This article compares Fifth Street Finance (FSC) to Prospect Capital (PSEC). Both FSC and PSEC are business development companies (BDCS) that invest in small to mid-sized businesses. Based on the analysis herein, it is argued that FSC is a stock to sell, while PSEC is a stock to own due to portfolio metrics, dividend yield, and valuation.
FSC's portfolio has a total cost of $1.268B and a current fair value of $1.288B, so the overall portfolio is valued at 1.02 cents on the dollar. Thus, the overall portfolio of FSC is incredibly healthy. However, it is also worthwhile to evaluate all of the portfolio holdings individually to identify possible companies that may materially impact FSC's portfolio quality on a going forward basis. It is possible, for example, for a few holdings to be valued at multiples of cost, which could compensate for other struggling portfolio holdings.
An analysis of FSC's portfolio holdings from its latest 10-K (posted about 3 weeks ago) was performed. All loans were expressed in terms of fair value divided by cost, and those below 90 cents on the dollar were flagged. Preferred equity and common stock holdings were excluded from this analysis because 1.) they make a relatively small percentage of their holdings and 2.) they can fluctuate from quarter to quarter. This methodology flagged two troubled companies as seen in the table below.
|Company||Cost (M)||Fair Value||Valuation|
|Coll Materials Group||12.2||3.2||0.26|
The identification of Coll Materials Group is not surprising. This company had been put on non-accrual status as of September 30th, 2012. Were this investment to be written down to zero (i.e. a fair value of 0), it would be result in a $0.035 drop in book value per share assuming 91.1M shares outstanding as of September 30th, 2012:
book value change = (0-[current fair value])/[# of shares]=-3.2/91.9=-$0.035
The other investment, Trans-trade, is more disconcerting. One of FSC's loans to this company is valued at 1.2M USD with an original cost of 7.1M USD. A worse case scenario for Trans-trade would cause a 17 cent hit to book value:
book value change = (0-[current fair value])/[# of shares]=-15.9/91.9=-$0.17
A similar analysis was performed on PSEC's portfolio as discussed here. Three potentially troublesome companies were identified when compared to FSC's two. Furthermore, the worst write-down scenario for PSEC would result in a 20 cent drop in book value. Overall, both companies have healthy portfolios with similar valuations.
Dividend And Net Investment Income
FSC currently pays a monthly dividend of $0.0958 per share, or about $1.15 per share on an annual basis. Based on the closing stock price of $10.40, the stock is currently yielding 11.1%. Net investment income (NII) for the fiscal year ending September 30th was $1.11 per share. The coverage ratio (NII/annual dividend) is 0.97, which implies that FSC is paying out slightly more in dividends than in income it is making.
Over the last four quarters (from most recent to latest), PSEC has NII per share of $0.46, $0.51, $0.51, and $0.59, respectively, or $2.07 over the last year. For the same time period, PSEC has paid out approximately $1.21 per share in dividends, for a juicy coverage ratio of 1.71.
In a recent development, PSEC announced a 8.2% increase in its dividend to 11 cents per share. Based on a closing share price of $10.74, PSEC is currently yielding 12.3%.
FSC has featured a static net asset value (NAV) of $9.92, $9.85, $9.87, and $9.89 over the last four quarters. During the fiscal year, FSC's NAV increased by 0.3%. Based on the current share price, FSC trades at a 4.8% premium to book value. Given this, it is not surprising that FSC did a secondary offering of stock since stock issuance at these levels is accretive to NAV on a per share basis.
PSEC features a better trend in book value, with values of $10.88, $10.83, $10.82, and $10.69 over the last four quarters. Over this time, PSEC has increased NAV by 1.8%. Based on the closing stock price of $10.74, PSEC is currently trading at a slight discount to NAV.
Based on the similar portfolio metrics and portfolio valuation, coupled with the following summary points below is motivation for buying PSEC and selling FSC:
- PSEC has a larger dividend yield (12.3% vs. 11.1% for FSC)
- PSEC has a superior dividend coverage ratio (1.71 vs. 0.97 for FSC); it should be noted that FSC did not cover its dividend with NII over the trailing 4 quarters
- PSEC trades at a discount to NAV (-1.3%) while FSC trades at a 4.8% premium to NAV based on current share prices
Disclosure: I am long PSEC.