Fifth Street Senior Floating Rate's Recent Material Equity Offering And Its Impact On NAV

Aug.18.14 | About: Fifth Street (FSFR)

Summary

On 8/13/2014, after FSFR reported results for the fiscal third quarter of 2014, the company announced the anticipated equity offering that was discussed in my prior article.

However, what surprised markets and myself was the size of the announced equity offering (22.8 million shares of common stock; over three times the size of FSFR’s initial public offering).

This article incorporates FSFR’s recently announced material equity offering into the financials and shows why this event will materially decrease the company’s current NAV.

The net issuance price of FSFR’s recently announced equity offering is $12.14 per share which is materially below the company’s NAV as of 6/30/2014 thus materially diluting existing shareholders.

My buy, sell, or hold recommendation for FSFR is stated in the “Conclusions Drawn” section of the article.

Focus of Article:

The focus of this article is to provide an update to Fifth Street Senior Floating Rate Corp.'s (NASDAQ:FSFR) net asset value ('NAV') per share to incorporate the recent offering of 22.8 million shares of common stock that was announced on 8/13/2014. Even though this announced equity offering will be finalized on approximately 8/19/2014, I want to perform an analysis on FSFR's NAV as of 6/30/2014 to highlight the dilutive effects this event will have on existing shareholders. Due to the fact this recent equity offering has a net issuance price of $12.14 per share (materially below FSFR's NAV as of 6/30/2014 of $15.13 per share) and is approximately 3.5x the size of the company's initial public offering ('IPO'), I believe it is important for existing and potential shareholders to understand the impact this event will have on CURRENT NAV. My current BUY, SELL, or HOLD recommendation for FSFR will be in the "Conclusions Drawn" section of this article.

A previous article I wrote laid the ground works for this update. In that article, I projected/analyzed FSFR's NAV as of 6/30/2014 prior to this announced equity offering. The link to my projection article is provided below:

Fifth Street Senior Floating Rate's Upcoming Fiscal Q3 2014 Net Asset Value Projection

Side Note: This is a hypothetical analysis that will show FSFR's NAV as of 6/30/2014 when including the impacts from the recent offering of 22.8 million shares of common stock. This analysis will not include activity during the fiscal fourth quarter of 2014 and is merely showing the dilutive impact of this recently announced material equity offering. FSFR has also granted the underwriters an option, exercisable up to 30 days after the date of the prospectus supplement, to purchase up to an additional 3.4 million shares of common stock. If the underwriters fully exercise this option, FSFR's equity offering would increase to 26.2 million shares of common stock. This analysis will EXCLUDE the notion of the underwriters exercising this option (0 additional shares of common stock being issued). However, readers should understand any additional shares of common stock being issued at a net issuance price of $12.14 per share would further dilute existing shareholders and would further decrease FSFR's CURRENT NAV.

Analysis Showing the Dilutive Impact of FSFR's Recent Material Equity Offering:

Let us calculate FSFR's NAV as of 6/30/2014 to incorporate the recent offering of 22.8 million shares of common stock that was announced on 8/13/2014. This hypothetical NAV will be calculated using Table 1 below.

Table 1 - FSFR Nine-Months Ended NAV (NAV as of 6/30/2014) (Excluding and Including the Recent Material Equity Offering)

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(Source: Table created entirely by myself, partially using FSFR data obtained from the SEC's EDGAR Database)

Using Table 1 above as a reference, let us take a look at the calculation for FSFR's NAV as of 6/30/2014 when including the impact from the recent offering of 22.8 million shares of common stock. Unless otherwise noted, all figures below are for the "nine-months ended" time frame. Let us focus only on the figures that are impacted by FSFR's recent material equity offering. As such, let us first look at the following figure (in corresponding order to the "Ref." column shown in Table 1 next to the June 30, 2014 column):

C) Capital Share Transactions:

- Net Increase (Decrease) in Net Assets From Capital Share Transactions EXCLUDING the Offering of 22.8 Million Shares of Common Stock: $0

- Net Increase (Decrease) in Net Assets From Capital Share Transactions INCLUDING the Offering of 22.8 Million Shares of Common Stock: $276.4 Million

- See Red Reference "C" in Table 1 Above Next to the June 30, 2014 Column

This "net increase (decrease) in net assets from capital share transactions" figure consists of the following three amounts: 1) issuance of common stock, net (see blue reference "A" in Table 1 above and Table 2 below); 2) issuance of common stock under dividend reinvestment plan, net; and 3) repurchases of common stock. Let us focus our attention on the only figure that is affected by FSFR's recent offering of 22.8 million shares of common stock.

