Description

CM Finance is a micro-cap BDC trading at 66% of NAV and 12.2% dividend yield. I think this can trade to 75% of NAV in a year, providing a 20%+ IRR when including the dividend. Besides the small market cap, 44% of the float is tied up in related entities, so this idea is for personal accounts and small funds. Still, it has 8 times the liquidity of SNNY.

Background: CMFN was previously written up by shteinb and which provides good background. To summarize, a lot of the portfolio consists of investments that are easily marked, so the portfolio marks are very transparent. Also, management is above average. A recent company presentation can be found here.

The main reason for the stock trading lower than when it was first written up is that CMFN committed the two cardinal sins of BDC management. It cut the dividend and passed a resolution to sell equity below NAV. So let's cut to the chase and discuss the dividend.

Dividend: BDC's live and die by the dividend. The market got spooked in the fall when CMFN reported its first quarter (the company runs on a fiscal year ending 6/30) results, as the net income per share was below the dividend. Part of this is related to its credit facility which is done through a collateralized special purpose vehicle (SPV). Lenders give a more favorable rate via a SPV but it acts more like a loan than a credit facility. Thus, it is less flexible. With a credit facility, a BDC normally uses repayments to pay down the CF until it can lend the money back out. With the SPV, the BDC will hold the cash and pay financing interest, which makes income lumpier.

In the last quarter, net income was $0.27/sh vs. the quarterly dividend of $0.25/sh. That is not a lot of extra coverage but I believe it will improve due  to a recent change in the law that now allows for increased leverage at BDC's. The debt to equity ratio was $1 debt to $1 equity and is now $2 to $1. Most people who follow BDC's view the change with skepticism. BDC's did a fairly decent job of blowing up ten years ago on 1-1 leverage, so increasing leverage certainly increases risk, although it offers the opportunity to increase net income. It remains to be seen how CMFN will approach this change. The company's leverage ratio was 69% as of 12/31/2017. I think CMFN could go to 0.85 leverage, which has been management's upper-end leverage target prior to the change, and still be in a reasonable position.

So how does going to 85% leverage impact net income? 16% of $171 million of equity is $27.4 million. Multiply that by 5% spread and divide by 13.7 million shares and it adds $0.10/sh to net income on an annual basis. It is not a big change, and with a 12% yield, it doesn't have to be. Four dividends and a $9.00 stock price a year from now and I will be happy.

 Debt: The main portion of the debt consists of $102 million in floating rate term financing. This is done through the special purpose vehicle (SPV) that is collateralized by assets.

Ownership Structure: The two largest shareholders are related parties. Cyrus Capital owns 28% of the common stock and has a 38% indirect economic interest in the adviser, CM Investment Partners (CMIP), while Stifel owns 16% of the common stock and has a 20% interest in CMIP. The co-CIO's, Michael Mauer and Chris Jansen, own 42% of CMIP, but only a combined 1.3% of the common. It is a weird situation, where the adviser is like a Mexican stand-off, and CMFN is the orphan, bastard child that does not fit into the much bigger relations of Cyrus and Stifel. In fact, one of the stranger moments was on the February 8 earnings call, where a member of Ares Management got on the call and asked the following, which sums up the situation:

"Hi. Good afternoon, guys. This is Troy Ward with Ares. Hey, I just want to kind of follow-up a little bit on Robert’s question more just, Mike, on what is the long-term strategic vision for you and CM obviously? I think you just crossed your four-year anniversary of a public company. I don’t think there’s any way you thought that you’d have the current equity base that you have, but that’s been the reality and quite honestly, we don’t see you going into a trading position where you can raise new equity. So, at what point does that low equity base that you just used as a rationalization not to buy back stock, that’s just where you’re going to be for the foreseeable future, if not indefinitely. What is your strategic vision for this? If you’re talking about long-term shareholder value, maybe it isn’t just “Keep doing what we’ve been doing. Let’s find something that can unlock that value, which could be buybacks, which could be a strategic combination of some sort?” Would you like to comment on that?"

Bottom line, it would be very hard to dislodge the current investment adviser and there is a definite misalignment of interests between the common stock shareholders and management.

Given that backdrop, in January 2018, Caxton Corporation, led by billionaire Bruce Kovner, disclosed a 5.3% stake in the company via a 13G filing.

Conclusion: This is not a great company, or even good one. It's mediocre but there is an opportunity here to make money if the company simply sucks a little less.

Risks: There are a few:

·         45% of portfolio is 2nd liens.

·         The portfolio is relatively concentrated in 23 companies. Any deterioration in one of the larger investments could impact the dividend.

Catalyst

Net income steadies, shares rebound, collect dividend.