I believe in the cockroach theory of investing: there's never just one. So let me just show you one glaring cockroach in the portfolio of MCG Capital, which makes me concerned that the Company is perpetrating a valuation fraud based on its carrying value for its largest investment, Broadview Networks. Based on any reasonable valuation, the equity of Broadview is worthless or nearly so, yet MCG Capital carries it at an implied equity value of over $150 million ($103 million of which is attributable to MCG Capital's ownership). The result of this egregious overvaluation is an approximate 18% overstatement to MCG Capital's book value. If you look at their history of writedowns on other investments (active brands, jet plastica, total sleep, etc), it's not hard to begin believing that there are serious issues here and the NAV could be massively overstated. Looking at the valuation sections of the 10-K it is clear that there have been many more writedowns than write-ups in the past two years despite the performance of the equity markets. This is a strong sign the portfolio is filled with crap. For the sake of brevity, I will focus this write-up on MCG Capital's largest investment: Broadview Networks.
MCG Capital is a business development company with a large proportion of its investments in equity securities rather than the more typical debt securities favored by most business development companies. The largest investment in MCG Capital's portfolio is Broadview Networks a CLEC focused on providing commodity communications solutions to businesses. Unlike many of MCG Capital's other investments, Broadview is a public filer and we can therefore see the underlying performance of Broadview. Here is where the picture starts to get concerning. At the end of 2010, MCG Capital carried its ownership interests in Broadview at a total valuation of $103 million. This was comprised of $47.5 million of Series A preferred stock, $54.8 million of series A-1 preferred stock, and $0.7 million of Series B preferred stock. MCG Capital had also written off its investment in the common stock of Broadview Networks. According to page 109 of the Broadview 10-K, MCG Capital owns 100% of the Series A and Series A-1 Preferred but only 1.4% of the Series B Preferred Stock. Accordingly, conservatively assuming that all of the other classes of stock (both common and preferred) are worthless, the implied equity value of Broadview is $152.3 million, composed of:
+$47.5 Million Series A Preferred
+$54.8 Million Series A-1 Preferred
+$50 Million Series B Preferred ($0.7/1.4% = $50)
=$152.3 Million equity value
Based on the above, we can calculate that MCG Capital is claiming that the fair enterprise value of Broadview Networks is about $459.8 million based on the following:
+$152.3 million equity value
-$22.0 million cash
-$1.9 million certificates of deposit
+$3.1 million current capital leases
+$326.5 million long-term debt
+$1.8 million long-term capital leases
=$459.8 million enterprise value
The above enterprise value means that Broadview is being valued at 7.1x trailing EBITDA of $64.9 million. Trailing EBITDA of $70.6 million is comprised of $20.8 million of EBIT and $44.1 million of depreciation and amortization. When I asked MCG Capital's IR to please explain their valuation, he cited three methods that the company uses to value Broadview: (1) comparable traded companies, (2) comparable transactions, and (3) MCG Capital's internal DCF valuation.
I have identified three comparable public companies against which I have compared Broadview Networks: Paetec Holdings (PAET - 5x 2011E EBITDA), XO Holdings (XOHO - 5x trailing EBITDA), and Cbeyond (CBEY - 4.4x 2011E EBITDA). Using a 5x EBITDA multiple for Broadview would make the total equity value $17 million or an 80+% writedown relative to the current value at which MCG Capital holds Broadview. This valuation, however, may be too generous, because of Broadview's terrible performance. For instance, each of the comparable companies listed above grew both revenue and EBITDA in 2010. Only Cbeyond saw any dip in these metrics in 2009 and only then with regards to EBITDA, which fell by about 2%. In contrast, Broadview networks saw its revenue fall in both 2009 and 2010 and has seen EBITDA decline a cumulative 8% since 2008. This type of performance deserves a discount.
On the comparable deal front, MCG Capital's IR pointed me to five deals: Fibernet/nTelos, Earthlink/ITC Deltacom, Windstream/Nuvox, Comcast/CIMCO, and Paetec/Cavalier. I was able to find multiples on all of these deals with the exception of Comcast/CIMCO. The average multiple was 5.5x EBITDA and the range was 4.7x-6.5x. Using a 5.5x multiple, the total equity value that would be implied for Broadview would be $49.5 million or a 50+% writedown to MCG Capital. Again, we continue to believe that Broadview's poor operating performance merits a discount multiple.
Lastly, we considered a DCF valuation. We assumed that the company could turn around operations and start growing at 2% per year while maintaining margins and not needing to increase capex relative to sales. We also assumed they could shield the next $200 million of pre-tax income based on their NOLs. At a 10% discount rate, this implied an EV of $376.5 million or an equity value of $69 million, again resulting in a large writedown to MCG Capital. Frankly, this DCF valuation was way too generous to them because it assumed that the company had a painless turnaround and a WACC that is lower than the interest rate on the debt alone.
Any way you cut it, MCG Capital has a cockroach in Braodview Networks. Its history of writedowns in just the past two years strongly suggests that this is not the only one. There's never only one cockroach!
True operating performance of investments ultimately flows into NAV