Fifth Street Finance Corp. (FSC), like other BDCs (Business Development Companies), is a finance company that lends to and invests in small and mid-sized companies. FSC had its initial public offering on June 12th of 2008 and closed that day at $12.12. The first dividend was at the rate of $0.31/share per quarter. It had two years of dividend inconsistency - with a high quarterly dividend of $0.38 and a low of $0.25. FSC closed Wednesday at $10.71. It is currently paying a monthly dividend of $0.0958/share or $0.2874/quarter. Of the 16 BDCs in my coverage universe that were paying dividends in 2009, 12 cut their dividends during the credit crisis. 11 of those 16 are paying lower dividends today than in 2009. While FSC is in that unfortunate majority - the size of its dividend cut was relatively small.
I would call that performance "not good, but far from terrible." And that assessment will be echoed in my opinions on factor after factor in this article. Why should investors be interested in FSC? It has a yield of 10.71% as of closing on 5-15-13. You can buy "not good" for a "terrible" price. That's the good news. The bad news: You can buy something better than "not good" at a yield that is too close to that "terrible" valuation. In this article, I will provide a metric focused look at the Q1-13 earnings, generate a NII/share projection, show the current BDC valuations, and share my assessment as to whether FSC is a buy, sell or hold.
FSC Reports NII of $0.2575/share compared to a forward dividend of $0.2874/quarter
What They Earned: Fifth Street Finance Corp reported for calendar Q1-13 Total Investment Income of $54.687 million ($0.5158/share or $0.4805/diluted share). Net Investment Income of $29.303 million ($0.2764/share or $0.2575/diluted share). The Net Increase in Net Assets Resulting from Operations was $31.834 million ($0.3002/share or $0.2797/diluted share). For the last 6 months, PIK income accrued was $8.382 million while PIK interest received in cash was $4.598 million. FSC's net asset value per share was $9.90 compared to a NAV last quarter of $9.88.
FSC's Ratio of total expenses (including interest expense) to average stockholders' equity was 9.77% for the last 3 months. The Ratio of net investment income to average net assets was 11.28%. FSC's Ratio of portfolio turnover to average investments at fair value was 9.93%.
|PIK interest income||4,047||3,720||3,562||3,926||2,892||3,415||3,498||3,562||3,471||3,144||3,326||2,654|
|Dividend + other||1,089||346||71||81||39||34||36||164||8||2||26||385|
|TII in thousands||54.687||51.783||42,532||41,008||42,080||39,497||37,686||32,442||29,701||25,335||20,033||19,407|
|Investments in billions||1.749||1.580||1.288||1.198||1.056||1.580||1.120||1.053||0.940||0.742||0.651||0.563|
What They Own: As of 3-31-13 FSC's weighted average yield on debt investments was approximately 11.40% and included a cash component of 10.52%. At 3-31-13, FSC's portfolio consisted of investments in 86 companies. Approximately 96.4% of FSC's portfolio consisted of debt investments. The portfolio was comprised of $1,113.770 million (63.7%) of first lien loans, $260.783 million (14.9%) of second lien loans, $311.341 million (17.8%) of subordinated loans, $24.575 million (1.4%) in preferred equity and $38.426 million (2.2%) in common equity. Approximately 73.7% of FSC's portfolio of debt investments at fair value were at floating rates.
Originations: During the quarter, FSC closed $362.8 million of investments in 15 new and 4 existing portfolio companies, and funded $334.8 million. During the quarter, FSC also received $140.9 million in connection with the exits of 7 of their portfolio companies and $20.2 million in partial sales of investments.
What They Owe: FSC had long-term debt (SBA debentures payable) of $181.750 million at a yield of 3.555%, "convertible senior notes payable" of $115.000 million at a yield of 5.375% that mature on 4-1-16 (why diluted shares differ so much from non-diluted shares), Senior unsecured notes of $75.000 million at a yield of 5.875% and credit facility debt of $373.548 million (total = $745.298 million). With 106.209 million shares outstanding, the debt/share was $7.0173 and the debt/NAV ratio was 70.88%.
