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As buying low and selling high is the well-known and fundamental principle of investing, I believe, less-known lower middle-market lender Monroe Capital (NASDAQ:MRCC), could be one of the options that perfectly fits on principle. Its stock price lost nearly 27% in value in the past three years due to temporary setbacks, such as a decline in net asset value and higher unrealized losses. Despite that, the BDC looks fundamentally sound with end markets offering significant support. Moreover, its dividend is fully covered by its net investment income, with expectations that earnings will continue to surpass dividend payments over the long term. The company also improved its debt and liquidity position while its portfolio’s credit quality is strong with non-accruals standing around 1.50% of the entire portfolio.
Direct Lending Outlook and Monroe Position
Established in 2004, Monroe Capital is a business development company specializing in lower middle private credit markets using various strategies, such as senior secured first lien debt investments and private equity financing. Private credit market bolstered in the last decade due to tightening lending policies from traditional banks and a significant growth in lower and middle-market companies. However, market conditions were extremely volatile in 2023 due to the risk of recession, decades-high inflation and one of the fastest rate hikes from the Fed. All this resulted in muted growth for the private credit market and higher unrealized losses for business development companies. Monroe Capital also experienced unrealized losses and it ended 2023 with a net asset value of $9.58 per share compared to $10.39 per share at the end of 2022.
On the positive side, the company’s portfolio credit condition was strong as it kept non-accruals around 1.5%, which is in line with an industry average. Moreover, the outlook improved significantly in the past quarter due to the Fed’s pivot and moderate economic growth. Besides that, a record equity dry powder also hints at robust deal activity in 2024. As of the end of 2023, global private equity firms were sitting on a record $2.59 trillion in cash reserves for buyouts and other investments while private equity dry powder stood around $645 billion in the United States.
In the earnings call, Monroe Capital CEO Ted Koenig also expressed confidence in the deal activity. He said direct lending volumes increased by 31% in the fourth quarter from the third quarter, anticipating the momentum will carry throughout 2024 due to improving confidence in the broader market conditions and signs of the deployment of record dry powder and LP capital.
Direct lenders, such as Monroe, stand to benefit from a growing opportunity set and a more active M&A environment. The current market dynamics continue to provide favorable tailwinds for private credit. While pricing has generally leveled off in recent months, loan-to-value and leverage attachment points remain at attractive levels. These deal structures offer compelling risk-adjusted returns for predominantly first lien senior secured lenders.
The new investment commitments of $10 million during the fourth quarter compared to only $2 million in the previous quarter clearly reflects that Monroe is seeking to capitalize on attractive opportunities. The company’s portfolio credit quality, diversification and cash position also appears to be strong enough to back its growth strategy. Its investment portfolio of $488.4 million is composed of 96 debt and equity investments in more than 10 industries with an average investment size of $5 million. Significant diversification positions the company to capitalize on opportunities from various industries and help lower the downside during volatility. Moreover, 82% of its portfolio debt investments are first lien.
On the liquidity side, the company has significantly lowered its debt to equity ratio to 1.50x from 1.60x in the previous quarter. At the end of the fourth quarter, its total debt declined to $304.1 million compared to $331 million in the previous quarter. Instead of using its existing cash resources and raising additional debt, the company is actively redeploying its capital from payoffs to fund new investments and lower its debt. In the fourth quarter, it received $32.6 million in three full payoffs. In addition to payoff, the company has $80.9 million in revolving credit facility and $10 million in cash to invest in growth opportunities. It can also issue new shares to raise capital as a number of other BDCs are using various methods to fund investments and repay debt. At the moment, no stock issuance plan has been authorized by Monroe Capital.
High Dividend Is Sustainable
Although a number of Seeking Alpha analysts have raised concerns over Monroe’s dividend stability, I believe Monroe’s dividend yield of 13.5% is sustainable and its quarterly dividend of $0.25 per share is safe. Monroe does not appear to be a dividend yield trap because its dividend is fully covered by its net investment income. In fact, in the past 15 consecutive quarters, its investment income provided a complete coverage to its dividends payout. In the latest quarter, the company’s adjusted net investment income of $0.28 per share reflects a dividend coverage ratio of 1.1. For the full 2023, its investment income of $1.07 per share also exceeded the annual dividend of $1 per share.
Moreover, there is no risk to its dividend in 2024 and ahead because of expectations for higher loan demand, strong portfolio credit quarterly and effective portfolio yield of above 12%. Its dividend also appears safe based on Wall Street’s net investment income outlook of $1.02 per share in 2024. However, given a significant acceleration in its investments in new opportunities and increasing demand for private credit, I believe the company is in a position to beat Wall Street expectations.
Monroe Capital is Trading at a Significant Discount
It’s important to understand that a low valuation doesn’t always signal that the stock is undervalued. For instance, stocks trading at low valuations for a longer time reflect that business is experiencing permanent challenges or slowing demand from the end market. Moreover, the financial numbers, investment strategy and fundamentals also help in avoiding the value trap. In my view, a stock is undervalued when it has a combination of low valuation and strong fundamentals.
In the case of Monroe Capital, its price upside is likely to be backed by both fundamentals and valuation. The fundamental factor includes credit market stability, solid economic growth and a robust deal activity outlook, which I already discussed in detail. Meanwhile, its stock also looks significantly undervalued based on valuations, such as price to earnings and book ratios. Its price to earnings ratio of 6.8 is down from the sector median of 11x and an industry average of 8x. Although its net asset value dropped in the past few quarters due to unrealized losses, it is still high from the current share price of $7. The company ended December 2023 with a net asset value of $9.40 per share.
Risk Factors to Consider
There are a number of risk factors to consider when investing in Monroe Capital. The biggest risk factor in 2024 could be the Fed’s hard landing. Although there is a limited chance of hard landing at present due to moderate economic growth and robust job market, the risk factor could increase if the Fed hold rates higher for longer. High rates can negatively impact investor confidence, deal activity and economic growth. Moreover, the company’s high debt to equity ratio is another crucial factor to watch in 2024 and ahead. The company has successfully used investment sales and payoff to lower its debt and fund investments in growth opportunities in the last year.
In Conclusion
Monroe Capital appears to be one of the best options for long-term investors, who believe in buying and holding undervalued but fundamentally strong stocks for healthy returns. At present, Monroe’s shares are trading at a discount based on both valuation and fundamentals. Moreover, its current dividend payout is completely safe given its potential to generate higher earnings than dividends. The end market outlook is also robust, with expectation that momentum will increase once the Fed initiates rate cuts in the second half.
