Monday, April 14, 2014

FS Investment Report: April 2014

This report includes projected EPS and dividend coverage with best and worse case scenarios, price targets and recommendations, risk considerations and rankings compared to the other 25 BDCs that I cover, total return and earnings estimates for dividend sustainability including the potential for dividend growth. I will also include an interest rate sensitivity analysis that discuss the potential impacts to income and expenses if interest rates begin to rise with a side by side comparison to other BDCs. To sign up for this report to be sent to you when it comes out tomorrow please see below.

FS Investment (FSIC) has been operating as BDC since January 2009 and I will be adding to my coverage this week after its IPO tomorrow listed on the NYSE.  FSIC is managed by affiliates of Franklin Square Capital and sub-advised by affiliates of GSO Capital Partners, the credit platform of The Blackstone Group.  Last week I spoke with management regarding its strategic direction and approach to investing. This will be one of the larger BDCs that I follow with a $4.1 billion portfolio that is 82% senior secured loans (see table below), growing net asset value (“NAV”), recently increased its monthly dividend and announced special dividends for Q3 and Q4 of this year.  The good news for investors is that FSIC does not have exposure directly related to the Russell indices because it is not public yet.  I will have a special report coming out before the IPO with pricing, projections and dividend coverage as well as its relative risk profile and rankings.

Highlights for FSIC with associated rankings:
  • Dividend growth of 10% over last 12 months (ranked #3)
  • Dividend coverage of 113% using core NII (ranked #3)
  • 9% NAV growth over the last 24 months (ranked #4)
  • Special dividends announced of $0.20 for 2014 (yield of 2% using NAV)
  • Current monthly dividend of almost 9% annual yield using NAV
 



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Sunday, April 13, 2014

FSC Report: April 2014



Fifth Street Finance (FSC) is a component in my suggested ‘High-Yield’, ‘Underdog’ and ‘Value’ BDC portfolios due to having a higher than average dividend yield and lower than average multiples.  Last year FSC implemented a multi-point plan to increase returns to shareholders and the company has already seen strong results and hinted at higher dividends later this year.  Currently FSC is trading at a discount for two reasons: two dividend cuts in the last three years and continually raising equity capital.  I believe this is in the past and the company will be more prudent with using capital efficiently and is headed in a direction that could lead to dividend increases.

During the most recently reported quarter FSC grew its portfolio by 26% and more than any other BDC by almost double. The company accomplished this through the use of debt capital only and increased origination efforts.  There are pros and cons to this amount of growth including increased net investment income (“NII”) along with risks associated with increased lending in a ‘frothy’ environment.  I believe FSC still has a safer than average risk profile but has recently taken on more risk.  This is a deliberate effort to cover and grow dividends for shareholders.

Some of the new initiatives should have positive impacts over the coming quarters.  My favorite is the venture based lending platform that focuses on high growth portfolio companies that are venture backed (see page 15).  Other BDCs with a similar focus have experienced much higher amounts of net asset value (“NAV”) per share growth and/or pay special dividends. In the last few weeks this team has closed three deals and a strong pipeline as well as had one company with a warrant position file for an IPO.  Another platform that is almost complete is its Senior Secured Loan Program (SSLP) that is similar to other BDCs to provide increased yields from safer than average loans through taking a second lien position to a more senior partner such as Ares Capital (ARCC) and its program with GE (see page 10).  This could also lead to higher fee income as well.

As these new initiatives start to increase returns to shareholders I will include in my total return projections but for now investors can rely on the 10.7% dividend yield with a stable NAV and a safer than average amount of risk.

This report includes updated projections, recommendations, pricing, rankings, total return and earnings estimates for dividend sustainability including the best and worst case scenarios along with the potential impacts to dividend growth. It also includes an interest rate sensitivity analysis that discuss the potential impacts to income and expenses if interest rates begin to rise with a side by side comparison to other BDCs.  There is a new section covering the potential impacts from being excluded from the Russell 2000.

