Income investors are a little desperate these days — the traditional CD ladders and government bonds and savings accounts just don’t do much for you, and rare is the person whose portfolio is so large that they can retire on a portfolio that yields only 2%. That creates a great market for folks who are selling yield — lots of folks are apparently lining up to subscribe to newsletter services that look for high-income investments, and publishers are eager to pitch yields and payouts.
So in that environment, it’s no surprise that Jimmy Mengel’s pitch for a “Guaranteed 30% Payout” is getting attention — it’s not only a big slug of money, but it’s also got that exciting sense of urgency because you have to buy in before March 25 to start slurping from the river of gold. So what’s he actually talking about?
Well, to get the details you can either sign up for $69 to subscribe to his newsletter, The Crow’s Nest… or you can have a little patience with your friendly neighborhood Stock Gumshoe as I dig through the clues and get you some answers. Let’s get started, here’s how Mengel entices us:
“COLLECT THIS GUARANTEED 30% PAYOUT
“In order to receive preferential tax treatment, this small company is going to dole out $34 million to its shareholders…
“Join this lucky group of investors by March 25th and collect this easy, one-time-only payout.
OK, so “preferential tax treatment” means, in almost every case, that the company converts to one of the special kinds of corporate entities or partnerships that doesn’t pay taxes — which means that they have to pass their income on to shareholders, who get the tax liability along with the earnings. You’re probably familiar with several of these kinds of “preferential” entities — Real Estate Investment Trusts (REITS), Master Limited Partnerships (MLPs), and Business Development Companies (BDCs).
So we’re almost certainly dealing with one of those kinds of companies, which almost always pay above-average yields compared to taxable corporations. Which one? More clues:
“… there are only roughly 50 companies that fit the profile these guys do….
“So long as you take action by March 25th, you will be guaranteed a 30% payout on however much you decide to put into this company….
“The company I’m about to fill you in on has been around for a decade and was recently invited to ring the opening bell at the NASDAQ exchange….”
So that’s pretty good, we’re close to a definitive answer already. And Mengel compares this opportunity to past cases like Equinix (EQIX), Ryman Hospitality (RHP) and others — both of those were REIT conversions, taxable corporations that became Real Estate Investment Trusts, so that’s no surprise.
And he does point out that the “secret that will give you the chance to DOUBLE this payout” is that you can hold on to the stock a while longer — sticking with these conversion stocks past that first big dividend or first special payout, since a few of the examples he gave (including EQIX) continued to rise nicely after that first payment to shareholders.
So that’s obviously not that exciting a “secret,” but at least he’s not just advocating a “dividend capture” where you buy to get the dividend, then sell shortly therafter… which is good, because that doesn’t usually work very well for large dividends and incurs a lot of taxable buying and selling (assuming you’re not using a tax-deferred account like a 401K or IRA, of course — REITs and BDCs are excellent for tax-deferred or tax-free accounts, since the dividends are “ordinary income” for the most part, not tax-advantaged “dividend income”, though MLPs are more complicated when it comes to tax considerations).
Not surprisingly, this “30%” that Mengel dangles in front of us is not the whole picture — there is also going to be, we’re told, an ongoing dividend stream. Here’s how he puts it:
“To even further reduce its tax bill (this company hates paying taxes almost as much as I do), this company is prepared to offer a very attractive dividend.
“Current estimations are looking at 12.5%, paid quarterly.
“That’s a great chunk of change every three months, AND it’s on top of the 30% you’ll earn if you get in by March 25, 2015….
“Now, when you calculate this stock’s yield with the one-time-only payout, you get a massive yield of 20%.”
So who is it? Well, Thinkolator sez we’re dealing with recent BDC conversion Newtek Business Services (NEWT), which has a happy little blue newt as its mascot… they won’t be giving the Geico gecko a real run for his money, but they actually do have a small insurance business, too.
This is a somewhat unusual business development company, because though they are a small business lender (as most BDCs are) they are also an established business services company — they do payment processing and payroll, primarily, though they do also do some other small-scale things like website design and hosting and consulting to help small businesses increase efficiency… presumably a lot of this work is done with the same companies they partner with to do small-scale business loans, so they probably know their customers and their businesses pretty well. Always good for a lender.
This is perceived as a pretty risky enterprise in general, though, lending to small businesses — the economy is doing reasonably well right now, but even in a good economy restaurants fail, dry cleaners go out of business, convenience stores go into bankruptcy. Like most BDCs, which are essentially little investment banks for small businesses, they diversify across a large number of clients so that a single geographic area or single business (or type of business) going into pain won’t crush their portfolio, and they lend to both startups and established businesses and new business acquisitions. They are way down at the low end of the scale in BDCs in the types of companies they lend to, it looks to me after a quick glance like they are loaning to REALLY small companies for the most part, with their average outstanding loan balance somewhere in the neighborhood of $150,000 — mostly collateralized with commercial real estate, tools and equipment, or residential real estate.
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Like other lenders, whether they be BDCs or banks, they earn a lot of their money because of leverage — though BDCs are limited in the amount of leverage they can have compared to banks or REITs. They lend out a million dollars, with half of it from their own equity and half from borrowed money. The borrowed money might cost 4%, for example, and they might charge interest of 8%, so the cost of the loan to Newtek is about 2% and the net margin would be 6% (those aren’t real numbers and may be nowhere near the ballpark, they’re just examples to help visualize). So that’s how being a BDC in general is profitable — their cost of borrowing is a lot less than the interest rates they can earn. The risk comes from the fact that their customers may not be the most credit-worthy businesses in the world, and — as we saw in 2008 and 2009 — sometimes those businesses get in trouble and have problems paying off their loans at just the same time that the cost to borrow for the BDC rises because of risk aversion from banks or other lenders. Still, in the end the better BDCs recovered fine from the recession — though in many cases it took a long time. So is Newtek worth considering?
