
  • Yield to Maturity: 7.25%
  • Record Dates: The 15th of each of March, June, September, and December

Note: Yield to maturity calculated based on October 22, 2020, market close price.

Access to capital markets and interest coverage ratio makes it unlikely that FCRD will go bankrupt in the next few years. The interest coverage ratio is 1.7x and the debt/asset ratio is 50% based on Q2 data. The company’s $30 cash balance and access to the equity market provide a safety net to bondholders.

Summary

FCRD’s disappointing revenues this year is part of a broader downward trajectory that extends long before COVID. The fall in FCRD’s stock price and the discount to NAV reflect the company’s deteriorating fundamentals that stem from a low-quality portfolio.

Access to capital markets and the sufficient interest coverage ratio provide a safety net against default, opening an opportunity to lock in quality high yields on FCRD publicly-traded bonds.

Thanks for reading. If you have any questions, please don’t hesitate to leave a comment.

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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