Unique Investment Opportunity for Income Investors
In the U.S., there is a unique group of businesses often labeled as “middle-market firms.”
These are no startups. While middle-market companies have yet to become household names, they can still generate tens of millions of dollars of revenue every year. A middle-market firm may also have a leading position in its operating market.
To make it to the big leagues, middle-market companies are trying hard to grow through market expansions, acquisitions, and organic growth strategies. And to do that, they need capital.
Nowadays, banks face tighter regulations. So when a private middle-market company comes to them with a request to borrow $10.0 million for an expansion project, banks often say no.
As a result, middle-market firms have to go to what I call “alternative banks,” which are lenders that specialize in providing financing solutions to middle-market companies.
CM Finance Inc (NASDAQ:CMFN) is a middle-market lender. Headquartered in New York City, the company invests primarily in middle-market businesses with annual revenues of at least $50.0 million and earnings before interest, tax, depreciation, and amortization (EBITDA) of at least $15.0 million.
And that’s just the start. Other than having these revenue and EBITDA thresholds, CM Finance also targets companies with a history of positive operating cash flow, a defensive and stable business model, and a seasoned management team with meaningful equity ownership.
Moreover, each time CM Finance invests in a middle-market firm, it always has an exit strategy in mind.
Here’s the best part: Because the company makes most of its investments through lending, it can collect a steady stream of interest payments. And that means it can afford to have a regular dividend policy.
CM Finance Inc Dishes Out Generous Dividends
In fact, CM Finance has no choice but paying out most of its profits to shareholders through dividends. That’s because it chooses to be regulated as a business development company (BDC). BDCs pay little to no tax at the corporate level, but in exchange for that benefit, it must adhere to this mandatory distribution requirement.
Today, CM Finance pays quarterly dividends of $0.25 per share, giving CMFN stock an annual yield of 11.3%.
The company’s generous dividends are backed by a profitable business. As I mentioned earlier, it’s hard for middle-market companies to get a loan from large banks. One of the consequences is that they have to pay higher financing costs to middle-market lenders. At CM Finance, the weighted average yield of its debt investments stood at 11.12% as of March 31, 2018. (Source: “CM Finance Inc,” CM Finance Inc, last accessed July 12, 2018.)
Managing Portfolio Risk
Of course, high-yield debt can be risky investments. The good news is, CM Finance focuses on senior secured lending. By the end of March 2018, first-lien loans represented 48.3% of its total portfolio, while second-lien loans accounted for another 42.4%.
As a first-lien lender, CM Finance will be the first one standing in line to get its money back in the event of borrower liquidation. With more than 90% of its portfolio made up of first- and second-lien loans, CM Finance has an added level of security in its investment income stream.
Moreover, CM Finance invests in a large number of companies. While the company has a $297.0-million portfolio, each investment usually has a size of between $5.0 million and $25.0 million.
The portfolio is also well-diversified. As of March 31, 2018, CM Finance has investments across 16 different industries. Its largest industry exposure, Business Services, accounts for just 12.7% of the company’s total portfolio. And within Business Services, CM Finance’s investments are diversified across six investments. (Source: Ibid.)
Solid Financials
At the end of the day, in order for a company to pay sustainable dividends, it needs to make enough money to cover its payout. For an investment company like CM Finance, that means we should take a look at its net investment income and compare the number to its dividend payments.
In the third quarter of the company’s fiscal year 2018, which ended March 31, CM Finance generated net investment income of $3.7 million, or $0.27 per share. This was more than enough to cover its quarterly dividend rate of $0.25 per share. (Source: “CM Finance Inc Reports Results for its Fiscal Third Quarter ended March 31, 2018 and Announces Share Repurchase Program,” CM Finance Inc, May 8, 2018.)
In the first nine months of its fiscal year 2018, CM Finance’s net investment income came in at $0.76 per share, while it declared total dividends of $0.75 per share. So again, the company made more money than what was needed to meet its dividend obligations.
Good Value for Money?
Last but certainly not least, this alternative bank could offer good value for money. At the end of March, CM Finance had a net asset value of $12.55 per share, yet the stock is trading at just $8.88 apiece.
In other words, if the company’s fundamentals hasn’t changed much since the end of the first quarter, its current share price would represent a nearly 30% discount compared to its net asset value.
Adding the fact that CM Finance pays a generous dividend of 11.3%, this alternative bank could represent an opportunity for yield-seeking investors.