Main Street Capital (MAIN): One of the Safest High-Yield BDCs

In this age of record low interest rates, yield-hungry investors have a vast array of high-yield industries to choose from, including Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), YieldCos, and Business Development Corporations (BDCs).

 

While these sectors have business models that make for naturally high-yields, they come with their own inherent risks and challenges.

 

In other words, it can be challenging to know which particular stocks to own for safe, dependable, and growing income (see 28 of the best high dividend stocks here).

 

Let’s take a look at Main Street Capital (MAIN), which is arguably the gold standard of BDCs, to see if this could be an appropriate investment for conservative income investors.

 

Business Overview

All BDCs are basically middle market lenders, which means they lend or take equity stakes in the 200,000 or so subprime businesses that generate about 33% of the US economy.

 

Essentially, BDCs serve a market of small companies that regular banks don’t want to touch to help those companies fund acquisitions, leveraged buyouts, growth projects, and restructurings.

 

 

Main Street is a medium-sized BDC with $3.5 billion in assets under management ($2.4 billion of its own capital and $1.1 billion that Main Street manages as a third-party asset manager).

 

The firm deals mostly with lower middle market companies with annual revenue of $10 million to $150 million and $3 million to $20 million in EBITDA.

 

Main Street’s portfolio consists of loans and equity stakes in approximately 200 companies, diversified both by industry and geography.

 

With its average loan only $9 million in size, Main Street is relatively well protected against a failure of any one of its clients. In fact, its single largest loan represents just 2.8% of its portfolio and generates 4.2% of its total interest income.

 

 

However, what makes Main Street such a standout BDC isn’t its size or its precise business model, but rather its world-class management team, which has one of the best track records in its industry.

 

Business Analysis

Main Street has had a fantastic last few years, with portfolio growth, as well as growth in investment income and distributable net investment income (what funds the dividend), rising sharply.

 

 

However, you have to remember that the last decade has been unique in that the Federal Reserve has both kept interest rates at their lowest levels in history, greatly expanded the money supply (by $3.5 trillion) and limiting the amount of risky loans that major banks were allowed to make.

 

In other words, the BDC industry as a whole has been living in a golden age of relatively little competition from big banks, very cheap borrowing rates, and a world awash with cash and investors desperate for anything with a generous and growing dividend (which made it very easy to raise equity capital).

 

That being said, what makes Main Street different from its increasing number of rivals (there are around 115 BDCs in the U.S.) is that the firm’s management is far more disciplined and skilled at which investments it makes on behalf of shareholders.

 

That’s largely due to the fact that Main Street is one of the few internally managed BDCs, providing a meaningful cost advantage compared to its rivals.

 

Unlike BDCs that are managed by a third party, which collects fees based on the size of the overall portfolio, Main Street’s management team actually works for and owns a large percentage of Main Street itself (over 3.1 million shares worth about $120 million, or nearly 6% of the company).

 

This results in much lower operating costs and higher profitability for the company.

 

 

In fact, Main Street Capital is one of the most profitable BDCs in America, generating impressive margins and returns on shareholder capital (especially compared to its peers).

 

BDC	Operating Margin	Net Margin	Return On Assets	Return On Equity	Return On Invested Capital
Main Street Capital	64.9%	77.9%	7.0%	12.2%	10.0%
Industry Average	28.9%	17.7%	1.4%	10.6%	NA

Source: Morningstar, Simply Safe Dividends

 

Better yet, those operating cost advantages result in substantially higher distributable net investment income (DNII) per share, which makes for more secure and faster-growing dividends in the short-term.

 

Over the long-term, Main Street’s higher profitability compounds into far better returns on shareholder capital, which ultimately results in strong growth in net asset value (NAV), or book value per share.

 

That’s an important point because the BDC industry is essentially a subprime banking industry, meaning that share prices track changes in book value per share over time.

 

As you can see, while Main Street’s NAV per share has seen periodic volatility, during recessions and recently during the oil crash (which decreased the value of its energy related investments), in general the book value of the company (dark green line) has been rising steadily.

 

 

This is in contrast to most other BDCs, which have external management structures that provide incentives for management teams to grow their portfolios’ size even if it requires funding this growth through excessively diluting their shareholders with equity offerings.

 

Since BDCs have to pay out 90% of taxable income as dividends by law (to avoid paying taxes at the corporate level), they can’t retain much cash flow to fund growth. Therefore, they rely on external debt and equity markets to supply growth capital.