This report is not publicly available, will not be published on Seeking Alpha and is $9.95 or if you would like to become a premium subscriber and receive this report plus 19 more (20 total) for $50 or 60 reports for $125, please visit “Premium Subscriber”.

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Thursday, March 27, 2014

Total Return BDC Portfolios

This portfolio attempts to find the best of breed BDCs for 2014 and is for investors that want dependable regular dividends and the potential for special dividends as well as long-term capital appreciation from increased stock values. The returns from this portfolio will most likely be higher and have more favorable tax treatments while requiring less turnover. I have decided to break this portfolio into two for investors that want less risk and others that want higher returns.

Click here to see previous Total Return articles.

Currently the lower risk portfolio includes:


Currently the higher return portfolio includes:

 

Wednesday, March 26, 2014

GLAD: March 2014 Report



Summary and Recommendations

Gladstone Capital (GLAD) is a component in my suggestedHigher Total Return’ and ‘Underdog’ BDC portfolios due to its much higher than average returns but along with higher amounts of risk.  I have changed my recommendation from a ‘Hold’ to a ‘Buy’ but investors should be aware of the increased amount of risk compared to the other BDCs I recommend.  If the price moves higher toward the upper end of my price targets I will change it back to a ‘Hold’. The reasons for changing my recommendation was based on improved credit quality, net asset value (“NAV”) growth, commitment to dividend coverage, low use of leverage, selective portfolio growth and expected total return.  

Over the last 6 months GLAD has provided total returns of 17% to shareholders and well above most BDCs (if not all).  This is mostly due to recent increases in its NAV per share and investors paying higher prices.  However it is still trading under NAV.

The key risks are related to the potential opportunities including depressed values of portfolio investments.  Historically GLAD has been near the bottom of my rankings but has shown signs of improvement over the last two quarters with 17% growth in NAV per share.  I believe there is a good chance for future NAV increases but this is dependent on many factors some of which are external (see page 14).

The depressed portfolio values have come from a combination of having higher than average amounts of subordinated debt (see page 8) along with originations during periods of increased competition and potentially less protective covenants before the financial crisis.  GLAD has also had issues with exposure to the broadcasting and media sectors, specifically radio, that were disproportionately impacted by the recession (see page 9).

GLAD has not grown the portfolio over the last few years and has focused on improving credit quality and increasing value to shareholders.  The external manager has been waiving fess “to ensure distributions to stockholders, were covered entirely by net investment income. 100% of common and preferred stock distributions paid in over the last three years were covered by NII.”

This article discusses the pros and cons of investing in GLAD along with earnings projections, dividend sustainability and growth potential over the coming quarters including best and worst case scenarios as well as key risk considerations, updated rankings/pricing compared to the other 25 BDCs that I follow.

Also included:
  • Interest rate sensitivity analysis
  • Timing for future share issuances
  • Projected total returns compared to the other BDCs
  • Price target based on expected total returns
  • Pricing based on multiples of NAV and projected earnings
  • Overall rankings and recommendations

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Monday, March 24, 2014

PFLT: March 2014 Report


Summary and Recommendations

PennantPark Floating Rate Capital (PFLT) is a component in my suggestedRisk Averse’ BDC portfolio due to its safer than average risk profile. PFLT was founded by Arthur Penn in 2010 who also co-founded Apollo Investment (AINV) in 2004 and PennantPark Investment (PNNT) in 2007.

PFLT is not the ‘sexiest’ BDC and is for investors that want solid returns without the average amount of risk assumed with other BDC investments.  PFLT focuses on high quality, 1st lien senior secured investments at floating rates. Over the last three weeks its stock price has outperformed most of its competitors (see page 10) and will hopefully continue to do so in down markets.

One thing about PFLT that surprised me was the interest rate sensitivity analysis (see page 8) with lower than expected returns as rates begin to rise.  This is mostly due to having 100% of borrowings at variable rates.  

