FSK - Main Street Capital Continues To Deliver But Trades At A Lofty Premium

2023-08-29 08:45:00 ET

Summary

• Main Street Capital has delivered strong financial performance and shareholder value over the years.
• MAIN has consistently increased its monthly dividend and has a track record of growing net investment income and net asset value.
• However, MAIN's current valuation is trading at a premium compared to its peers, making it less attractive for adding to positions at the moment.

Business Development Corporations (BDCs) are sought after by income investors for their oversized dividend yields. One of the most popular BDCs is Main Street Capital (MAIN), the 7th largest BDC by net assets and the 5 ^th largest by market cap. MAIN continues to deliver for shareholders as they produced a top and bottom line beat in Q2 while driving their net asset value ((NAV)) higher. MAIN has been a great investment for long-term shareholders, and while MAIN is part of my portfolio, I wouldn't add to my position at the current valuation. For some reason, MAIN has traded at a lofty premium compared to its peer group for some time, and while I would like to add more shares, I feel there are better opportunities in the BDC sector. I plan to hold MAIN and reinvest the dividends until the valuation comes more in line with its peer group.

I wish I had known about Main Street Capital earlier as it's been a great investment for shareholders

MAIN went public in October of 2007. If someone had told me that for every $1,500 you invest, the appreciation would be 165.13% on the initial investment, and there would be $3,854 of income generated over the next 16 years, I would have purchased shares hand over fist. A major reason why MAIN has a loyal following is because it's delivered tremendous shareholder value over the years.

MAIN has never decreased its monthly dividend, and since its IPO, the dividend has grown 114%. Since the IPO, MAIN has paid $33.38 per share in regular dividends while declaring an additional $5.17 in supplemental dividends over the years. For every share purchased for $15, the current share price plus the dividends ends up at a value of $78.31, a 422.07% return on the investment that breaks down to an annualized return of 26.38%. This also doesn't factor in reinvesting the dividends. 16 years later, MAIN continues to increase its dividend, generate monthly income, and drive value for its investors. While I don't think the valuation today makes sense, it's undeniable that MAIN has been a solid investment over the years.

Main Street Capital is a great company that continues to deliver for its shareholders

When it comes to BDCs, I want to see growing net investment income ((NII)), NAV, and dividends. MAIN has the trifecta in spades. MAIN has over $6.7 billion in capital under management and primarily invests in companies with revenue between $10 - $150 billion and EBITDA between $3 - $20 million. These are typically underserved companies in the lower middle market ((LMM)). MAIN makes proprietary debt investments in privately held companies that are normally first-lien or senior-secured debt investments.

In the LMM, MAIN has invested in 79 companies with a $2.2 billion fair value. The debt is yielding 12.9%, with 99% of the debt investments having a first lien position and 70% of the debt earning fixed-rate interest. MAIN's equity ownership position is roughly 40% across its LLM portfolio. On the private loan side, MAIN has made 88 investments at a $1.5 billion fair value with an average investment of $17.3 million. The debt on the private loan investment yields 12.6%, with 98% bearing interest at floating rates. In the Middle Market, MAIN has made 28 investments at a $295.9 million fair value, with the debt yielding 11.8%.

In Q2 2023 , MAIN delivered $127.58 million of investment income, which was a 50% increase YoY. This translated to $90.33 million of distributable net investment income ((DNII)) and $85.73 million of net investment income ((NII)) which was up 58% and 57% YoY. In Q2, MAIN generated $1.06 per share of NII and $1.12 of DNII per share. Due to MAIN's investments, its NAV increased to $27.69, which is a 1.66% QoQ and 8.38% YoY increase. From a shareholder perspective, this is what I want to see because MAIN is delivering on its critical success factors, and this correlates to increasing shareholder value.

The 3 critical success factors for MAIN are driving larger amounts of DNII, NAV, and dividends. Going back to 2007, MAIN has established a strong track record of growing these three segments. As DNII increases, so does the amount of NII that can be allocated to the dividend so they are tied together. When NII and DNII increase, it allows MAIN to increase the dividend. MAIN's NAV, which is their book value increases, it helps the overall share price appreciate. There is a large spread between the amount of DNII being generated and the dividend being paid. This has allowed MAIN to declare and pay a supplemental dividend of $0.225 per share in Q2, taking the overall dividends paid in Q2 to $0.90 per share, which is a 25% increase YoY and a 5.9% increase QoQ. As long as MAIN continues to improve on these metrics, shareholders could continue to see MAIN trade at a large premium compared to its peers.

I am holding off on adding to my position in Main Street Capital until the valuation comes more in line with its peers

I want to purchase more shares of MAIN, but I just see other opportunities in the BDC space. I compared MAIN's NII multiple, valuation to NAV, NII generated, and dividend yield against the following companies, and I am stuck in neutral for the time being:

• Prospect Capital Corp (PSEC)
• FS KKR Capital Corp ( FSK )
• Barings BDC (BBDC)
• Blue Owl Capital Corporation (OBDC)
• MidCap Financial Investment Corporation ( MFIC )
• Goldman Sachs BDC ( GSBD )
• Oaktree Specialty Lending Corporation ( OCSL )
• Golub Capital BDC (GBDC)
• Ares Capital ( ARCC )
• Gladstone Investment ( GLAD )
• Sixth Street Specialty Lending ( TSLX )

I went through each company's financials to establish their NII on a TTM basis. PSEC is the only one that hasn't reported Q2 yet, so their NII metric is still Q1 2023 – Q3 2022. I placed the table below

MAIN is in the upper middle of the pack as they generate the 5 ^th largest amount of NII in the peer group. ARCC, FSK, and OBDC generate significantly more NII than the other BDCs, so the average is not favorable to the bottom half. MAIN has generated $305 million in NII compared to the peer group average of $387.91 million.

When I am buying shares of BDCs, I am paying the multiple on their NII as this drives future investments and paying dividends. MAIN trades at a market cap to NII multiple of 10.75x, which is the largest in the peer group and significantly above the peer group average of 8.42x.

MAIN is trading at a 43.63% premium to its NAV, while the peer group average is a discount of -2.01%. There are 5 companies trading at a premium and 7 trading at a discount. MAIN looks to have an oversized premium compared to its peers on this metric.

MAIN also has the lowest dividend yield of the peer group at 6.64%. The average yield in the peer group is 10.21%.

Conclusion

MAIN has been a fantastic investment for long-term shareholders and continues to deliver on its critical success factors. Over the long-term, MAIN has driven its DNII, NAV, and dividend higher, creating shareholder value. MAIN has established a long track record of financial success, and shareholders have been rewarded. I am a huge fan of MAIN, and I am a shareholder. While I want to own more, I am not inclined to pay 10.75x for MAIN's NII or a 43.63% premium on MAIN's NAV when FSK trades at 6.38x its NII, yields 12.71% and shares are -19.08% of its NAV. I am keeping a close eye on MAIN, and if the premium tightens, I will be adding more shares in the future.

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