 

However, by law the maximum amount of leverage BDCs can have is 1:1, meaning that they can only borrow $1 in debt for each $1 in assets.

 

As a result, BDCs are frequently selling new shares to raise growth capital and make new loans.

 

The problem with this is that each new share is like a perpetual bond, raising the cost of the dividend and making it harder to secure and grow the existing dividend over time.

 

That’s partially what makes the BDC industry such a challenging one to do well in over time.

 

Investors need to be very selective, trusting their hard-earned money only to management teams that don’t have incentives to grow the BDC (and their management fees) at the expense of shareholders.

 

One way investors can identify such firms is to carefully watch the long-term trend in NAV per share (i.e. a rough estimate of the intrinsic value of the BDC’s shares), which should rise over time if the company is being disciplined in the loans it chooses to make.

 

Not only does Main Street’s track record show that management has its interests aligned with that of regular investors (as does the steadily growing dividend over time), but Main Street is famous for taking a long-term approach to running its business in several other ways.

 

First, Main Street has always had a conservative approach to debt.

 

For example at the end of 2016 its net debt / equity ratio was 0.69, far below the legal limit of 1.0.

 

However, whereas many other BDCs would want to leverage as much as possible to increase their portfolio size (and management fees), Main Street’s safer debt levels help to lower its borrowing costs.

 

That’s because Main Street is one of the few BDCs with an investment grade credit rating (BBB).

 

As a result, the company can sell bonds and gain access to low-cost credit facilities at much lower interest rates. Main Street can more easily gain approval for SBIC (Small Business Investment Companies) loans as well, which further provide it with low interest capital.

 

Main Street’s combination of lower borrowing costs and lower operating costs (from its internally managed business structure) means that management can be far more selective with its underwriting and investments.

 

For example, the company’s average coupon (loan interest rate) is between 8.5% and 12.5%, which is much lower compared to many BDCs that are making loans at 13% to 15% interest rates.

 

While lower interest rates may mean less investment income in the short-term, it also means that Main Street is likely making less risky loans to higher quality companies.

 

Such conservatism will likely prove to be an advantage the next time the economy turns south and small businesses start defaulting on loans.

 

In addition, Main Street uses its expertise in small business management to not just lend to carefully selected clients, but also to take equity stakes and guide them towards their financial goals.

 

This benefits shareholders in three ways. First, it increases the value of Main Street’s brand because businesses know that Main Street isn’t just a lender, but a true business partner that can help better manage their companies.

 

Second, by becoming a part owner in some of its clients, Main Street benefits from the growth and success of its clients.

 

When this happens, Main Street gets a larger-than-normal portion of its income from capital gains. That means more of its dividends are taxed at lower rates (0-20%) rather than ordinary income rates, which can be as high as 43.6%.

 

 

Finally, while rising interest rates will pose a major growth challenge to most BDCs due to higher borrowing and equity costs, Main Street has made sure that it is well positioned.

 

The company’s large amount of floating interest rate loans will allow it to realize an increase in net investment income as rates rise.

 

 

Even better, because of the lower risk profile of its portfolio book, Main Street doesn’t have to worry as much about the rising yields on its loans creating undue financial stress on its clients.

 

The same isn’t true for many of its externally managed rivals, which have been reaching for yield in recent years and have lower quality portfolios that are at higher risk of large defaults during the next economic downturn.

 

Key Risks

While Main Street Capital’s relatively conservative and disciplined management team means that it represents one of the best BDCs, it still comes with a high amount of risk compared to many other dividend stocks.

 

That’s because, while Main Street’s portfolio of loans and investments is less risky than that of most BDCs, we can’t forget that the majority of its clients are still B or BB rated companies.

 

In other words, the BDC industry is essentially a subprime junk bond market, resulting in higher risks of loan defaults and even bankruptcies during an economic downturn.

 

Now the good thing about Main Street is that as one of the oldest BDCs (the company went public in 2007) we know that management is able to guide the company through a major recession (e.g. 2008-2009).

 

However, while the Great Recession was very severe, it was also fairly short-lived. A more protracted downturn could result in more severe declines in DNII, as well as capital gains and dividends from its equity holdings in its clients.

 

This ties into the next risk, which is that Main Street’s special dividends, which are funded by capital gains and equity dividends (not DNII from loans), are a big factor in what makes Main Street’s stock so popular with many investors.