PFLT is an investor friendly externally managed BDC with the lowest base management fee in the industry.  Thanks to this lower fee structure even my worst case scenario has PFLT covering dividends in 2014.  As the company begins to mature I believe it will continue to increase its dividends in the coming quarters (see page 6).

If the current stock price rises there is a high probability that the company will issue additional shares next quarter but management has stated that it will not have an offering below book value (currently $14.24).

This article discusses the pros and cons of investing in PFLT along with earnings projections, dividend sustainability and growth potential over the coming quarters including best and worst case scenarios as well as key risk considerations, updated rankings/pricing compared to the other 25 BDCs that I follow.

Also included:
  • Interest rate sensitivity analysis
  • Timing for future share issuances
  • Projected total returns compared to the other BDCs
  • Price target based on expected total returns
  • Pricing based on multiples of NAV and projected earnings
  • Overall rankings and recommendations

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Tuesday, March 18, 2014

PNNT: February 2014 Report

This is a sample ‘premium’ BDC report and if you would like to subscribe it is $50 for 20 reports through June 30, 2014 or $125 for 60 reports through December 31, 2014 as soon as they are available.  If you would like to sign up for these reports please visit "Premium Subscribers".

Please keep in mind that the actual reports are downloadable in PDF format.



Summary and Recommendations

I have upgraded PennantPark Investment (PNNT) to a ‘Buy’ and added it to my ‘higher total return’ BDC portfolio due to its higher than average dividend yield and net asset value (“NAV”) per share growth.  PennantPark Investment was founded by Arthur Penn who also co-founded Apollo Investment (AINV) in 2004.

One of the keys to PNNT’s strategy that allows it to grow NAV more than other BDCs is its ‘equity co-invest’ strategy of having an equity investment in many of its portfolio companies.  I believe this is more of a partner type approach to lending with upside potential for investors.  At this point PNNT is a mature BDC that has reached its optimum dividend rate with little room for growth.  However I believe the dividend is sustainable through mostly recurring income and through the use of increased leverage to offset potential declines in portfolio yield (see page 7).

I consider PNNT to have an average risk profile due to its investment mix, portfolio companies leverage ratio of 4.4 times EBITDA (see page 10) that is near the industry average and no loans on non-accrual status.  My primary concern is its higher than average portfolio yield and the potential for early repayments and falling yields.  

Currently PNNT is increasing its use of leverage and plans to tap its second SBIC license with $75 million in potential financing at attractive long-term rates.  This will lower its overall cost of capital and increase returns in the coming quarters.  I do not expect an equity offering until late calendar Q2 or early Q3 as management has given guidance regarding increases in leverage to fully cover dividends first.

Thanks to the research in this report I will most likely be starting a position in PNNT on the next dip due to its higher than average returns for average amounts of risk. At this point I believe the correct price for PNNT is between $12.25 (based on multiples of NAV) and $12.75 (based on projected returns).  

Growth Capital

Management has recently stated “We have plenty of liquidity, as of December 31, we had in total nearly $300 million of available liquidity consisting of $190 million of available credit facility, $75 million of new SBIC debt financing in our second SBIC and over $30 million of cash on hand. As a reminder we have exemptive relief from the SEC to exclude SBIC debt from our asset coverage ratios and SBIC accounting is cost accounting, not mark to market accounting. These facts highlight how the SBIC debt reduces overall risk of the company.”


Currently SBIC loans are at a lower rate than the previous borrowings and as PNNT uses this long-term fixed rate debt it will lower its overall borrowing costs.  When asked about future uses of debt, management responded with “We have funded the equity in SBIC too. We are looking forward to drawing down that. Again it’s very idiosyncratic about what deals come in and do they indeed fit the box of the SBIC in the definition of what are small businesses for that box. Clearly, if we find deals that fit, we would love to put them in there, I’d say the outlook is probably again over the next 6 to 12 months, where we can more fully utilize or fully utilized that $75 million of potential financing.”

If PNNT decided to increase its debt-to-equity ratio to 0.80 (including SBIC debt) and used $15 million in cash it could grow the current portfolio by another 11% without the need for additional equity.  This is less than the average BDC with the ability to grow by over 20% without issuing additional shares.

