Focus of Article
The focus of this article is to provide a detailed analysis with supporting documentation (via two tables) on the dividend sustainability of Fifth Street Finance Corp. (FSC). I am writing this article after FSC reported its recent fiscal Q2 2013 via its press release and earnings call. Q2 2013 was a pretty typical quarter for FSC. Its net income and net asset value ('NAV') was relatively in line with most analysts' estimates. The figures I previously estimated within my income statement and net asset value articles were within predicated ranges for the quarter.
Understanding the tax/dividend payout characteristics of FSC will provide investors with an overall better understanding of the business development company ('BDC') sector as a whole. Due to the fact FSC currently produces an annual dividend yield of over 10%, many investors turn to this stock (including other stocks within the BDC sector) for income-producing equity investments. From reading this article, investors will better understand how a company comes up with its current dividend rate and specific signs when an impending dividend raise or cut will eventually be implemented. I will be performing one dividend sustainability calculation (TEST 1) within this article. At the end of this article, there will be a conclusion on my opinions about the overall dividend sustainability of AGNC.
General Overview of FSC:
FSC is a BDC, which lends to and invests in small and mid-sized companies whose annual revenues are in the range of $25 - $250 million. Its investment objective is to maximize its portfolio's total return by generating income through its debt investments and also through capital appreciation from its equity investments. FSC's fiscal year-end is September 30th, of a given year. Therefore, FSC's first fiscal quarter ends December 31st, of a given year. Historically, FSC has had an attractive dividend yield between 10% - 13%.
Discussion of FSC's Taxation as a Regulated Investment Company ('RIC'):
As a BDC, FSC elects to be treated as a RIC under sub-chapter M of the internal revenue code. To continue to qualify annually as a RIC (for tax purposes), FSC must meet certain "source-of-income" and "asset diversification" requirements. These requirements are beyond the scope of this specific article and will not be mentioned again. In addition, FSC is required to distribute annually to its stockholders at least 90% of its "investment company taxable income" and net capital gains in order to be eligible for the tax benefits allowed to a RIC. Investment company taxable income is mainly FSC's "net increase (decrease) in net assets resulting from operations" account (from the income statement) including several "book to tax" adjustments. Net capital gains consist of realized net short term capital gains in excess of realized net long term capital losses for each taxable year. At 9/30/2012, FSC had net capital loss "carry-forwards" of $41.8 million to offset any net short term capital gains that might arise. These two accounts combined are also referred to as FSC's "investment company net taxable income" or FSC's "annual distribution requirement".
FSC intends to distribute (at a minimum) between 90% - 100% of its investment company net taxable income. Therefore, FSC anticipates that it will not incur any federal or state income tax at the RIC level. The amount to be paid out as a dividend is determined by the board of directors and is based on management's estimate of FSC's annual distribution requirement.
Side Note: As a RIC, FSC is also subject to a 4% non-deductible federal excise tax based on distribution requirements of its investment company taxable income (excluding the net capital gains component) on a calendar year basis. FSC will be subject to a 4% non-deductible federal excise tax in two situations discussed below.
The first scenario where a federal excise tax could arise involves any of FSC's remaining undistributed investment company taxable income (< 100%) in a given calendar year. This federal excise tax will be assessed unless FSC distributes (in a timely fashion) an amount of at least the sum of the following:
1) 98% of its net ordinary income (investment company taxable income) for each calendar year
2) 98.2% of its net capital gain income for the annual period ending October 31, in a given calendar year
3) Any income recognized, but not distributed, in preceding years
This is also known as the "excise tax avoidance requirement."
The second scenario where an excise tax could arise is when FSC chooses to carry forward its investment company taxable income in a calendar year (in excess of its current year distributions) into the next calendar tax year. If FSC chooses to proceed with this scenario, it will be subject to a 4% federal excise tax. Any such carryover investment company taxable income must be distributed through a dividend declared prior to filing of the final tax return (usually September 30 of the following year) related to the year in which such investment company taxable income was obtained.
FSC usually tries to avoid paying this 4% non-deductible federal excise tax by making sufficient distributions to stockholders (at least 100% of its investment company taxable income). However, FSC incurred an excise tax in the past for the calendar years 2008 - 2010. FSC has not incurred an excise tax for calendar years 2011 - 2012 and does not expect to so for the calendar year 2013.
