Rising M&A Competition And Lower Rates Will Pressure Earnings Despite Fair Long Term Outlook

Catalysts

About Gladstone Investment

Gladstone Investment is a business development company that acquires and finances lower middle market businesses through a combination of debt and equity investments.

What are the underlying business or industry changes driving this perspective?

• Persistently competitive M&A conditions and abundant private capital make it harder to source buyouts at attractive entry multiples. This can limit future capital gains and pressure earnings growth.
• Potential easing in benchmark interest rates over time could erode the benefit of currently elevated interest rate floors on the debt portfolio. This may lead to slower growth or eventual compression in net interest income.
• Macroeconomic uncertainty, including tariff volatility and uneven consumer demand, may weigh on certain portfolio companies and increase the risk of additional nonaccruals. This could constrain revenue and net margin expansion.
• Broader multiple compression across private markets, already noted in portfolio valuations, may persist as the industry normalizes from a high-valuation cycle. This may dampen unrealized appreciation and realized gains and thereby moderate earnings.
• Reliance on ongoing access to accretive equity issuance and reasonably priced debt to fund a robust pipeline could become a headwind if capital markets reprice risk. Higher funding costs could pressure net margins and earnings growth.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Gladstone Investment's revenue will grow by 6.1% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 95.0% today to 7.6% in 3 years time.
• Analysts expect earnings to reach $8.9 million (and earnings per share of $0.18) by about December 2028, down from $92.8 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $10.1 million.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 102.0x on those 2028 earnings, up from 6.0x today. This future PE is greater than the current PE for the US Capital Markets industry at 25.2x.
• Analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.77%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• If the current strong deal pipeline converts into a higher pace of accretive buyouts at attractive valuations, sustained capital deployment into high yielding debt and equity could drive higher investment income and capital gains, supporting growth in revenue and earnings.
• Management is gradually targeting larger portfolio companies with more consistent EBITDA. If this shift results in stronger operating performance and higher exit values, it could accelerate net unrealized and realized gains and lift net margins and earnings.
• Elevated interest rate floors in the debt portfolio and improving performance at key holdings could continue to support high yields even as SOFR normalizes. This may underpin further growth in total investment income and stabilize or expand net interest margins.
• Restructurings like J.R. Hobbs that turn nonaccrual assets into performing loans and valuable equity can transform realized losses into long term income streams and appreciation, potentially increasing net asset value, net margins and earnings.
• A strong liquidity position, ongoing access to equity through an accretive ATM program and ample borrowing capacity could enable Gladstone Investment to scale the portfolio through cycles, which may support sustained growth in assets, revenue and long term earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of $14.12 for Gladstone Investment based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be $116.6 million, earnings will come to $8.9 million, and it would be trading on a PE ratio of 102.0x, assuming you use a discount rate of 9.8%.
  
• Given the current share price of $13.96, the analyst price target of $14.12 is 1.2% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.