PNNT has historically used leverage ratios between 0.45 and 0.85 and the chart below shows debt and equity levels since 2011.  


PNNT has been slowly increasing its use of leverage to maximize returns to shareholders.  The next equity offering will probably be in late calendar Q2 or Q3 2014 depending on portfolio growth.  The following table shows my net portfolio growth assumptions of $75 million per quarter funded with debt and cash for calendar Q1 and then an equity offering in calendar Q2 followed by additional debt.



Earnings Projections and Dividend Sustainability

PNNT has a slow and steady approach to growing its portfolio with an increase of only 14% over the last 12 months.  I believe this is partly due to its careful selection of portfolio companies and an effort to maintain a higher than average portfolio yield.



Portfolio yields have been steady at around 13% over the last few quarters but given its higher than average yield and the potential for early repayments as well as future originations at lower yields I believe PNNT will experience slightly lower yields in the coming quarters.  New originations last quarter were added at an average yield of 12.4% that is more in-line with the industry.  I have assumed a decline of 0.1% per quarter.

Other income has not been a major driver for PNNT and I consider this a positive since it can be lumpy and inconsistent for projecting BDC earnings.  I have used the average from the last 12 months going forward.

I have included the new debt borrowing rates of around 3.2% on additional SBA debt and Libor plus 2.75% for the credit facility.  The base management fees are driven by the amount of gross assets at 2% a year paid quarterly. The incentive fees are par for the industry at 20% of pre-incentive net investment income and gains.

As you can see the resulting net investment income (“NII”) per share is around $0.28 per quarter and this is roughly in-line with current analyst estimates but my projections include mostly conservative assumptions regarding yield and dividend income with increased shares from an equity offering in calendar Q2.



Worst Case Scenario
 
I assumed no quarterly net portfolio growth, reduced the portfolio yield by 0.2% per quarter and reduced dividend and other income to $1 million.  I also assumed the company would not need to raise equity.  The NII per share would fall to between $0.24 and $0.25 and around 10% short of covering dividends over the next few quarters. 

Best Case Scenario

I assumed quarterly net portfolio growth of $125 million, a portfolio yield of 13.1% with dividend income of $4 million.  In this scenario I also assumed the company would need to raise $140 million in an equity offering with 12.5 million shares and the NII per share would be between $0.30 and $0.31 covering dividends with a 10% surplus as shown below.  


My estimates are near the average of these scenarios and maybe skewed conservatively with NII barely covering dividends.

Optimal Leverage and Dividend Potential

As discussed earlier PNNT is slowly increasing its use of leverage for higher returns.  Management stated on the last call “So we are – look we won’t change our view about what appropriate leverage is for this portfolio, we believe it’s 0.6 to 0.8 times. Again, it’s 0.4 times excluding the SBIC debt, which is our SEC exemptive relief. Hopefully we can slowly grow and still maintain our debt discipline. We are not sitting here micro managing whether a 0.6 or 0.65 or 0.7, we need to find good deals and we need to find good deals first to replace the deals that are good deals that are getting refinanced.”

I ran six different scenarios with various levels of leverage and using the current yield of 13.2% and a lower yield of 12.6% to determine the impacts on dividend coverage.  Each of these scenarios assumes a full quarter of benefit from interest income but also a full quarter of interest expense, management and incentive fees.  I have used the same dividend and other income assumptions.  The following table shows each scenario along with the impacts to dividend coverage:


These scenarios assume the highest level of efficiency and actual results will be lower because there will always be some turnover in the portfolio (that could drive higher fee income).  The company has stated that it is willing to have NII per share that does not completely cover dividends while it repositions the portfolio for a few quarters and I believe this is the sensible thing to do.   

The following are some recent statements from management regarding dividends:

“if we wanted to put the money out of work today and happy to cover our dividend we could do that. First and foremost, we have to pick the right credits and preserve capital. Also this is – our decision is that we are not going to cut the dividend at this point since we do think we can gradually and slowly grow and maintain our investment discipline.”

