Fifth Street Finance (FSC) reported results after the market closed yesterday, missing its earnings projections and finally reducing its dividend by 13%. FSC is part of my 'High-Yield BDC Portfolio' but was the smallest holding at 10% due to the likelihood of this dividend cut and earnings miss. While trying to come up with my 'General BDC Portfolio' I discussed that FSC had recently announced an offering of 17.6 million shares and was not projected to cover dividends this year. But now the dividend is $1 a year or around 10% annual yield (could be higher depending on how much it dips over the next few days) and would have almost been covered by earnings this last quarter. Should investors buy or sell?
The Good News
FSC grew its portfolio by 5% and ended the quarter with a large amount of available growth capital, thanks to the additional $182 million in equity. As of September 30, 2013 it had $147 million in cash and a reduced debt-to-equity ratio of 0.47 (from 0.56). Its portfolio investment classes are still safer than the average BDC with almost 80% in senior secured debt as discussed in "BDCs And Risk: Part 1" and no investments on non-accrual status. Its weighted average yield on debt investments declined from 12.0% in 2012 to 11.1% as they continue to focus on safer senior debt and a reduced yield is a good sign that they are maintaining underwriting standards in an industry that is experiencing competition and yield compression.
FSC's target leverage is a debt-to-equity ratio between 0.6 and 0.7 excluding SBA leverage. Given the recent infusion of equity capital, bringing net assets to $1.37 billion, would equate to an additional amount of debt capital of $350 million to $500 million, plus $43 million available in SBIC debentures, less the amounts owed for unsettled transactions of $36 million, plus cash of $147 million equals total growth capital of $500 million to $650 million. This could grow the current portfolio of $1.9 billion by 25% to 35% before going back to the market to raise equity.
On October 23, FSC announced an increase to its credit facility commitments by $125 million to $605 million, with an accordion feature allowing for potential future expansion up to $800 million. "This upsize further enhances our ability to commit up to $250 million in support of our private equity sponsor clients. Combined with our Wells Fargo and Sumitomo facilities, as well as available debenture capacity through our SBIC subsidiaries, FSC has access to over $1 billion of debt capital," commented FSC's CEO, Leonard M. Tannenbaum.
FSC also recently announced that it has closed a record $664 million of new investments in the first 55 days of the current quarter. Depending on the final net originations for Q1 2014 this could be a large increase in total portfolio and net investment income for the coming quarters.
Dividend Cut and Sustainability
For the quarter ending December 31, 2013, the Board of Directors declared monthly dividends totaling $0.24 per share, which is representative of the net investment income per share that was earned during the quarter ended September 30, 2013. "The Board's decision to re-align the dividend with net investment income reflects the higher quality and lower overall risk of the portfolio in an environment where investment yields continue to compress. Fifth Street's leading direct origination platform continues to generate assets with attractive risk-adjusted returns, but at lower yields and reduced levels of risk than in the past. We have a robust pipeline into calendar-year end and continue to make progress on several initiatives that should lead to improving net investment income over time," stated our Chief Executive Officer, Leonard M. Tannenbaum.
Most investors were well aware that this was going to happen including Scott Kennedy in his "Dividend Sustainability Analysis". The current dividend of $0.0833 per month or $1 per year is a yield of 10% that I believe is sustainable and discussed in detail in "FSC: Time to Buy or to Sell? Part 2".
Potential Bargain Prices and Stock Repurchase
In after hours trading FSC hit a low of $9.50 and will most likely be down this morning. Its book value per share is $9.85 and has been stable over the last two years.
On November 21, 2013, its Board of Directors approved a new $100 million stock repurchase program. Any stock repurchases under this program would be made through the open market and only if it trades below its book value per share.
I believe FSC is a buy and that its current price already reflects a discount in anticipation of the dividend cut. Given the current amount of originations for the quarter and available growth capital I believe FSC will cover its dividend in the near future. For detailed earnings projections and dividend coverage as well as updated rankings, pricing and total return expectations please see "Fifth Street Finance: Time To Buy or Sell? Part 2".
Investors should only use this information as a starting point for due diligence. See the following for more information: