By our count PennantPark Investment Corporation (PNNT) is the eighth Business Development Company (BDC) in recent months to raise new equity. Just before the news the stock was trading at $10.74, but dropped 6% in after hours trading to $10.10. This is not unusual for BDCs: existing investors often bail on a new equity announcement, perturbed by the prospect of imminent dilution. However, given that BDCs are required to pay out all their income as distributions to shareholders, issuing new stock is the only way for a company to grow. In most cases the ability to access the public market should be rated a good sign, especially when the new funds are likely to be used for new investment asset formation rather than just permanently paying down debt to keep lenders happy.
In this case, PNNT, which has navigated through the Great Recession with some success (albeit not without taking substantial Realized Losses, equal to 20% of paid-in equity capital) should be able to boost its earnings per share , notwithstanding issuing nearly 20% more stock. (The Company will issue 5.75mn shares, including underwriter’s overallotment).
The ace in the hole which PNNT enjoys is access to very inexpensive debt, arranged during the go-go days and not up for renewing till 2012. However, PNNT has not been able to fully access its $300mn Revolver because to do so might have caused covenant compliance issues. At December 31, 2009, PNNT had borrowed $245mn. Now with an estimated $60mn or so of new new equity capital being added to the $306mn in equity at year end, PNNT will have the ability to take full advantage of some of the cheapest bank borrowing anywhere. Even if the Revolver goes fully drawn, debt to equity will be 0.8 to 1:0, which is pretty much the current level.
The difference, though, will be the ability to increase total assets by about $100mn or more (we’re assuming PNNT will actually borrow $40mn and spend the $60mn from the capital raise). We calculate that when fully deployed Net Investment Income Per Share (we call it NIIPS) will jump from $0.28 a quarter to $0.36. That’s a potential 28% increase. Some of that comes from the huge margin spread between new assets yielding 12.8% and a borrowing cost of 1.2%. That’s a remarkable 11.6% gross spread.
Even when PNNT’s relatively high operating cost structure (which CEO Arthur Penn argues is the norm for the industry) is taken into account we expect the net operating margin (which we define as yield on debt instruments less operating expenses, but not including interest expense) will be 8.8%. When you deduct out 1.2% for those new investment assets which are funded by borrowing on the Revolver the net margin spread (one of our favorite calculations) is still a way above average 7.6%.
Still, some of the upside in PNNT has nothing to do with the availability of high yielding investments (although the Company has added $150mn in “attractive” new investments in just the last 3 quarters), and inexpensive debt. Some of the projected growth in NIIPS will come from re-circulating the remaining lower yielding assets added in the early days of the Company to create a steady revenue source. There’s $35mn of investment assets earning a miserable 2.7% yield that will be re-circulated into high yielding loans before long.
At the 9.6x NIIPS multiple which the Company was trading at just before the new equity announcement, PNNT’s stock could eventually trade up to a price of $13.8 if our NIIPS projection is right, and before a new round of capital raising will be required.
Of course, even though new equity is usually accretive, the sudden influx of new shareholders can cause NIIPS to drop in the first quarter or two after the money is raised but before the funds can be deployed. Jumpy shareholders can become concerned that worry that the company may be forced to cut its dividend to meet its temporarily lower earnings level. (Something like that happened to Fifth Street Finance-FSC- last year). PNNT, like any sophisticated BDC, has been building a small gap between its running earnings rate and its dividend liability. In the fourth quarter of 2009 that was a 2 cent gap and meant PNNT earned $527,000 more than it paid out in distributions. Furthermore, the total “savings account” of undistributed Net Investment Income totalled $2.7mn at year end. We believe that Company will be able to absorb the $1.55mn of additional distributions required for the new shareholders every quarter (at the $0.27 a quarter dividend rate announced) by using its “saving account”. NIIPS may drop for a quarter or two below the dividend rate but the difference should be minimal and PNNT should be able to maintain its dividend regardless.
However, investors taking the long view have to face the fact that bad debts will eventually erode our projected earnings for PNNT. After all the Company does not get paid yield returns in the low teens for no risk. We always calculate what pro-forma earnings might be if a reasonable level of non-performing loans is included. We can’t give you all our assumptions and calculations here, but we can say this: If PNNT manages to keep bad debts at or under 10% of total yield assets, we expect NIIPS will increase to $0.30 a quarter or higher. That will mean this equity raise will have been accretive and good for shareholders.
If bad debts reach 20% of assets, we project NIIPS will be below the current level, and presumably that will be bad for shareholders. Neither we, nor management, know how well the credit underwriting will be in the years ahead. Much of it, despite any illusions management has, is outside any lender’s control. However, at this stage in the economic cycle, and with most of the downside with PNNT being limited to lower than expected earnings rather than bankruptcy, we’re relatively optimistic. We see the predictable stock price drop that comes after these new equity announcements as an opportunity to buy.
Disclosure: Long PNNT