The FSC Wells facility bore interest at LIBOR + 300 and paid a weighted average interest rate of 3.005% for the six months ending 3-31-13. The FSC ING facility bore interest at LIBOR plus 3.0% when the facility is drawn more than 35%. Otherwise, the interest rate was LIBOR plus 3.25%. FSC paid a weighted average interest rate of 3.357% for the six months ended March 31, 2013. The FSC Sumitomo facility bears interest at a rate of the "one month" LIBOR plus 2.25%. FSC's borrowings under the Sumitomo facility bore interest at a weighted average interest rate of 4.164% for the six months ended March 31, 2013.
On October 18, 2012, FSC issued $75.0 million in 5.875% senior unsecured notes due 2024 for net proceeds of approximately $72.8 million. On November 1, 2012, the notes were listed on the NYSE under the trading symbol "FSCE" with a par value of $25.00 per share. The notes were assigned an investment grade (BBB-) credit rating from Fitch Ratings and Standard & Poor's.
After quarter end developments FSC issued $86.3 million in aggregate principal amount of the 6.125% unsecured notes (FSCFL) due 2028 for net proceeds of $83.4 million. In April FSC did a secondary public offering of 14,435,253 shares at $10.85 for proceeds of $151.5 million.
FSC's per share numbers
|Number of shares||106.022 million||113.812 million|
|Total Investment Income||$54.687 million||$0.5158||$0.4805|
|Interest Expenses||-$7.761 million||-$0.0732||-$0.0682|
|Based Management Fee||-$8.891 million||-$0.0838||-$0.0781|
|Incentive Fee||-$7.001 million||-$0.0660||-$0.0615|
|Total Investment Expenses||-$26.684 million||-$0.2517||-$0.2344|
|Net Investment Income||$29.303 million||$0.2764||$0.2575|
|Realized gain (loss) on investments||-$0.149 million||-$0.0014||-$0.0013|
|Unrealized appreciation||$2.680 million||$0.0253||$0.0235|
|Net Increase in Net Assets Resulting from Operations||$31.834 million||$0.3002||$0.2797|
|Investments at fair value||$1,748.895 million|
|Cash and cash equivalents||$38.169 million|
My run rate NII projection: FSC had Q1-13 portfolio growth of $169 million. I will project another $180 million of growth in Q2. Because that growth will not produce income for the full quarter, I will only add $90 million when I do the income calculation. (In other words, the income of $180 million for half a quarter is equal to the income from $90 million for a full quarter.) The Q4-12 average yield was 11.99% while the Q1-13 average was 11.40%. I will continue that downward trend in my projection. With 96.4% of $1.849 billion having an average yield of 11.20% - forward "interest income" per quarter would be $49.908 million compared to this quarter's $41.672 million - which is the interest plus PIK interest. I will use the last twelve month average fee income of $10.095 million as the run rate. The dividend income run rate is $0.397 million. The sum of those three components produces a TII total per quarter projection of $60.003 million. The Q1-13 actual TII was $54.687 million. The Q2-13 analyst "revenue" projection is $58.220 million with a high of $63.700 million and a low of $51.910 million. That is a huge projection range. The consensus Q3-13 projection is $62.530 million, with a high of $70.900 million to a low of $53.100 million.
The NII/TII ratio for Q1-13 was 56.3%. But a rising portfolio will add to management fees while decreased use of the credit facility combined with higher costs of the publicly traded debt (FSCFL) should put downward pressure on that ratio. So I will substitute taking that shortcut in using the NII/TII ratio to calculate a NII projection.
