Business Description
Main Street Capital Corporation (MAIN) is a business development company (BDC) that primarily provides capital to private U.S. companies. Its objective is to maximize portfolio's total return by generating (1) current income from debt investments in lower middle market (LMM) companies and middle market companies and (ii) dividend income, capital appreciation and periodic realized gains from equity and equity related investments in LMM companies.
In other words, you can see MAIN as a shadow banking lender, stepping in to fill the gap left by large banks, leaving the middle market lending industry after the Great Recession.
What so unique about the companies are:
Internally managed with an asset management business that acts as an External Investment Manager for others. This allows shareholders to capture the economics of the off-balance sheet income (~8% of net investment income). The off-balance sheet income is one reason the company can show an extraordinary annual return on equity averaging 13.6% from 2010 through the third quarter of 2023. It provides operating leverage to MAIN’s business model and alignment of management and shareholders’. Operating Expense to Assets Ratio was only 1.4% (2.7% for other BDCs, and 2.3% for commercial banks).
The focus on LMM companies provides lower correlation to the broader debt and equity markets.
It's an inefficient asset class with limited competition
Secured debt with meaningful equity participation and attractive risk-adjusted returns
Generally companies with revenues between $10-$150 million and eBITDA between $3-$20 million. Usually with debt/EBITDA ratios of 2 to 6.5X
Transaction types include growth/expansion initiatives, management buyout/change of control transactions, recapitalizations and acquisitions
Investments are structured for (i) protection of capital, (ii) high recurring income and (iii) meaningful capital gain opportunity
There are about 200,000 LMM-sized companies in the US, and MAIN is so selective they lend to just 1 in 1,000 or 0.1% of them.
It is also conservatively funded with a net debt to NAV ratio of 0.79x.
MAIN's underwriting is so conservative that its average loan is to a company with 3.1X leverage which is almost as good as investment grade (3.0X or less according to S&P and Fitch). It invests in its clients, and sometimes takes equity stakes, that's why its portfolio investments at fair value can be higher than its cost basis: 113% at 2023 Q3. That's why MAIN's growth rates are the best in the business.
Its portfolio is diversified and performing well. Total investment portfolio at fair value consists of approximately 51% LMM / 36% Private Loan / 7% Middle Market / 6% Other Portfolio investments with a weighted-average effective yield of 12.8% as of 2023 Q3:
One thing to note is that MAIN's assets and debt structures indicate its net investment income is positively correlated with Fed interest rate:
MAIN is a long-term investor in its customers, with 24% of its loans being with companies it's been doing business with for over a decade. 54% of their loan book is with customers who have been with MAIN for over five years.
MAIN’s unique focus on equity investments in the LMM provides the opportunity for significant NAV per share growth. Track record:
MAIN has been meaningfully growing its Net Asset Value (NAV) Per Share
$12.85 at December 31, 2007(2) to $28.33 at September 30, 2023 – 120% growth; CAGR of 5.1%. That is an incremental economic return to investors beyond dividends.
MAIN’s debt-focused peers (which comprises most BDCs) have not been able to generate NAV per share growth through the cycles.
Unrealized appreciation is a good proxy for future dividend growth without the need for additional capital through growing portfolio dividend income and periodic harvesting of realized gains from equity investments.
According to Brad Thomas, "Management owns $134 million worth of shares, or about 6% of the company, paying about $10 million per year in safe and steadily rising monthly dividends.
The management team made $22 million in 2022, a record year for MAIN. 90% of that was stock; their MAIN ownership paid them $10 million in dividends.
So yes, they care very much about that safe monthly income.
CEO Dwayne Hyzak, one of the co-founders of MAIN, made $657,000 in salary in 2022. He owns $19 million worth of MAIN shares, paying him $1.3 million per year in monthly income.
Or, to put it another way, the CEO of MAIN gets paid twice as much from his dividends as he makes in salary.
This is a man who is eating his own cooking.
90% of MAIN's executive compensation is in stock options, and 50% is restricted stock they can't just sell immediately. And those restricted grants are based on what matters to investors.
MAIN's executive compensation is focused on key drivers of value to MAIN shareholders – DNII, Dividends, and NAV per share.