1) Issuance of Common Stock, Net:

- EXCLUDING the Offering of 22.8 Million Shares of Common Stock: $0

- INCLUDING the Offering of 22.8 Million Shares of Common Stock: $276.4 Million

- See Blue Reference "A" in Table 1 Above Next to the June 30, 2014 Column

- See Blue Reference "A" in Table 2 Below

FSFR's issuance of common stock, net for the fiscal first, second, and third quarters of 2014 was $0. Now, let us calculate FSFR's issuance of common stock, net when including the recent offering of 22.8 million shares of common stock. This is performed in Table 2 below.

Table 2 - FSFR Nine-Months Ended Issuance of Common Stock, Net (Including Offering of 22.8 Million Shares of Common Stock)

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(Source: Table created entirely by myself, partially using FSFR data obtained from the SEC's EDGAR Database [link provided below Table 1])

Using Table 2 above as a reference, an initial 22.8 million shares of common stock will be issued on approximately 8/19/2014. The gross issuance price has been established at $12.91 per share. Therefore, gross proceeds of $294.3 million will be raised in conjunction with the issuance of 22.8 million shares of common stock.

As stated earlier, FSFR has also granted the underwriters an option, exercisable up to 30 days after the date of the prospectus supplement, to purchase up to an additional 3.4 million shares of common stock. If the underwriters fully exercise this option, FSFR's equity offering would increase to 26.2 million shares of common stock. If the underwriters fully exercise this option, FSFR's equity offering would increase to 26.2 million shares of common stock. This analysis will EXCLUDE the notion of the underwriters exercising this option (0 additional shares of common stock being issued). At this point in time, it is uncertain what portion the underwriters will exercise. As such, I will exclude this part of the calculation in my analysis above. However, readers should understand any additional shares of common stock being issued at a net issuance price of $12.14 per share would further dilute existing shareholders and would further decrease FSFR's CURRENT NAV.

Next, one must subtract the underwriters' discount of ($17.7) million and estimated offering costs of ($0.3) million. After subtracting out these costs, FSFR's net proceeds raised from the company's recent offering of 22.8 million shares of common stock will be $276.4 million.

Therefore, when this figure is combined with the six-months ended figure of $0, FSFR would have reported an issuance of common stock, net figure of $276.4 million for the nine-months ended 6/30/2014 (see blue reference "A" in Tables 1 and 2 above).

Remainder of NAV Calculation:

When including FSFR's recent offering of 22.8 million shares of common stock, the company would have had a "total increase (decrease) in net assets" of $276.4 million for the nine-months ended 6/30/2014 (see red reference "(A + B + C) = D" in Table 1 above).

Having this figure established, let us now calculate FSFR's NAV per share as of 6/30/2014 when including the company's recent offering of 22.8 million shares of common stock (see red references "D, E, F, G" in Table 1 above):

Total Increase (Decrease) in Net Assets: $276.4 million

(+) Net Assets at Beginning of Period: $100.8 million

(=) Net Assets at End of Period: $377.2 million

(/) Outstanding Shares of Common Stock as of 6/30/2014 *: 29.5 million

(=) NAV Per Share as of 6/30/2014 *: $12.80 per share

* = Including FSFR's recent offering of 22.8 million shares of common stock

Conclusions Drawn:

To sum up all the information discussed above, on 8/13/2014 FSFR reported the following NAV per share as of 6/30/2014:

FSFR's Reported NAV as of 6/30/2014 = $15.13 Per Share

However, when incorporating FSFR's recent offering of 22.8 million shares of common stock, the following NAV per share as of 6/30/2014 was calculated:

FSFR's NAV as of 6/30/2014 When Including the Recent Offering of 22.8 Million Shares of Common Stock = $12.80 Per Share

Even though this announced equity offering will be finalized on approximately 8/19/2014, I performed this analysis on FSFR's NAV as of 6/30/2014 to highlight the dilutive effects this event will have on existing shareholders. Due to the fact this recent equity offering has a net issuance price of $12.14 per share (materially below FSFR's NAV as of 6/30/2014 of $15.13 per share) and is approximately 3.5x the size of the company's IPO, I believe it is important for existing and potential shareholders to understand the impact this event will have on CURRENT NAV.

Table 3 below calculates the quarterly per share changes for the fiscal third quarter of 2014 when incorporating the recent offering of 22.8 million shares of common stock.