With the portfolio up $169 million, base management fees (which are generally charged one quarter in arrears) would be projected to increase by $0.845 million. $86 million of new debt at 6.125% will rise interest cost $1.317 million. That new source of debt should drop credit facility use, but probably not by the full amount as the portfolio grows. A guesstimated $70 million drop in credit facility use would drop interest expenses by $0.525 million. The net change in cost would be $1.637 million. My TII projection of $60.003 million minus Q1-13 expenses of $26.684 million minus the expense increase of $1.465 million results in a NII projection of $30.902 million.
Q1-13 had an ending share count of existing shares of 106.209 million. For 11/13th of Q2 FSC will have an additional 14.435 million shares. We need a weighted average share count of Q2-13. 11/13th of 14.435 equals 12.214. 12.214 + 106.209 = 118.423.
With NII of $30.902 million divided by 118.423 million shares, the NII would be $0.2609/non-diluted share. NII should rise during the rest of the year as FSC invests the new money in the equity and debit capital increases. This projection compares to a Q1-13 actual of $0.2764/non-diluted share/quarter and a 2013 EPS estimate of $1.13 or $0.2825/share/quarter - with a high of $1.22 and a low of $1.08. This projection - and the flat NAV trend - suggests that FSC will not be capable of dividend growth in 2013.
Portfolio Quality Metrics: FSC reported "cash" non-accruals of $37.224 (2.14% of the portfolio) at cost and $19.733 million (1.13%) at fair value. FSC had PIK non-accruals of $6.203 million at cost (0.36%) and zero (0.0%) of fair value. FSC and TCAP are the only two BDCs where I have noticed PIK non-accrual data.
FSC had $225.180 million (12.88% of portfolio) rated a "1" with a leverage ratio of 2.77x and $1,489.077 million (85.14% of the portfolio) rated a "2" with a leverage ratio of 4.22x. $1.000 million or 0.06% of the portfolio was at the lowest rating of "5" - which is close to matching non-accruals. Total portfolio average leverage was 4.10x compared with 4.05x last quarter.
My short-term CAGR (Compound Annual Growth Rate) projection for the dividend: Q2-13 over Q2-12 dividend growth was zero. EPS growth is projected at (1.13/1.07) 5.61 in 2013; and is projected to grow (1.17/1.13) 3.54% in 2014. There is no room in the Dividend/NII ratio [1.15/1.13] for dividend growth in 2013. For NAV, growth for the last twelve months was (9.88/9.87) 0.10%. And the last twelve months has been a BDC friendly environment. I also use the dividend discount model to solve for a price implied CAGR. That calculation is currently a little below 0%. For the years where I have visibility, I see little change of dividend growth. Over the mid term, dividend growth will be in line with NAV growth.
My risk assessment of FSC: The dividend cuts since 2009 have been relatively small. FSC has had poor - or well below sector average - EPS projection accuracy since 2010. And those projection changes have strongly tended to be in the wrong direction. I really hate that. With a spread of 2013 EPS projections (high estimate minus low, with that result divided by the consensus estimate) at 13.27%, the spread indicates above average risk. For FSC's portfolio of investments, the weighted average debt / EBITDA ratio is 4.10x. That metric is very similar to Ares Capital Corporation (ARCC) - which is perceived as having below sector average risk. The portfolio weighted average yield is 11.40% - and this important metric suggests average portfolio risk. With FSC's debt/NAV at 70.88%, its leverage indicates higher than average risk. The FSC portfolio is 78.6% in secured debt - which indicates lower than average risk. FSC has 2.14% of its loans at cost on non-accrual. That would normally indicate average risk. But all of those non-accruals popped up this quarter. This is a high risk indicator. With investments in 86 portfolio companies, the FSC portfolio is better than average based on granularity or diversification. The yield-to-maturity numbers for FSC's publicly traded debt (FSCE) and (FSCFL) indicate average risk. The FSC debt rating of BBB- may give it a small advantage. FSC's cost on its three credit facilities are above sector average - suggesting above sector average risk. This picture is muddy with inconsistencies - but there are too many important indicators of high risk. The risk qualities of FSC should result in a higher than sector average "yield plus CAGR" valuation.
