Apollo Investment (NASDAQ:AINV) reported stellar earnings for the March quarter and left the dividend unchanged at $0.36. With the report, it is clear that the latest model, the Howard Widra, is now out on parade. Bring a camp chair, sit for a spell, while the parade’s grand marshal passes.

The Quarter

The parade opens, “Beginning with our results, Net investment income for the quarter was $0.42, which reflects a slight increase in interest income and strong fee and prepayment income.” The company announced an unchanged dividend of $0.36 payable in early July. Leverage held steady at 1.51. But, the big news was the elimination of non-core designations after the company exited or is about to exit all of the remaining non-core holdings.

Net asset value per share dropped a little, appropriately 2%, to $15.79 from small changes from non-core divestment and from a loss of three aircraft that were leased in Russia. The company expects a full value payment from insurance for the three lost aircraft.

Two formerly non-core assets, Carbon-free and Glacier, are now considered core.

High Leverage or Is It?

For us, the most important discussion concerning leverage finally happened. Some believe that Apollo’s model using zero 2nd lien and premium 1st lien investments while leveraging in a 1.40-1.60 range is risky. So, from our investor point of view, the back and forth between the CEO and analysts discussing leverage vs. investment quality is essential. We begin with noting that the corporate revenue portfolio is 94% 1st lien with a weighted average attach reporting of 0.2x. 0.2x means that all of its 1st liens are at or close to the most senior level.

Continuing, during the call, Arren Cyganovich of Citi Global Markets asked, “And then you’re still in kind of at around 1.5x net leverage. It’s still not super high relative to your limit, but it is higher than I’d say most BDCs have been operating new lending portfolios. Is there an intention to bring that down? Or do you continue to expect to run around the 1.5?”

Howard Widra. Apollo CEO, answered, “Yes. I mean we’ve talked about our range being 1.4 to 1.6, but likely on the sort of the lower end of that range. . . So, this goes to the underlying risk of the portfolio in large amount, like when we continue to focus on trying to focus on everybody that our attachment point is 0.2. . . And so if we’re 1.5x leverage and we’re true senior where we’re at 1.25 leverage, and we have a turn in front of us. They’re actually the same on a risk perspective.”

Continuing, Wildra added, “So, we feel like from a risk perspective, we’re actually at a very similar range to what people are doing, . .”

The CEO also noted in the discussion that management plans to lower the leverage a bit with uncertainty on the horizon. Although he didn’t specifically state how far, our guess is that it will be into the lower end of Apollo’s target or near 1.4-1.45.

From an investment point of risk, Apollo sits in the 1.2-1.3 risk range with this format, very similar to others such as Ares Capital (ARCC).

Calculating the Worth of Model

With the conversion complete, it seems important to understand what future distributions might equal, and as with any company, the moving parts can be many. Changes affecting coming distributions may include: slight increases from FED interest rate hikes, a reduction in Merx exposure, changes in fees and leverage.

Management noted that the coming change in interest rate spreads could add an additional $0.07 per year in earnings plus $0.19 in net asset value.

With respect to Merx, again the call included this statement, “AINV’s investment in Merx, had a fair value of $299 million, representing 12% of the total portfolio at the end of March. It is our intention to reduce our investment in Merx through selling aircraft and deemphasizing its servicing business.” Our own guess is that this business exposure will be in half or to 6%. With Merx being a significantly higher return, a slight demise in earnings will occur. To help investors understand what this change might be, we included the following slide.

Per the above slide, Merx generates approximately 10% yield at 12% of the total portfolio. The balance of the investment earn 7.8%. If the company lowered Merx to 6% while investing the balance at 7.8%, the change in earnings equals approximately $0.750 million per quarter (Total portfolio of 2.530 billion times 0.06 times 0.02). Based on this last quarter report, the net change equals approximately 0.75/26.88 or a minus 0.01 against net earnings.

Next, we deal with the lower fees affect. Management stated, “As a reminder, AINV’s incentive fees on income include the total return hurdle with a rolling 12 quarter return hurdle with a rolling 12 quarter. Given the net loss during the quarter inside of fees during the quarter totaled approximately $1 million compared to $5.4 million last quarter.” The difference at $4.3 million represents exactly the difference in net earnings at $0.42 vs. $0.35-6. We included a slide showing the last five quarters of operating results.

One interesting result shown in the above slide is that even with a million in fees during March, the operating earnings equaled $26 million plus. In the June and March quarters of last year, the company earned in the middle $25 million range without fees.

A table summarizing the pluses and minuses going forward follows:

*Disregarded changes from the sell and reinvestment in several non-core assets. The reinvestment could actually add to earnings.

In the long-run, earnings at Apollo appear to be focused at $0.35-$0.37 per quarter with dividends in that range. But, management also noted that a lower leverage will be targeted in the near future until the business environment improves. We stated above that our belief is that 1.40-1.45 leverage is coming over the next few quarters. In evaluating a net leverage change effect on earnings, we turn to an old article, Apollo Turns a Corner, in which estimated the effect of leverage. “If each 0.1 in leverage adds $4-5 million in earnings, expanding leverage from 0.93 to 1.4, Apollo’s goal, increases earnings by roughly $20 million.” This calculation excluded the 20% fee, thus a change of 0.05 to 0.1 in leverage could reduce earnings by $1.5 – $3.0 million or 7% – 13%. (In a more normal quarter that would equal $0.315 to $0.35 in total earnings per share.) This is a temporary situation. A yearly earnings of $1.25 to $1.40 seems reasonable for the near future. At today’s prices near $12, the yield would be 10.5% to 11.5%. Today’s full leverage yield equals 12%.

Conclusion & Risk

The business model driving Apollo is settled, filled with lower risk top of line 100% floating 1st lien investments. The last several quarters show a measured level of stability in earnings being in the $0.35 range. What is gone or leaving are the balance of the non-core businesses plus a lower exposure to the more volatile aircraft leasing business. Management seems to have turned this Business Development Company (BDC) into a less risk operation with high probabilities for steady returns. In our view from the camp chair, the Grand Marshall, the Howard Widra, is a strong buy with this caveat, buy in chunks on market weakness. The risk from economic uncertainty prevails. Opening positions must be through thoughtful ways.