“We have met our goal of a steady, stable and consistent dividend stream since our IPO nearly seven years ago despite the overall economic and market turmoil throughout that time period. We are one of the only BDCs to not cut its dividend during this time period. We anticipate continuing the steady, stable dividend stream going forward.”

I believe these statements along with my financial projections including best, worst and baseline scenarios as well as the leverage vs. yield analysis indicate a strong level of dividend sustainability but without much room for growth.

Interest Rate Sensitivity Analysis

As of December 31, 2013, PNNT had around 52% of its investments at floating rates and almost 53% of its borrowings at floating rates as well.  However many of its investments have higher floors than the average BDC implying less upside potential.


PNNT provides information about how changes in rates would impact NII and I have done my own analysis using that information and the financials.  The following table assumes that borrowings for this coming quarter will be in part from fixed rate SBIC debt and the rest from its credit facility with floating rates and shows the impacts to income and expenses as interest rates rise.  My projected annual NII impact for a 200 and 300 basis point increase in rates is a loss of $0.5 million and a gain of $2.1 million, respectively.  At this point I do not believe PNNT is positioned well for rising rates and has less upside potential compared to other BDCs.


Revised Rankings and Potential Risks

My key concern for PNNT is its higher-than-average portfolio yield and the potential for heavy amounts of prepayments similar to my analysis for Triangle Capital (TCAP) in “Triangle Capital Suffers From Repayments: But Is It An Opportunity?  Currently 60% of its investments are first or second lien secured debt, 29% are subordinated notes and the remaining 11% in equity and warrants.  Its weighted portfolio yield of 13.2% is higher than the average BDC with yields closer to 12%.  A good sign that a BDC is maintaining its underwriting standards is decreasing portfolio yields as the industry experiences compression due to increased competition.  As previously discussed PNNT has maintained a fairly steady yield.  The charts below show the difference in portfolio mix between PNNT and its sister BDC PennantPark Floating Rate Capital (PFLT).  Obviously these BDCs have different investment philosophies and yields, with PFLT currently at 8.1%.


Portfolio debt-to-EBITDA measures the weighted average portfolio debt as a multiple of cash flow.  Ratios greater than five times usually indicate that a company is likely to face difficulties in handling its debt burden, and is less likely to be able to raise additional loans required to grow and expand the business and it can result in a lowered credit rating.  

On the last earnings call the CEO mentioned “The cash interest coverage ratio, the amount by which EBITDA or cash flow exceeds cash interest expense continued to be a healthy 2.7 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt-to-EBITDA on the overall portfolio was 4.4 times, another indication of prudent risk.”  As a comparison PFLT’s portfolio is currently leveraged at 3.7 times and recently reviewed Fidus Investment (FDUS) is 3.8 times but there are quite a few BDCs that have been investing in companies with much higher leverage ratios such as AINV at 5.2 times and ACAS at 5.6 times.  

Another positive sign is the slower portfolio growth as the company makes more selective investments.  Management has explained “We have continued to be selective about which investments we make in this environment. Given our strong origination network and the size of our company, we believe we can continue to prudently grow. We remained focused on long-term value and making investments that will perform well over several years and can withstand different economic cycles. We continue to set a high bar in terms of our investment parameters and remain cautious and selective about which investments we add to our portfolio. Our focus continues to be on companies or structures that are more defensive, have low leverage, strong covenants and high returns. With plenty of dry powder, we are well-positioned to take advantage of the investment opportunities as they arise.”

“As a result of our focus on high quality and new investments, solid performance of the existing investments and continuing diversification, our portfolio was constructed to withstand market and economic volatility.”



Despite the financial crisis PennantPark entities have had only seven non-accruals out of 380 investments.  While I am concerned about the higher portfolio yield that is not declining as quickly as other BDCs, the average leverage ratios of the portfolio companies and no loans on non-accrual status indicate adequate portfolio credit quality.  For these reasons as well as having an average portfolio investment mix PNNT’s risk ranking remained at 5.3 out of 10.0 (10 implying the least amount of risk).