Table 1 - Overview of Accounts: [See Table 1 Below; Red References "A" Through "(F / E)" Next to the Q2 2013 Column]
Before we begin FSC's dividend sustainability analysis, let us first get accustomed to the information provided in Table 1. Table 1 begins with calculating FSC's investment company taxable income for its second quarter of 2013 and goes back to its first quarter of 2012. All account figures in Table 1 are for the "three-month" time-frame. The quarterly figures in regards to the red references "A" through "C" are derived from FSC's footnote within its quarterly 10-Q or 10-K submissions named "Taxable/Distributable Income and Dividend Distributions." FSC currently (and at least since its first quarter of 2012) does not have any net capital gains (red reference "D") to add to its investment company taxable income (red reference "C"). As stated earlier in the article, FSC had net capital loss "carry-forwards" of $41.8 million as of 9/30/2012 to offset any net capital gains that might arise in the future. Therefore, FSC's investment company net taxable income / annual distribution requirement figure (red reference "E") will be the same amount as its investment company taxable income.
Table 1 then shows a separate, but indirectly linked, dividend sustainability calculation (TEST 1). This specific test will be discussed later on in the article. For now, I am just describing what the accounts in Table 1 mean and where the information is derived. FSC does not provide a table that shows any dividend sustainability analysis (red references "F" through "F / E"). Therefore, the table (in regards to red references "F" through "F / E") is created by my own research. All figures are checked and tied back to various spreadsheets and data from FSC's supported documentation.
Let us now take a look at Table 1's accounts (in corresponding order) and briefly describe what these accounts mean and where the information comes from.
A) Net Increase in Net Assets Resulting From Operations:
This figure comes directly from FSC's quarterly 10-Q or 10-K submissions via its consolidated statement of operations (income statement). In a previous article I wrote (link is at the top of this article), I explained in detail how FSC's "net increase in net assets resulting from operations" figure was calculated in any given quarter. Further discussion of this figure will not occur in this article. This article's focus is a dividend sustainability analysis.
B) Book to Tax Differences (Reversals):
In order for FSC to come up with a proper investment company taxable income figure, there are specific GAAP (book) to internal revenue code ('tax') adjustments/reversals that need to take place each quarter. Income and expense recognition of certain accounting transactions differ between GAAP (book) and the internal revenue code ('tax').
Examples of FSC's book to tax differences (temporary and permanent) are the following:
- Unrealized appreciation (depreciation) on investments (investment gains and losses are not included in taxable income until realized)
- Origination and exit fees received in connection with certain investments
- Organizational and deferred offering costs
- Timing recognition of interest income on certain loans
- Income or loss recognition on exited investments.
There are several other book to tax adjustments, however, due to immateriality, further discussion is unwarranted.
C) Investment Company Taxable Income:
After adding back (or subtracting out) FSC's book to tax differences from "net increase in net assets resulting from operations", one can now calculate FSC's investment company taxable income.
D) Net Capital Gains:
Once investment company taxable income is known, one adds any net capital gains to this figure. As discussed earlier in this article, FSC does not currently have any net capital gains. FSC has not had net capital gains since at least the first quarter of 2012.
E) Investment Company Net Taxable Income:
As discussed earlier, this figure will currently (and since the first quarter of 2012) be the same amount as FSC's investment company taxable income.
This figure is the main determination on how FSC bases its current and future dividend rates. This figure will be used within TEST 1's analysis. As was discussed earlier in this article, FSC is required to distribute at least 90% of its investment company net taxable income (annual distribution requirement) in the current tax year to continue to be classified as a RIC per the internal revenue code. In certain situations, FSC has until the finalization of its tax return of the preceding year to pay out this requirement. As will be shown, this has not been an issue with FSC and will not be discussed further. FSC intends to distribute (at a minimum) between 90% - 100% of its investment company net taxable income. Therefore, FSC anticipates that it will not incur any federal or state income tax at the RIC level.
F) Distributions to Stockholders from Net Investment Income:
This figure is the actual monthly dividends accrued for and paid by FSC in regards to its outstanding common shares. All quarterly distribution figures are reconciled and tied back to FSC's supported documentation.