[...]
MAIN might not be that large, but it has a cost advantage thanks to its internal management.
Its rivals average twice its expense ratio because of their higher fees. MAIN is able to operate with lower expenses than most commercial banks in this industry.
That's why it is able to safely offer 12.4% average yielding private loans while many of its externally managed peers are forced to target much riskier loans."
Recent financial result in 2023 Q3:
Trailing 12-month: $4.05 per share net investment income per share
Ongoing dividend rate of $2.88 per year that pays monthly. The company also gives supplemental dividend payments occasionally. For example, it paid a $0.275 supplemental dividend in 2023 Q3.
$28.33 NAV per share. 9.21% growth y-o-y.
$4.5 billion assets, $2.5 billion NAV
Weighted Average Shares: 82,921,764
SWOT analysis
Strengths
Internally managed company with high alignment of interest between shareholders and the management
An asset management business for off-balance sheet investment income.
Focus on equity investment allows the company to grow faster than other BDCs
Long-term partnering with its clients differentiate the company with other providers of capital. One example is the Annual Main Street President's Meeting. It is an annual event Main Street hosts for which they invite their lower middle market portfolio company leaders to Austin for a 2-day event to network and relationship build, share best practices, learn from each other and benefit from being part of Main Street's portfolio.
Weaknesses
Subject to macro environment
May not scale at some point because it's hard to scale conservative investment that has long-term partners, while doing equity investment with superior returns.
Opportunities
Portfolio growth should not be that hard given the world is always hungry for capital. MAIN's NAV is less than $3 billion, so it should have plenty of runway in growth.
Threats
Per-share growth rate can be impacted by its share price because the company uses equity issuance frequently for external growth.
References
Q3 2023 MAIN Executive Summary Fact Sheet
Q3 2023 MAIN Investor Presentation
2023/07/24 Main Street Capital: Who Else Likes Monthly Mailbox Money?
Updates
2023/12/24 Update on my accumulation criteria for MAIN
Main Street Capital (MAIN) at around $43 is a bit above my buy below price of $41.14 set on 2023/11/06. However, it is likely that my calculation was too conservative given its historical dividend growth was more than 5% annually instead of the 4% I used to calculate its buy below price. Its potential supplemental dividend will provide some margin of safety as well.
Of course, I was also attracted by its monthly income, and it's great to see my monthly dividend income from MAIN keeps growing every time I put some money in the portfolio. Hence, I decided to keep buying as long as the dividend yield is above 6%.
One thing to note is that MAIN's earnings are positively correlated with the Fed interest rate due to its high portfolio of debt being fixed rate, while its assets are mostly variable rate loans. But we cannot look at the static picture. Repayments and new acquisitions can steer towards a more favorable balance for MAIN. This is not a difficult task when the Fed interest rate is expected to go down very slowly from here. MAIN can also choose to increase its leverage a bit if needed.
Overall, with its internal management and its long track record, I am not so worried about MAIN having its earnings power being reduced enough to jeopardize its dividends and its growth trajectory even with the expectation of Fed interest rate hikes coming in 2024.
2023/11/06 Valuation
Average return on equity of about 13% should warrant a 1.3x NAV. That is $28.33 * 1.3 = $36.82 using 2023 Q3 data.
The payout ratio without the supplemental dividend is about 71%. So the sustainable growth from retained earnings can be at least 4% annually given some of the income growth can come from the asset management business that does not need capital. It is very conservative given historically it can grow 5% in addition to NAV growth of ~5%. Of course, the growth in the future is subject to its future share price as well, so it's quite unpredictable, but 4% is a very solid floor.
With a return on equity of 13%, it belongs to the low ROIC category, so the valuation has to be low enough to get a good investment return on the stock. I would use 11% as my discount rate, so the required dividend yield is 7%. Buy below price calculated from this model is thus: $2.88/0.07 = $41.14.
It is not trading at a great discount to my buy below price when it's trading at around $40 currently, but its high quality and good upside made up for the lack of a discount. I also like its monthly dividend yield of about 7%. In fact, I may keep accumulating its shares even if it's not at a discount due to the high dividend yield paid monthly and good upside potential combination.
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