I have improved the profit ranking from 3.7 to 4.2 due to the revised projections and a higher likelihood of sustaining dividends but not as likely to increase them as BDCs with higher profit rankings.  I consider PNNT to be underpriced at this point giving it a ranking of 7.0 for the valuation category.  The much higher than average return ranking includes the higher than average dividend yield as well as higher amounts of historical and projected NAV growth.



Projected Total Return

Total return accounts for income and capital appreciation. Income includes regular and special dividends and capital appreciation represents the change in the value of the investment.  

The following table shows the recent growth in NAV per share along with the current dividend yield.  This is why PNNT is part of the ‘higher total return’ portfolio because it has higher amounts NAV per share growth along with a higher than average dividend yield.


Gladstone Capital (GLAD) is an outlier in this chart with historically large declines in NAV and a portfolio at 83% of cost with a lot of ground to make up for.

One of the primary methods that BDCs use to increase value to shareholders is through equity participation in portfolio companies.  I believe this is more of a partnership approach and gives the lender skin in the game so that all parties are aligned.

Management explains their approach as follows:

“To refresh your memory about our business model we try as hard as we can to avoid mistakes but default and realized losses are inevitable as a lender. We are proud of our track record of underwriting credits through the cycle. One way we mitigate those losses is through our equity co-investment portfolio. We are optimistic that our co-investment portfolio will generate gains over time.”

“We continue to be able to get the options to co invest in the equity. We usually negotiate that option so to us each layer of the capital structure needs to be debated separately refresh the sense whether we like the debt and we think the debts taken. And secondly, do we want to co-invest in the equity. We’re being more and more skeptical these days about where some of these equity values are so we will still negotiate the option.”

I believe this approach is important for investors seeking reurns from capital gains and special dividends.  Other BDCs that have taken a similar approach are Main Street Capital (MAIN), Fidus Investment (FDUS) and Triangle Capital (TCAP) all of which I consider to be higher quality BDCs with higher NAV growth.

PNNT has a higher projected total return than the average BDC.  When projecting total return for BDCs I assume that the ones with declining NAV per share find a way to stabilize and at least maintain 0% growth and BDCs with positive growth over the last 12 months I discount by 50% and assume they continue to grow at least half as fast as the previous year (except ACAS that does not pay a dividend and I assume the same amount of growth).  PNNT’s NAV per share has grown 4.2% over the last 12 months so I assumed 2.1% growth over the next 12 months.

It is also important to note that a key driver of the recent NAV upside was due to the positive price movement of its investment in Affinion. Affinion rose from about $0.58 on the dollar to the value of about $0.89 on the dollar due to better financial results and a debt exchange offer that created a financial cushion for the company.

The table below shows the projected total return for each BDC with PNNT at 11.9% and above the current average of 10.8% and well above its expected return of 10.7%


Total Return Pricing

As discussed in “Total Return Pricing for BDCs” I believe BDCs are priced on more than just multiples of NAV and EPS.  Please read the article for more detail regarding this methodology of pricing.  My expected total return for PNNT given its risk ranking of 5.3 out of 10.0 (10 implying the least amount of risk) is 10.7% which is well below the projected return of 11.9%.  

This would imply that PNNT is underpriced for its current risk vs. return and the correct price should be around $12.75 as shown in the table below:



In other words: each share of PNNT stock is likely to return $1.36 (its regular dividend plus value accretion) over the next twelve months to the investor which means that if an investor is only expecting 10.7% for the amount of risk then the proper price for each share would be $12.77.


Multiples Pricing

PNNT has an average risk profile and should be priced using average multiples, with its current NAV per share of $10.80 and an implied multiple of 1.14 would price it at around $12.27.  Using my projected calendar 2014 EPS of $1.12 and P/E multiple of 11.2 would imply a price of $12.55.  I would value PNNT closer to $12.40 using only multiples.




 






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