Table 3 - FSFR Quarterly NAV Per Share Changes

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(Source: Table created entirely by myself, including all calculated figures and projected valuations)

Using Table 3 above as a reference, FSFR's net increase (decrease) in net assets resulting from operations (also known as EPS) was $0.27 per share for the fiscal third quarter of 2014 (rounded to the nearest cent). In comparison, FSFR had dividend distributions of ($0.27) per share for the fiscal third quarter of 2014 (also rounded to the nearest cent).

However, when incorporating the ($2.33) per share dilution from the offering of 22.8 million shares of common stock, FSFR's NAV of $15.13 per share as of 6/30/2014 would decrease to only $12.80 per share. In my opinion, existing shareholders are negatively impacted from this material equity offering because FSFR's CURRENT NAV has now materially decreased.

My BUY, SELL, or HOLD Recommendation:

In my prior FSFR article, I stated as part of the JV partnership agreement with GF Funding 2014, FSFR needed to obtain an additional source of financing/capital to fund the company's portion of the investment portfolio. FSFR had basically used up all of the equity proceeds in relation to the company's IPO in July 2013 and borrowings through its $100 million Natixis Revolving Credit Facility created in November 2013. I believed FSFR needed to establish additional sources of financing/capital in the debt/equity markets. However, I also stated it currently remained "non advantageous" for FSFR to perform an additional equity offering due to the fact the company's stock price continued to trade at a modest discount to NAV as of 6/30/2014.

On 7/10/2014, FSFR held a special meeting of stockholders where a proposal was approved allowing the company to sell shares of its common stock at a price up to (25%) above (below) CURRENT NAV. In my opinion, this particular "restriction" has a very large "threshold" and was one of the main reasons why FSFR's stock price continued to trade at a modest discount to CURRENT NAV. Potential investors knew an equity offering, most likely below CURRENT NAV, was basically a certainty in the near future. I believed this was a fairly important negative factor. I stated such an equity offering would cause dilution to existing shareholders and have a negative impact on FSFR's future NAV.

Using FSFR's latest reported NAV as a hypothetical example, the company reported NAV of $15.13 per share as of 6/30/2014 when excluding the recent offering of 22.8 million shares of common stock. However, when including the recent material equity offering, FSFR would have a NAV of only $12.80 per share as of 6/30/2014. When calculated, this recent offering of 22.8 million shares of common stock causes a ($2.33) per share dilution to FSFR's CURRENT NAV.

FSFR recently closed at $12.37 per share as of 8/15/2014. This was a ($0.43) per share premium (discount) to my recalculated NAV of $12.80 per share as of 6/30/2014 (when including the dilution from the recent offering of 22.8 million shares of common stock). This calculates to a price to NAV ratio of 0.966 or a premium (discount) of (3.4%).

As of 8/15/2014, FSFR traded at less of a discount when compared to the past couple of months. In my opinion, the key to FSFR's results over the next few fiscal quarters will be how efficient the company can deploy this substantial amount of newly raised capital (proportionately speaking).

Furthermore, as stated in a recent SEC filing, management is seeking approval to allow Fifth Street Finance Corp. (NASDAQ:FSC) and FSFR to "co-invest" in future loans. As such, it will be interesting to observe if FSFR "steals" future investments from the company's "big brother" so management better utilizes this newly received capital. Therefore, FSFR's recent material equity offering may also negatively affect FSC's future investment portfolio growth.

From the positive and negative factors listed in my previous article and updated analysis above, I currently rate FSFR with a "wait-and-see" attitude for all new potential investors. Before I consider an initial investment in FSFR, I am waiting to see how fast the company can deploy the capital received from the recent offering of 22.8 million shares of common stock. I am also waiting to see what kind of potential returns will be generated from all newly funded loan originations. These considerations will directly impact earnings over the next several fiscal quarters including future dividend declarations.

This decision includes considering FSFR is currently trading at a minor discount to CURRENT NAV and no additional equity offerings should occur for at least the next several quarters. I continue to believe when compared to FSFR, FSC is the more attractive BDC to invest in. I cannot see how FSFR's recent substantial equity offering materially below NAV as of 6/30/2014 builds trust with existing (or potential) shareholders. Furthermore, FSC currently CANNOT issue shares below CURRENT NAV. I believe this is an important distinction between the two companies.

Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation may not fit each investor's current investing strategy.

Disclosure: The author is long FSC. I have no position in FSFR.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.