Description

I am recommending MCGC as a short-term investment with the potential to make a good annualized return in a short-period, and with a very small likelihood of losing money. I view it as a case of heads-you-win-a-little; tails-you-win-a-lot.

MCG Capital (MCGC) was first written up on VIC on 4/5/11 as a short recommendation by nha855 when the price was $6.74. It was subsequently recommended by brook1001 as a long position on 11/15/12, when the price was $4.09. A month ago several messages were posted on brook1001’s thread. I believe that enough has changed since brook’s posting two years ago to warrant a new writeup. Also, there appears to be some misunderstanding about the company’s plans, the number of shares outstanding, and the NAV, which I hope to clarify here. Finally, I hope to draw other members who have not been following MCGC into the discussion, so that we can get additional insights into the situation.

The stock is trading at $3.70. This is a discount of over 18% to the 10/27/14 NAV of $4.535. More importantly, if the company’s pending $75 million tender offer is fully subscribed at the maximum end of the $3.25 to $3.75 range, the number of shares will be reduced by 20 million, from the current 43.5 million, a decrease of 46%. The remaining 23.5 million shares will have an NAV of about $5.12 per share. (If the tendered shares are repurchased at a price lower than $3.75, which I consider unlikely, the NAV will be higher than $5.12.)

I view this as a relatively short-term investment – probably no more than a couple of months, and possibly much less – which has the potential to earn us 10%+ (not annualized) over our investment period.

I recommend that members read the 2011 and 2012 writeups as these provide valuable background information. Below I will provide some description of recent events at the company and why I think that this is an investment opportunity with asymmetric reward/risk characteristics.

BALANCE SHEET

The balance sheet has been dramatically transformed since the end of last year – i.e. over the last 11 months. This transformation has occurred in several forms:

• A sharp shrinkage of the balance sheet as assets (loans and investments) have been paid down by borrowers or been sold by the company. Another reason the balance sheet shrank is because some investments have been written-down in value to reflect their true lower market value. Total investments have declined from $368.9 million on 12/31/13 to $93.6 million on 9/30/14. (The company sold another of its investments for $1.6 million in October, so the balance sheet continues to shrink.) I think that there are unlikely to be further significant write-downs of asset values.
• As assets have been monetized, the company has used a portion of the cash to pay off all of its debt. The company is now-debt free, from $175 million of borrowings at end-2013.
• A large amount of the cash has also been used to buy back shares in the open market. The number of shares outstanding has decreased from 70.5 million at the end of 2013 to 43.5 million at present, or by over 38% in ten months. The company paid approximately $3.71 on average for the repurchased shares, which is marginally higher than the current stock price.

TENDER OFFER

In early November, MCG initiated a Modified Dutch Auction tender offer, offering to buy up to $75 million worth of shares between $3.25 at $3.75 per share. The tender expires on December 3^rd. The stock is trading at $3.70 today, so if the shares were purchased today and tendered, you could make a gain of 1.3% in a couple of weeks if all your shares are accepted in the tender. If all your shares are not accepted, it will be because the tender is oversubscribed. That would be a happy outcome, because the NAV following the tender will then be about $5.12 per share, up from $4.535 today, and it is likely that the stock price will increase to reflect the higher NAV. If the stock then traded at a discount of 20% to NAV, or about $4.10, our gain would be about 11%. A 15% discount would result in a stock price of $4.35, for a gain of about 18%. My guess is that this will play out relatively soon, i.e. over the next few weeks.

The good news is that if the tender is not fully subscribed, and the NAV increases by a smaller amount, the company will likely continue buying back shares on the open market. They have demonstrated their willingness to buy shares at $3.75 in the tender, and at an average price of $3.71 over the last year, and this should provide support to the stock price. I think it very unlikely that we will lose money on this investment.

FUTURE PLANS / END-GAME

Management is very tight-lipped about the future strategy of the business. Based on the events of the last couple of years, I think it is reasonable to conclude that we are in the end-game stages. The balance sheet keeps shrinking; all the debt has been paid off; the company surrendered its SBIC license in September; and excess cash has been used, and continues to be used, to repurchase shares at well below NAV. In addition, management states in the 10-Q that at its current size, the income generated from investments is not adequate to cover the expenses of operating the business, so that we can expect modest operating losses in future quarters.

The company has large capital loss carryforwards aggregating about $180 million at the end of 2013, two-thirds of which have no expiration. Not being a tax expert, it is unclear to me how this can be utilized to increase the value of remaining shares as the end-game plays out. It is clearly a hidden asset, but I am not certain that it can be monetized to benefit the remaining shareholders. I look to members of the VIC community for additional thoughts on this.

Catalyst

Expiration of tender offer and increase in NAV.

Additional open-market buybacks.