Well, it’s small and it’s quite promotional, which turns some people off (they’ve hired Tobin Smith’s NBT Equities as a investor relations consultant, it appears, and he’s issued very promotional language about them that’s quite similar to Jimmy Mengel’s ad in parts).
And they do generate the lion’s share of their income from the sneaky-sounding process of originating small business loans that are 75% guaranteed by the government. There’s not necessarily anything wrong with this, but it’s an area where they generate a lot of their profit just from the fact that they can re-sell the guaranteed portion of the SBA loans they make at a big premium, which helps to cover a lot of the risk that they take with their 25%, and I don’t know if that regulatory framework will always be there or not. You can see the way they explain it in their investor presentation here from December, it’s worth getting your head around this idea if you are thinking about buying the stock.
So if you can get yourself a calculation of the risk involved that makes you comfortable, it’s a delightful stock. They will be paying a large special dividend sometime late this year, probably in the Fall (not March — that will just be their first regular dividend), and that will be something in the neighborhood of a 30% special dividend. That’s basically what they have to pay to square the books — paying out the lion’s share of their accumulated profits so that they can be a BDC, since BDCs aren’t allowed to reinvest their earnings into the business. Estimates now from the company are apparently that this dividend will be about $4.50, 80% of which will likely be paid in stock (20% in cash), and that dividend is expected “by the end of 2015.” And yes, a payout is “guaranteed” thanks to the BDC conversion, since the conversion has already taken place… but the amount is an estimate still.
That’s not an ongoing payment, of course — and it will cause the share price to drop (I “guarantee” it!) by just about exactly the amount of the special dividend on the ex-dividend day (the first day that the stock trades without the rights to that dividend attached), so that’s where the talk about an “ongoing 20% dividend” comes from. That would mean essentially that you take your $4.50, lower your cost basis in the stock to about $12 (the stock was at $14.50 or lower a few weeks ago, so they’re using $10 or less as that cost basis), and then you have what the company has predicted to be a regular dividend for calendar year 2015 that amounts to $1.80. So at these prices, $1.80 is 15% of $12 so you’d be getting more like a 15% cash yield after the special payout.
Forecasted annual yields of 15%, of course, generally come at a substantial risk — the current BDCs that get yields like that, including Prospect Capital (PSEC), are perceived as being substantially riskier than some others — like Golub Capital (GBDC), for example, which has a yield of about 7%. Those are just examples, there are dozens of decent-sized BDCs, and the average — if you go by the yield of the ETN that tracks the Wells Fargo BDC Index (ticker BDCS) — is about 8%. So investors are either misjudging the risk at Newtek, or they’re being careful because it’s in transition, or they’re fairly guessing that it will be among the riskier BDCs and should trade at a high yield to compensate investors for that risk level.
I like that it’s a small company focused on small business services, and that their average loans are small and that they have such a sweet deal (not different from others, but it looks sweet nonetheless) with the Small Business Administration and a track record as a major SBA lender and as a loan servicer (fee income without actually lending principal), and I like that they have a track record with their established non-lending businesses that provides both a way to stay connected with their borrowing customers and find new customers, and as a non-correlated income stream.
The lending part of the business will grow rapidly from here now that they’re a BDC and have raised some new capital, and the business services part probably will not grow so quickly so it will probably become an even smaller part of the business, but it seems a worthwhile “side business” for a small business lender to operate. The stock has jumped up in recent weeks, probably largely because of the attention from individual investors who are excited about the high yield and the quick dividend growth expected this year (the first ex-dividend date is March 26, for their initial quarterly 38-cent dividend, and they’ve already telegraphed substantial dividend growth to reach that $1.80 for the year), and partly from the attention driven their way by their presentations, newsletter and promoter attention, and attention from some real analysts and their inclusion in the BDC index.
So… it’s a real company, it’s a small business lender and loan servicer that also provides services to small businesses, it’s going to pay out a lot of cash to shareholders this year… so it really comes down to how risky you think the shares are. They’re not lending to major employers trying to build $3 billion factories in small towns, they’re lending to people who are borrowing $200,000 to buy a local Taco Bell or fund a renovation at their convenience store, so it is a pretty different kind of BDC compared to the larger players that get more attention these days… but it will also, to a great degree, probably move with the sector based on investor assessments of the economy and future interest rate moves, though the BDCs as a group are not quite as reactive to changing interest rate sentiment as are the REITs (if you want to get a good idea of how a stock reacts to abrupt changes in expectations about future interest rates, look at how it did in the late Spring and early Summer of 2013 when talk of “tapering” the Fed’s bond buying brought a rollercoaster — REITs as a whole, as tracked by the VNQ ETF, dropped about 20% on the “taper tantrum” that Spring of 2013 and didn’t catch back up with the S&P 500 until last month.)
And beyond that, I’ll confess to being interested — little companies who do things a bit differently catch my eye, and I’m not immune to fantasizing about 20% dividends… and am interested in diversifying some more of my income investing portfolio away from REITs — but I haven’t done enough research to throw my own money at the company, particularly after it’s been on a run for a few weeks of optimism and enthusiasm. So I’ll leave you to do your own assessment of the stock and see if it’s right for you — do let us know what you think with a comment below.