It has been a while since I visited Gladstone Capital (GLAD). In June of last year, I noted that GLAD’s valuation appeared to be stretched and as such did not present an attractive value proposition.
Well, a lot has happened since then, not the least of which is the 9.8% decline in GLAD’s stock price since June of last year (a negative return of just 5.6% when dividends are taken into account). In this article, I highlight why GLAD’s recent trading performance and price make it a buy, so let’s get started.
Gladstone: why this 7.4% yield looks more attractive
Gladstone Capital is a BDC managed externally by Gladstone Management Corp. and is part of the Gladstone family of companies, which includes Gladstone Investment (GAIN) and Gladstone Land (LAND) and Gladstone Commercial (GOOD) REITs. Unlike its BDC sister, GAIN, GLAD operates more like a traditional BDC in that it doesn’t hold as many equity investments in its investment portfolio.
GLAD’s strategy is to initiate secured debt investments in established lower middle market companies with sustainable margins/cash flow and favorable growth characteristics. His target companies typically have annual operating cash flow of $3 million to $15 million.
GLAD also maintains exposure to defensive-style businesses, including specialty manufacturing, industrial or commercial services, and healthcare services. Currently, GLAD has a portfolio fair value of $557 million across 46 portfolio companies and most of its transactions (81%) are verified and backed by an equity sponsor (a private equity firm in most of the cases).
Most of GLAD’s investments (85%) are in the form of secured debt (61% first lien and 24% second lien), with the remaining 15% being equity, giving GLAD the potential for a higher NAV/share on the rise. GLAD has been busy over the last 4 reported quarters with net creations of $55m over the period, driven by demand from PE sponsors for flexible first lien/unitranche funding and growth within companies existing portfolios.
Meanwhile, redemptions were lower in the last fiscal quarter of Q4 2021 (ended September 2021) compared to previous quarters, and appreciation in equity investments during the quarter contributed more than $20 million. and increased equity to 15% of the portfolio, offsetting proportional gains to 1st preferred investments. In addition, the weighted average return of GLAD’s portfolio of 10.3% remains healthy and above the BDC median of 9.0%.
Encouragingly, GLAD recorded a $31 million appreciation in net asset value over the 2-year period, which equates to a 12.5% increase in net asset value per share. As shown below, GLAD’s net asset value/unit of $9.28 now sits ahead of its pre-pandemic level.
Going forward, GLAD appears to be well positioned to grow its investment portfolio, as it maintains a strong balance sheet with a debt-to-equity ratio of just 78%, well below BDC’s median of 110% and below the regulatory limit of 200%. . Meanwhile, GLAD’s quarterly dividend rate of $0.195 (paid monthly) was covered by the Q4’21 NII/share of $0.199.
GLAD’s low use of leverage, combined with high investment returns, has resulted in a fairly high return on equity and, importantly, GLAD currently has no investments on the non-recognition. As shown below, GLAD’s ROE over the past year was 30.5%, well above BDC’s average and median.
Additionally, GLAD has the ability to deploy recent equity gains and increase its NII/share, as management noted on the conference call:
Although we have seen a modest compression in the return on earning assets through September 30, the $48 million in prepayments since the end of the quarter, which generated an average return of 11.1%, will be difficult to replace.
However, considering that we have an additional $16.6 million in equity gains to reinvest in earning assets as well, I wouldn’t expect NII to be negatively affected. As we have repeated over the past two quarters, we continue to target a one-to-one debt-to-equity ratio. However, based on the extent of portfolio appreciation in the last quarter, our leverage continues to be below our target range of 78% debt/equity.
While competitive pressures are undeniable, we will continue to be selective which, combined with NAV appreciation and excess debt capacity, positions us well to continue to grow our NII.
Risks to GLAD include its external management structure, which could lead to conflicts of interest. In addition, as discussed in management’s comments above, competitive pressures may lead to yield compression. Finally, BDC’s portfolio companies are generally sensitive to economic downturns and this should be kept in mind.
I see value in GLAD after its recent decline from the $11.50 level in recent weeks. Currently, GLAD is trading at a modest 14% premium to its book value. I consider the bonus to be deserved given the seasoned management team and its recent track record of net asset/share value growth.
GLAD’s price-to-book ratio is currently at the bottom of its 12-month range and below the 1.3x level at the start of 2020, as shown below. Analysts on the sell side have an average price target of $11.50, implying a potential total return of 16% over one year, including dividends.
Key takeaway for investors
Gladstone Capital maintains a well-balanced portfolio of secured debt and equity investments across a range of sectors. He sees healthy portfolio performance, growing net asset value/unit and significant appreciation in his equity investments. Meanwhile, it has a strong balance sheet with low leverage and plenty of dry powder to boost its NII/share. I see value in GLAD after the recent price drop for high income and growth.