BDC Valuations as of market close of 5-15-13
Yield in the spreadsheet below is based on the Q1-13 dividend. Spreadsheet header abbreviations: Div = dividend; EPS = earnings per share; LTM = last twelve months; YTD = year to date. The dividend to EPS ratio is a measure of dividend safety. The dividend to NAV ratio is a measure of safety and efficiency. The last four columns measure the percentage change in the 2013 EPS projection and the change in the price target since the beginning of the year. The change in the Q1-13 dividend from the Q1-12 dividend, and the change in the Q4-12 NAV from the Q4-11 NAV. Some BDCs have already started declaring Q2-13 dividends. KED, MAIN and TCRD are the only BDCs to declare an increase in their Q2-13 dividend.
|Share Price||Div/||Div/||Q4-12||Price||YTD Percent Change||LTM||LTM|
|With the 10 Treasury at 1.71% and sector average yield (on Q1 dividends) at 8.89% - the spread is 718 bps.|
|The cap weighted ETF BDCS is up 4.74% year to date - with dividends its total return is 8.46%.|
|Sector yield, Dividend/NAV and Dividend/EPS ratio filter out the zero payout ACAS and SAR.|
|Weeding out ACAS and SAR, the average share price gain is 6.44%.|
BDC Earnings Growth & P/E Ratios 05-15
Fiscal and calendar years are not in sync. BDCs than began fiscal 2013 on or before calendar Q3-12 include AINV, FULL, GAIN, GBDC, GLAD, MCC, PSEC, PFLT and PNNT. The range metric is the high estimate minus the low estimate, with that result dividend by the consensus estimate - and serves as one of several measurements for assessing risk. That average is currently inflated by almost 300 bps due to atypical spreads in the projections for ACAS and GAIN. With the exception of KED, all EPS projections are from Yahoo Finance.
|Earnings / Share||Earn. Growth||P/E Ratios||13 EPS Range|
My valuation assessment of FSC: A 10.67% yield while the sector average yield is 8.95% makes FSC attractive. A 1.09 price to NAV while the sector average is 1.12 is justified. Using the 2013 EPS and the 2013 P/E, FSC has a 9.53 ratio while the sector average is 11.20. Due to a higher risk assessment, most of that difference is justified. A moderate mix of publicly traded debt gives FSC a cost disadvantage that results in an slightly worse than average NII/TII ratio. The dividend is not covered by NII - and I hate that. Given a higher than sector average risk assessment, I want a higher than sector average yield plus CAGR. Share price appreciation should closely match dividend growth. And the prospects for dividend growth are close to none than slim. The yield plus CAGR is not higher than sector average. FSC is not a buy. On the other hand, you are paid so well for the risks of this investment, FSC is not a sell.
I believe that there should be some correlation between your quality level of due diligence in a given sector and your portfolio allocation to that sector. I provide a test for your correct BDC weighting in my most recent InstaBlog post here at SA. For those who can handle a strong does of tough love - take the test. I'll take your feedback in the comments section below. Those guidelines are for your protection. If that guide tightly limits your ownership of BDCs, then FSC is not for you.
A small dose of FSC could really help investors who are hungry for yield. If you can watch FSC like a hawk - then you can buy a small part of FSC. If you are going to watch it like a two year old - then you can't. If you know your overall portfolio is low risk and high dividend growth, then you can buy a small part of FSC. If you have not done a stock by stock growth and risk assessment of you portfolio components, then you should not be buying FSC.
FSC is not totally lacking in positive attributes. And you can buy the "not good" FSC for a "terrible" price. In the current market where everything is looking pricey, FSC can look like a bargain. But there is a Catch-22. If you are smart enough to supervise a "not good" investment, then you are probably smart enough to not want a "not good" investment.