Newtek Business Services (NEWT) is a business development company with a unique, well diversified business model. NEWT has benefited immensely from policy and societal changes that arose as a result of Covid-19. Although it cut dividends recently, it might surprise on the upside if there is additional government stimulus. With an 11% yield, NEWT makes a decent income investment.

Strategy and Portfolio

NEWT’s lending business is focused on providing loans under various Small Business Administration Programs. It holds one of only 4 Non-Bank SBA lender licenses, giving it an important competitive advantage in the space. In fact it’s the largest non-bank lender under the Section 7(NYSE:A) loan program based on annual origination volume. The Section 7(A) loan program provides loans up to $5 million to small businesses, with government guarantees covering up to 75% It has also been a major lender under the Paycheck Protection Program, which provides small businesses impacted by Covid-19 with with a government guaranteed loan covering up to 2.5 months of payroll costs.

Since SBA loans all have small balances relative to NEWT’s $637 million investment portfolio, it is well diversified across companies industries. Its largest single industry exposure is in “Data Processing, Hosting and Related Services”, a broad category covering mostly B2B technology companies. In the first nine months of 2020, interest income from Section 7(A) loans accounted for 25% of NEWT’s investment income and interest income from PPP loans accounted for 49%.

Small business loans are risky, even with partial government guarantees. Currently ~13% of NEWT’s portfolio is on non-accrual. Fortunately almost all (98.7%) of NEWT’s portfolio is secured by some type of collateral. Commercial real estate is the most common type of collateral, covering just over half of the portfolio.

Source: 10-Q, author’s calculations.

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NEWT’s portfolio is also notable for what it doesn’t have. It avoids derivatives, and complex structured securities such as CDOs. It has also avoided any exposure to the oil and gas sector.

Unique among BDCs, NEWT has multiple streams of recurring income. In addition to the lending business, it has a diverse portfolio of wholly owned business services and technology companies, accounting for approximately 32% of its investments. These wholly owned subsidiaries include electronic payment processing, cloud computing and IT consulting, e-commerce, accounts receivable financing and inventory financing, insurance, and payroll services.

These controlled businesses provide a steady stream of dividends. In the first nine months of 2020, income from control investments provided 13% of NEWT’s investment income. In a “normal” year without the temporary PPP program, subsidiaries will provide over 25% of NEWT’s investment income.

This diverse tech focused business model is well poised to benefit from societal changes occurring in the wake of Covid-19. Unlike banks it doesn’t rely on branch offices, or direct sales force outreach to make loans. Its payment processing business has benefited from an increase in e-commerce business, and an increase in electronic payments. Its payroll services technology was also an integral part of processing loans under the Paycheck Protection Program, which required documentation that funds were used to preserve jobs. Although Covid-19 has hit small businesses hard, NEWT will likely come out of the crisis with a stronger position in several markets.

The Impact Of Government Stimulus

NEWT’s medium term performance will be heavily impacted by government policy. So far, the federal government’s response to COVID-19 has been a major tailwind for NEWT.

NEWT benefited immensely from the Paycheck Protection Program, which provided government guaranteed loans to small businesses provided they kept employees on payroll. It funded more than $80 million in loans, generating $3.1 million in fees during the third quarter alone. Since these loans are guaranteed by the government, these fees are practically risk free. In the most recent earnings presentation, management noted that if there is another round of PPP funding they could generate additional income, and issue a special dividend. Newtek’s CEO also noted that if there is a new stimulus package, their dividend forecast will need to be revised up. All BDCS have benefited from the government’s aggressive stimulus programs, but NEWT has probably benefited more than most , because it an SBA lender that provides a broad spectrum of services to medium sized businesses

This slide from the latest management presentation emphasizes the outsize role the PPP has on NEWT’s business:

Source: Earnings Presentation

Dividend

NEWT reduced its latest quarterly dividend from $0.58 to $0.47. This will bring the total dividend for 2020 to $2.05 per share, down from $2.15 in 2019. Given the stock is actually up slightly since this announcement, it’s clear that the market had low expectations for NEWT’s dividend. Even after this cut, it still has a 10.75% forward yield. Its 2021 forecast is $2.00 and $2.50 in dividends. NEWT’s quarterly dividends vary depending on how much investment income it generates. Since it avoids overpaying, it has been able to maintain and grow NAV over time.

Notably management’s forecast for 2021 dividends assumes there will not be a third round of PPP, and there will not be any additional stimulus. If Congress pushes through additional stimulus programs, NEWT’s yield will end up being higher than expected

Management Incentives

Approximately 90% of publicly traded BDCs are externally managed, but Newtek is internally managed. This has important implications for shareholders. External management can create conflicts of interest. Management companies might use more leverage than otherwise justified in order to increase their fees. External management companies might also charge additional fees for transaction or advisory services to portfolio companies. Externally managed BDCs across the board tend to have higher expense ratios. Newtek is relatively unique because it avoids these conflicts.

Moreover, NEWT’s management has skin in the game. They own approximately 6.3% of outstanding shares. Moreover, the CEO made open market purchases in May, September, and November of this year. Management clearly believes in the business, and their incentives are well aligned.

Key Risks

NEWT generates income from a wide variety of business lines. However all of its income depends on small and medium companies, which are much more vulnerable to macroeconomic downturns. Closely related, NEWT’s entire business is built on making use of government policies to benefit small businesses. Therefore, it remains highly vulnerable to sudden shifts in public policy.

In 2021, NEWT will face two main policy risks. The first is that there will be an aggressive crackdown on allegedly fraudulent PPP loans. There has been growing concern over fraudulent PPP loans among policymakers. Even if NEWT’s loan book doesn’t have problems, responding to government inquiries could prove to be expensive. Second, there is gridlock in the federal government, it could reduce future stimulus. Without additional stimulus many more of their borrowers might face problems. Federal government gridlock combined with state level Covid-19 lockdowns would probably be the worst case scenario for NEWT’s loan book and business model.

Although there might not be an additional round of PPP funding, its exceedingly unlikely that the 7(A) program, which provides most of NEWT’s income in normal years, will be cut. Additionally, current management guidance is conservative in that it doesn’t assume additional government stimulus. Therefore these policy risks are well compensated by the strength of NEWT’s overall business.

Conclusion

NEWT’s unique business model makes it more resilient to a credit crisis than typical BDCs. Its unique position as an SBA lender is likely to continue to be lucrative. The internal management structure, and high insider ownership is also beneficial for shareholders. With a yield of ~11%, NEWT makes NEWT a great option for income investors. I’ll continue to hold NEWT and will look to add to the position on any market weakness.

Disclosure: I am/we are long NEWT. 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.