 

For example, while the BDC has a great track record of gradually raising the regular, monthly dividend (5.8% yield), the steady annual special dividends of 55 cents per year have lifted the total yield to much more appealing 7.2%.

 

 

During the next recession, those capital gains and dividends from clients will likely dry up, meaning that Main Street will likely have to cut or even eliminate its regular special dividends.

 

In turn, MAIN’s stock could face some pressure on its share price. Why does that matter to long-term investors who might be looking to own Main Street for many years, or even decades?

 

Because the BDC business model requires frequent sales of new shares in order to grow the portfolio, DNII, and dividend.

 

Main Street’s exceptional track record of disciplined and shareholder-friendly management has made it the darling of Wall Street.

 

In fact, Main Street has been the best performing BDC in America since its IPO, vastly outperforming its peers and the market at large.

 

 

As a result, MAIN’s shares trade at meaningful premium to the stock’s median historical book value per share of 1.40.

 

Remember how share prices tend to track book value per share over time?

 

Anytime a BDC can sell new shares at greater than book value, it is basically printing “free” money that automatically increases the company’s book value, and thus intrinsic value for existing shareholders.

 

Think of it like this. Main Street’s best-in-class leadership has so earned the trust of investors that they are willing to pay $1.74 (today’s premium to book value) for each $1 in new assets that the company’s freshly-issued shares represent.

 

That excess $0.74 per share in cash represents “free” money for management to invest on shareholders’ behalf and gives Main Street a major competitive advantage when it comes to raising profitable growth capital.

 

However, BDCs’ need to sell new shares does mean that Main Street, like all BDCs, is ultimately at the whims of a volatile and fickle stock market.

 

For example, during the 2008-2009 financial crash Main Street’s shares collapsed about 40% and its price-to-book value declined to 0.80.

 

In other words, during a market crash even the mighty Main Street Capital can fall into a liquidity trap in which it can’t raise equity growth capital without diluting and destroying shareholder value.

 

Then there’s the risk of increasing competition, which could result in falling net margin spreads.

 

For example, the BDC industry has very low barriers to entry. Pretty much anyone who can raise $50-$100 million can start a BDC.

 

In a world awash in capital, that has resulted in a boom in BDCs, all competing for a limited number of high quality investment opportunities.

 

Two negative trends for the industry have developed. First, the coupon yields on higher quality loans, those of lower risk companies, and first lien loans (those secured by valuable assets that can be sold to recoup losses in case of default) have declined due to rising competition.

 

In turn, this has caused many BDCs to go out further on the yield/risk curve, lending ever-higher interest rates and with less secured loans to riskier companies.

 

However, as with all distressed debt, this approach is highly risky and almost sure to end in higher long-term cash flow volatility whenever the next recession ends up resulting in soaring default rates and substantial loan losses.

 

Fortunately, Main Street’s low-cost business model, diversification, and disciplined underwriting and investment approach have largely kept it out of this highly dangerous trend.

 

In fact, of its roughly 200 investments, only four are on nonaccrual (default) status, representing just 0.6% of its portfolio.

 

Finally, we can’t forget that the factors that created this recent golden age of BDCs (e.g. low interest rates, banking regulations that prevented competition from major banks, slow but steady and protracted economic growth) could change in a hurry.

 

While a recession could end up devastating many of the lower quality BDCs, banking deregulation could once more allow large banks to lend to the middle market.

 

Such a development would only put further pressure on the profitability of the industry, even best-in-class BDCs like Main Street Capital.

 

Main Street’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Main Street’s Dividend Safety Score of 60, meaning that the dividend is about as secure as the average payout on Wall Street.

 

However, while that may be true, due to Main Street’s seemingly high payout ratio, you need to keep in mind that the BDC business model naturally makes for payout ratios that are very high, often 90% to 100%.

 

 

In addition, keep in mind that EPS, while a generally good proxy for dividend sustainability, isn’t exactly what funds Main Street’s dividend since EPS includes a lot of non-cash charges.

 

Main Street’s equivalent of free cash flow, what it calls distributable net investment income (DNII), was actually up 10% in 2016 and created an effective FCF payout ratio of 91%.

 

That’s among the best in the BDC industry and represents a secure regular dividend.

 

Of course, a strong payout ratio is just part of the dividend security puzzle. Reviewing a company’s balance sheet is extremely important because a company will always make its debt payments before issuing dividends.

 

At first glance, Main Street’s relatively large debt load ($583 million in debt compared to $24 million in cash) appears rather frightening. However, we have to remember that the BDC business model requires a large amount of debt.

