Fifth Street Finance Corporation (NASDAQ:FSC), a business development company or BDC, has a history of not covering its dividend out of current income. This has been the case for, at least, the last five years. In the last fiscal year (ending September 30), the coverage slipped to below 80% prompting a dividend cut to $1/annum. The basic reason is the large management and incentive fee that FSC pays its "manager" or "advisor" (Fifth Street Management, LLC), which has amounted to near 38% of net income in the last three years. Coupled with other expenses, the return on net assets has been only about 9%. In order to make their elevated dividends, FSC has relied on issuing equity, ideally above book value. If this template continues into 2014, which we see likely, FSC will have dividend coverage of about 90%. Assuming a more realistic coverage of 110% (paying out 90% as a RIC), then 80c/annum is the sustainable dividend level. Assuming a 9-10% dividend yield, this implies the stock should be priced between $8-9. While this is below today's NAV of ~$9.75, FSC costs and expenses dictate such a discount.
In the table below, we present historical data from FSC's SEC filings as well as our estimate for 2014. Investment income, as a percent of net assets, has been roughly 20% over the last three years, aided by a low interest rate (~5% in '13) and leverage (gross assets/equity) of about 1.5. However, as one can see below, the combined fees paid to FSC's manager was 28% of investment income. This is similar to a hedge fund with one exception. FSC's base management fee is 2% of gross assets, regardless of debt incurred. We should note that FSC waived $2.3mn in base management fee in '13 without which the financials would have been even poorer. Total net income for the year was $102mn versus distributions paid of $127.5mn, leading to a dividend coverage of 80%. There is no depreciation or amortization to speak of so, effectively, you get what you see as in GAAP financials. The net result was the excess dividend payment resulted in a decline in net assets of $26mn or 22c/share. This decline was mitigated by issuance of shares, above the then NAV, bringing in $491mn. NAV still declined by 7c over 2013 but issuing stock at $10.31 vs. a sub-10 book value, benefited existing shareholders. That said, if an investor wanted to maintain their percent ownership in the company, participating in the share issuance, a net purchase exceeding the dividend would have resulted.
Table 1: Financial Data for FSC
In the end, FSC was paying out too much in dividends and, once the stock price declined below NAV, they could no longer issue shares without diluting existing shareholders significantly. This must have been apparent to the board of directors who reduced December's dividend to 5c and next quarter's to a $1/annum run-rate. However, based on their net assets stated at fiscal year end (end of Q3 calendar year), we estimate that FSC's dividend coverage will still be low at 89%. We used the average return on net assets achieved over the last three years (19.67%) although we should note that, with credit conditions and yields dramatically improved, investment income may actually show up lower. We computed the management fee, without any waiver, and other expenses accordingly. Net income should be about $125mn, below the $139mn in dividends slated to be paid. This implies that NAV will decline by 11c to $9.75 undiluted (dilution would imply ~$9.5) or that 11% of next year's distribution is a return of capital.
BDCs that qualify for RIC status are required to pay out 90% of net taxable income. FSC has had a history of realized losses versus unrealized gains, due to defaults, resulting in taxable income potentially being less than net income. In our view, a pay-out ratio of 90% would seem more sensible, for a going concern, retaining earnings to grow the business and provide some cover for bad times. To get to a 90% coverage level, FSC would have to reduce its dividend to 80c. Investors should consider that a "steady-state" level. At that level, FSC would organically engender dividend growth albeit low (~1%). More importantly, it would provide a buffer in case capital markets are not as friendly as they have been over the last couple of years. In order to stress test our estimate, we determined that a (gross) return on net assets of near 25% would be required to see a 90% pay-out ratio. That seems like a huge stretch. Alternatively, FSC could reduce their management fee by $38mn but, once again, that does not seem likely.
Will FSC actually cut the dividend to 80c? We doubt it unless the market forces their hand. More likely, they will opportunistically issue shares during 2014 as they have in the past. While they could increase debt, both leverage and debt/free cash flow would argue against that, particularly in light of where we are in the credit cycle. Regardless, it is unclear if the market would reward the common shares much if leverage increases. The implication for FSC common shareholders though is that the stated "yield" is not all it's cracked up to be and investors should consider what yield they require assuming an 80c dividend. In our view, 9-10% on 80c sounds right but, of course, everyone has their own view. This means we see a mid $8 share price as closer to fair. In a recent article, the author makes a bullish case for the shares at their current price of around $9.40. We would temper such optimism with the facts we've laid out here and suggest investors weigh alternatives. For example, we laid out a bullish case on KFN recently (here), where management fees are much lower at about 17% of net income, half of FSC's fee cost.