G) Under (Over) Payment of Investment Company Net Taxable Income:
This figure is the under (over) payment of FSC's quarterly investment company net taxable income vs. quarterly distributions to outstanding common stock shareholders from net investment income (red reference "E - F = G"). I also include what percentage of investment company net taxable income is paid out in a given quarter (payout ratio) for additional clarity and insight.
After understanding how Table 1 works, now the dividend sustainability analysis (TEST 1) can be discussed.
1) Quarterly Investment Company Net Taxable Income vs. Quarterly Distributions to Shareholders from Net Investment Income Analysis (TEST 1): [See Table 1 Above; Red References "A" Through "(F / E)" Next to the Q2 2013 Column]
For this analysis, I take FSC's quarterly "investment company net taxable income / annual distribution requirement" (red reference "E" in Table 1) amount and subtract this figure by the quarterly "distributions to stockholders from net investment income" (red reference "F" in Table 1) amount. If FSC's reference "E" is greater than reference "F", then FSC has underpaid its quarterly investment company net taxable income. If reference "F" is greater than "E", then FSC has overpaid its quarterly investment company net taxable income. After performing this specific analysis, I conclude FSC has consistently overpaid its investment company net taxable income via its quarterly distributions to outstanding common stock shareholders. I will now explain why.
Within every quarter shown in Table 1 (Q2 2013 back to Q1 2012), FSC distributed an amount over its required 90% distribution of investment company net taxable income. Furthermore, FSC has overpaid its goal of 90%-100% distribution of its investment company net taxable income in every quarter. This is a troubling sign and can eventually lead to a future dividend cut. I have done this specific analysis for many companies (including several within the BDC sector) in the past. FSC's results in regards to this specific analysis are negative when compared to other companies.
Within Table's 1 data, the lowest payout ratio came in FSC's third quarter of 2012. In this quarter, FSC had an overpayment of investment company net taxable income of $2.25 million. This translates to a payout ratio of 110% of its investment company net taxable income. This may not seem like a material amount, but these results compounded over several years will lead to a large over-distribution amount. The highest payout came in FSC's fourth quarter of 2012. In this quarter, FSC had an overpayment of investment company net taxable income of $5.14 million. This translates to a payout ratio of 127% of its investment company net taxable income. As of the last reported quarter (second quarter of 2013), this distribution ratio was 116%. Every quarter since the first quarter of 2012 (possibly longer) has had an over-distribution of investment company net taxable income.
Currently, FSC pays out a monthly dividend of $0.0958 per share ($1.15 annually). FSC has kept this monthly dividend rate stable for the past 20 months. Prior to this rate, FSC paid out a monthly dividend rate of $0.1066 per share ($1.28 annually). FSC paid this prior monthly dividend rate for 12 months starting from January 2011 and ending in December 2011. The January 2012 dividend cut was approximately 10%. This dividend cut was anticipating a modest gradual decrease in overall market interest rates in 2012-2013 thus lowering FSC's weighted average yield on its debt investments. From TEST 1's analysis, it looks like another future dividend cut should occur.
FSC has recently declared the continued monthly dividend rate of $0.0958 per share ($1.15 annually). FSC reported these dividend declarations upon reporting its second quarter's results earlier this month. This dividend rate has been declared through August 2013. FSC has stated its dividend policy is based on the following three main criteria:
- Pay dividends consistent with its current and future earnings potential
- Set dividend rates that are projected to be stable and grow over time
- Intend to cover its dividend payout level with net investment income
From its recent dividend declaration, FSC has continued to remain confident the current dividend rate is sustainable. However, per TEST 1's results, the rate is under a fair amount of stress. This is due to the continued tightening of spreads in the general market over the last few years which has led to a decrease in FSC's weighted average yield. A future dividend cut is a high probability if overall interest rates continue to remain at relatively low levels. If rates begin to modestly rise over time, FSC will benefit from this scenario. Most of FSC's debt is fixed in nature (a small component is variable), while most of its portfolio investments have a variable rate feature.
Also, as a percentage of its overall investment portfolio, FSC has begun to lower its first lien portfolio holdings (lower risk companies; lower interest yields) and begun increasing its exposure to second lien holdings (higher risk companies; higher interest yields). One of the main reasons for FSC's change in "risk appetite" is due to the current low interest yield environment. This is a direct result of trying to generate a higher yield to support the currently overpaid dividend. As of the second quarter of 2013, FSC has a decrease in its weighted average yield on debt investments from 12.4% to 11.4% on a year-over-year basis. This weighted average yield will only continue to decrease in this low interest rate environment. FSC's current weighted average debt (including SBA debentures, three credit facilities, senior convertible notes, and unsecured notes) is between 4% - 5%. Therefore, the net interest "spread" on FSC's main source of income is between 7.4% - 8.4%. FSC can also obtain equity appreciation in select investments and prepayment fees associated with the exits of certain loans. However, these gains would only increase FSC's interest "spread" by an additional 0.5% - 1.5% at the most. FSC's net asset value ('NAV') at 6/30/2012 was $9.90 per share. At FSC's NAV, the current dividend would yield 11.62%. Again, this shows FSC's dividend is currently under some stress.
Further evidence FSC's dividend is under stress can be shown within its balance sheet. Table 2 (see below) is a "snapshot" of FSC's balance sheet over the last six quarters. Specifically, it looks at FSC's net assets (also known as stockholder's equity in other types of business entities).
Within FSC's net assets, there is an account named "accumulated undistributed net investment income (deficit)". This is the account highlighted in black with white lettering. As a direct result of FSC's continued overpayment of its monthly dividend, FSC's deficit within this balance has increased each quarter. This fact is also supported by TEST 1's results we analyzed earlier. For the first quarter of 2012, FSC's "accumulated undistributed net investment income (deficit)" balance was ($4.4) million. By the second quarter of 2013, this deficit has risen to ($10.5) million. If the current interest rate scenario persists, FSC will gradually increase this deficit further if it keeps the monthly dividend rate the same. This is another negative sign in regards to the future sustainability of FSC's current monthly dividend of $0.0958 per share.
TEST 1 shows FSC has constantly overpaid the required 90% distribution of its investment company net taxable income. FSC has also overpaid its goal of 90% - 100% distribution of its investment company net taxable income. From TEST 1's analysis, a brief weighted average discussion, and additional evidence in support of TEST 1's results via Table 2, FSC has shown growing vulnerability towards maintaining its monthly dividend rate of $0.0958 per share. This vulnerability may come to fruition when FSC declares dividends for the month of September 2013. This would most likely occur when FSC issues its third quarter of 2013's results in early August. However, FSC may wait to cut the dividend until it reports its fourth-quarter 2013 results (10-K) in November.
There is one possibility where FSC can maintain its current dividend. This scenario would involve a steady and sustained rise in overall market interest rates (example = 400 basis point move within a few years). Most of FSC's liabilities are currently locked in at fixed interest rates. FSC's investment portfolio has been geared toward a variable/floating interest rate environment. Therefore, when overall market interest rates rise, FSC's net investment income will increase greater than the slight increases in interest expense (thus a steepening yield curve will unfold). However, if this scenario does not occur within the next three-six months, I feel a dividend cut is inevitable.
FSC has begun trying to generate additional asset yield through its investment portfolio (with the increased percentage of second lien investments). However, this alone will not be enough to maintain the dividend. The probability of a future dividend cut grows as each quarter passes and the current low interest rate environment persists. The current low interest rate environment is heavily influenced by the FED's decision on when to exit its quantitative easing (QE) program. If the FED's exit of the QE program (via the MBS and Treasury markets) is prolonged and drawn out, this would be negative for FSC's future dividend sustainability.
Finally, many other BDCs have cut dividends in the past 20 months while FSC has yet to do so. FSC's fate may already be written in regards to a future dividend cut if market interest rates do not rapidly increase soon. When a dividend cut is finally announced, I would expect an approximate 10% cut to the current dividend.
Final Side Note: On December 22, 2010, the Regulated Investment Company Modernization Act of 2010 was enacted. This changed various technical rules governing the tax treatment of RICs. The changes are effective for taxable years beginning after the date of enactment. Under this act, FSC will be permitted to "carry-forward" net capital losses incurred in taxable years beginning after the date of enactment for an unlimited period. However, any losses FSC incurred during these future taxable years will be required to be utilized prior to the losses incurred in the pre-enacted taxable years (which carry an expiration date). As a result, FSC's pre-enactment net loss "carry-forwards" may be more likely to expire unused. This act has no current impact on the analysis performed above, but is good to mention for future reference/disclosure.