3 days Ago
J Studios In my previous article on Runway Growth Finance (NASDAQ: RWAY ) I laid out a quite bearish thesis making a case for investors to avoid investing in this BDC due to significantly worsening portfolio quality and dropping NII generation. In other words, the risk profile of RWAY increased to such a level, where it just did not make sense to have a buy rating, especially considering the prevailing sector-level headwinds (e.g.
, increased corporate distress levels, shallow M&A activity and general spread compression). Since the publication of the recent piece (June, 2024), RWAY has registered negative alpha. As the chart below shows, the total return performance has been very negative, while the broader BDC index has remained somewhat flat.
Ycharts With this in mind, let's now take a look at the Q2'24 earnings deck to understand whether after this correction, the price has decreased low enough to potentially substantiate a buy rating. Thesis review Before we dissect the Q2 data points, it is critical to take into account the context of the current discount to NAV. Namely, as of now RWAY trades at P/NAV of 0.
78x which is way below the s ector average of 0.97x and theoretically implies a great opportunity to benefit from multiple convergence. The question is whether RWAY will be able to achieve the necessary results that would accommodate higher multiple and/or mitigate the risks, which the market is currently clearly pricing in.
Now, speaking specifically of the Q2 earnings dynamics, the overall results continued to decline. For example, during the quarter RWAY generated total investment income of $34.2 million and net investment income of $14.
6 million, which is materially below the results achieved in the prior quarter - $40 million and $18.7 million in total investment income and NII, respectively. As a result of this, the NII per share has dropped to $0.
37, which is lower than the current quarterly dividend of $0.40 per share. The primary drivers behind the deteriorating results are related to declining portfolio base, spread compression and increased non-accruals.
While the first two items stem from the structural headwinds that are relevant for most of the BDCs out there, the third one (non-accruals) is rather RWAY-specific. The issue on top of the overall sector-wide challenges lies in RWAY's portfolio, which has lately been characterized by underperforming assets. For instance, just in Q2 , RWAY recorded an additional markdown of $5.
9 million. Plus, even after all of the adjustments and full writedowns, RWAY ended the quarter with two non-accrual loans, which together accounted for 3.1% of the total portfolio fair value.
The current percentage is not that large, but given the previous writedowns, the picture does not look that solid. An additional point of concern is that the portfolio quality (on an average portfolio risk rating basis) has continued to increase, reaching 2.47% (up by 3 basis points from the prior quarter).
In terms of the income quality, the current situation could be better as well. Namely, the PIK component remained relatively notable constituting ~7% of the total income generated by RWAY. In the context of already exhausted (or breached) dividend coverage level, receiving income that is not in the form of pure cash is quite suboptimal, making it even more difficult for m anagement to cover the existing dividend in a sustainable fashion.
The only positive I would note is that the absolute amount of new investments has gone up compared to the prior quarter. During Q2 RWAY managed to attract $75.5 million of new investment opportunities, which was more than enough to offset the repayments that came in at $25.
3 million (also below the Q1 figure of $34.5 million). So, we have some encouraging data points both on the new funding and the repayment front.
Yet, if we consider what Greg Greifeld (Managing Director, Deputy CIO and Head of Credit) stated on the recent earnings call , the future outlook on the M&A end does not seem that promising: I want to reiterate David's sentiments. We plan to thoughtfully accelerate origination growth moving forward, and these initiatives do not mean that we expect to drive incremental portfolio expansion every sequential quarter. However, it does mean that we're confident in our position to deploy capital from our balance sheet and redeploy capital that may come from prepayment activity.
As we evaluate various investments in our pipeline, we see a path to executing select transactions at more opportunistic terms in situations where we're confident the borrower is positioned to outperform. In other words, we might see a slight and gradual growth, but nothing that could be considered meaningful. Given the current gap in the dividend coverage and the other headwinds from spread compression and challenging portfolio quality statistics, RWAY has to have really significant growth agenda in order to offset these pressures through larger portfolio size.
In theory, looking at RWAY's balance sheet, the financial capacity to accommodate growth is there. For example, the leverage ratio ending the Q2, 2024 quarter stood at 1.1x, which is slightly below the sector average and certainty offers an optionality for RWAY to assume more debt to fund the expansion.
However, if the NII generation per share level remains consistently below the dividend amount and, in the worst case, if RWAY keeps recording incremental non-accrual positions, this capacity could quite quickly disappear. The bottom line Given the above, I just do not see a way for RWAY to increase its NII generation profile that would be sufficient to cover the dividend and leave some undistributed capital for growth purposes. It seems that the only way to avoid tapping into the debt financing sources in order to fund the dividends and growth is to make a deep cut to the current distribution level.
Since this is a base scenario, in my opinion, the existing discount will not matter that much once the announcement of a dividend cut happens. In practice, whenever dividend reductions are announced, the share price reaction is negative. As a result of this, I remain bearish on Runway Growth Finance, and would be willing to take another look after the dividend cut is announced.
At the same time, I would not recommend shorting this BDC as the discount is indeed steep, which means that there has to be only one somewhat positive data point to trigger a notable price appreciation movement. Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions.
I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Seeking Alpha's Disclosure: Past performance is no guarantee of future results.
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