 

When we compare Main Street’s balance sheet to that of its peers, we actually see that the firm’s leverage ratio is significantly lower than its rivals.

 

When combined with its very high interest coverage ratio, this explains why Main Street boasts one of the best credit ratings in the industry.

 

That in turn only helps to strengthen the dividend security, and makes for one of the safest dividends in the BDC industry.

 

BDC	Debt / EBITDA	EBITDA / Interest	Debt / Capital	S&P Credit Rating
Main Street Capital	4.95	5.09	41%	BBB
Industry Average	6.07	NA	39%	NA

Source: Morningstar, Fast Graphs

 

Overall, Main Street’s current dividend payment appears to be quite secure in today’s market environment. The company’s recurring monthly dividend has never been decreased, and I expect that to remain the case for now.

 

The company’s relatively high payout ratio, elevated financial leverage, and dependence on capital markets increase dividend risk during market downturns, but management’s conservatism, MAIN’s diversified investment portfolio, and the company’s track record help alleviate some of these concerns.

 

Main Street’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Main Street’s Dividend Growth Score is 36, which indicates below average dividend growth is likely in the future.

 

However, that’s to be expected because the BDC industry isn’t exactly known for its fast dividend growth.

 

Main Street’s regular dividend payments (excluding special dividends) grew 3.3% in 2016 and have increased by about 5% per year since the company went public in 2007.

 

The company’s measured pace of growth is partly driven by management’s long-term, conservative dividend growth strategy, in which it grows the regular dividend at a pace to maintain as low a payout ratio as possible, given its BDC tax regulations.

 

Given the cyclical nature of this industry, in which DNII comes in booms and busts based on the strength of the U.S. economy, this is precisely what low-risk dividend investors, such as those who require steady dividends to live off during retirement, should look for.

 

Finally, we can’t forget that right now, perhaps nearing the end of this economic cycle, Main Street’s ability to grow quickly is being hindered by the large amount of capital and competition that is hunting for the lowest risk clients.

 

Whenever the next downturn hits, Main Street’s disciplined refusal to pursue “growth at any price and risk level” will likely help it during the inevitable industry consolidation that results from its weakest and most overleveraged competitors going bust.

 

Until then, investors can probably expect regular dividend growth of around 3% a year.

 

Valuation

In the past year, Main Street Capital’s 35% total return has roughly doubled the market’s return, making many investors concerned about the current valuation.

 

When it comes to valuing BDCs, arguably the two best metrics to use are price-to-book value (P/BV) and dividend yield.

 

From that perspective, Main Street’s current valuation looks high. In fact, no other BDC in America has a higher premium to book value than MAIN right now.

 

While it’s certainly worth paying a premium for what is arguably the best BDC on Wall Street, today’s valuation appears somewhat staggering even compared to Main Street’s historically high and well-deserved premium.

 

BDC	P/BV	Historical P/BV	Yield (Regular dividend)	Historical Yield
Main Street Capital	1.74	1.40	5.7%	6.8%
Industry Median	1.01	NA	4.0%	NA

Source: Gurufocus

 

Looking at the regular dividend yield, Main Street’s current valuation also looks unappealing.

 

Income investors are probably better served waiting for a pullback to around $32 per share (versus $39 per share today), where MAIN’s dividend yield would be closer to 7%.

 

Even though the stock’s current share price (at an all-time high) means that management can raise plentiful amounts of cheap growth capital, the amount of good, profitable investing opportunities is becoming harder to come by this far into an economic cycle.

 

In other words, Main Street’s “free cash” printing machine might not be able to really help the BDC increase shareholder value enough to justify the current valuation.

 

Concluding Thoughts On Main Street Capital

As long as you understand that all BDCs are relatively higher risk stocks (due to their subprime lending business model and reliance on external capital markets), then Main Street Capital can make for a reasonable addition to a diversified dividend portfolio.

 

After all, Main Street’s long-term future is arguably among the brightest of any BDC in America.

 

Such optimism appears to be supported by the firm’s numerous competitive advantages, which include one of the most experienced, shareholder-friendly and disciplined management teams; a low-cost business model; and an unbeatable track record that has resulted in access to cheap equity capital.

 

That being said, the stock’s current valuation seems hard to justify. Dividend investors should probably relegate Main Street Capital to their watch lists until the next correction brings the price down to more reasonable levels.

 

Here are some of the other best monthly dividend stocks to consider until then.