We’ve been tracking Fifth Street Finance (FSC) since its IPO back in 2008, and it’s been quite a ride. The company was lucky enough to be a relatively new BDC (Business Development Company) when the Great Recession came along, and was able to avoid the loan defaults and forced de-leveraging that many BDCs faced.
Buoyed by available capital and an absence of many competitors, Fifth Street Finance grew by leaps and bounds during the early stages of the economic recovery. Nonetheless, a number of credit missteps caused the company’s earnings per share to drop sharply below expectations during 2010. During that period, FSC switched from paying dividends quarterly to monthly.
Now the company has reported earnings for its fiscal first quarter which ended December 31, 2010 and shortly thereafter announced the expansion of its debt facilities, the raising of new equity and a raft of new investments in 2011. We had a look at all that and undertook an overall review of the company’s earnings, balance sheet, and prospects, both in a recession and in a strong economy, with a view to determining what the future might hold.
Background: FSC is a mid-sized, middle market Business Development Company. FSC has been back to raising equity in the markets multiple times in the past three years, with five major offerings since its IPO. The most recent offering occurred just as the latest financials were announced. The company pays a monthly distribution of $0.1066, which annualizes at $1.2792. The stock price at March 22, 2011 was $13.3.
Earnings: For the quarter, Net Investment Income was $14.1mn, substantially higher than the $8.3mn earned a year before but only modestly higher on a per share basis: Increasing from $0.22 to $0.26, due to the new share issuance. FSC’s earnings remain behind its current dividend level.
Admittedly, the company is not fully leveraged. Despite adding deals in the last quarter at a frenetic pace ($273mn, spread over 13 companies), net debt to equity was only 0.29: 1.0, versus the hypothetical maximum 1:0 to 1.0: 1.0 that a BDC is allowed. Management has stated explicitly in its most recent newsletter that its target maximum leverage is 0.6: 1.0, so FSC was only halfway there at calendar year end.
Worth noting is that the most recent quarter’s earnings were boosted by an unusually high level of fees due to the large number of new deals being closed. Fee income was 18% of Total Investment Income in the period, or $4.5mn. Contrast that with fee income of just $0.9mn a year ago and one has to recognize that FSC’s earnings include some non-recurring income. Once deal activity settles down, there may be a drop-off in fee income levels, but that’s still a few quarters away.
Capital Structure: FSC, besides being an equity raising machine, finances itself from two distinct capital sources: Medium-term revolvers with Wells Fargo (WFC) and ING Bank (ING), and the SBIC. As of the last earnings report, FSC had $190mn in lines of credit with its revolver lenders and (according to our unofficial calculations) as much as $175mn drawn. No wonder FSC increased its facility limit with ING by $125mn in late February 2011. The ING facility was increased by the addition of new lenders, jumping from a $90mn limit at December 31, 2010. There was no reduction in the pricing as yet, but if FSC gets a BBB rating (clearly in the works) the debt will be priced at LIBOR + 3.0%, with no floor. (Separately, Wells Fargo did reduce its revolver pricing to LIBOR + 3.0%).
On the SBIC front, FSC has $123mn drawn on $150mn of potential borrowings. No word on getting a second SBIC license, which some BDCs have done, which could permit another $75mn of debt capacity.
Then there’s $43mn of cash on the balance sheet. How much of that is available for investing is unclear. Management may want to keep a reserve.
Stress Test: We like to ask ourselves what would happen to any BDC if faced with a sudden drop in asset values (we’re using a 25% bogey) brought on by a recession or fears thereof. Would this result in a default under borrowing arrangements? Where FSC is concerned (and we’re helped here by a very useful table on page 63 of the 10-Q, which details the covenants on the two loan facilities and shows where FSC stands on each) such a downdraft would be containable.
Even after adjusting for the higher borrowings, which occurred after year end, it seems that FSC could take such a major hit to its asset values (which affects all the covenants in one way or another) and avoid any default. That’s certainly true for the ING loan, but may be a little more precarious with Wells. We’re uncertain about what the impact would be with the SBIC. As with most public BDCs the 10-Q contains standard risk language about its SBIC debt, but does not specify what covenants we need to worry about.
Unfortunately, FSC does not believe in laddering its revolver liabilities. Both facilities have had had their maturity dates pushed out to 2014, which is commendable. However, we like to see borrowing maturities spread out to avoid having an unsustainable amount of debt called at an inopportune time should there be a credit crunch in our future. It may be hard to imagine today, but in a future crisis, lenders may not want to renew their credit lines at any price; having the bulk of your financing coming due at the same time is a recipe for potential disaster.
Overall, though, FSC’s balance sheet at it is currently constructed, should be able to absorb most any stress we can foresee in the medium term. Virtually all the investment assets (97%) are in yield-bearing instruments, the portfolio is well diversified with no egregious concentrations by industry or company, and an increasing proportion of the loans are in supposedly less-risky first lien loans.
Credit Quality: In the past we’ve expressed some concern about FSC’s credit quality. By its own recognition, many of the loans put on the books in 20007 have experienced problems. A year ago, five loans were on non-accrual. Ditto just three months ago. The drag on the company’s income is even quantified in the 10-Q: $2.4mn of forgone investment income in the last quarter alone. That’s 8.7% of Total Investment Income lost to non-performing loans and 15% of Net Investment Income.
To its credit, the company tackled its under-performing portfolio in this most recent period. Three of the five non-performers were restructured, resulting in Realized Losses of ($13.4mn). Two of the restructured companies are back to servicing their new, sleeker loans. That leaves three non-performing loans, totaling a still-disturbing $35.5mn at cost (or 5% of the aggregate loan balance at cost) and $19.1mn at Fair Market Value.
The good news here is that FSC does not seem to have any new troubles brewing with any other portfolio companies. In fact, it seems to us from a reading of the 10-Q that all the investments rated in the two lowest categories of FSC’s Portfolio Asset Quality rating system are the three non-performing loans. This suggests the remaining 42 companies in portfolio may be okay from a credit perspective.
Earnings and Dividend Outlook
That gives us some visibility and confidence for income in 2011 and beyond. The analyst consensus for the fiscal year ending September 2011 is for earnings of $1.14 and the following year of $1.28. Given the full year earnings ended September 2010 were $0.95 per share, these estimates underscore that FSC continues to be a growth story, even in the face of repeated dilution from new equity issuances.
Our own projections are in line with the consensus, but there are a number of variables that could skew the results one way or another.
First is the propensity of FSC to raise capital regularly, which could temporarily tamp down earnings per share.
Second, there is the potential impact of FSC’s new asset management initiative, which will give a boost to earnings in the future, if successful. (We are looking forward to hearing more about this in future earnings reports.)
Third is what happens to interest rates. FSC has been very aggressive in building a portfolio of mostly floating rate loans to take advantage of the universally-expected increase in shor- term interest rates. If that happens, earnings per share should increase sharply. If rates don’t increase any time soon, FSC will have left money on the table.
A fourth variable is gross yields. As FSC has substantial capital to spend much of its future income will depend on maintaining yields in the low teens on new business. This segment of the middle market has been very lender-friendly in this regard, but as the economy improves and the appetites of other lenders revive, spread compression could occur. It’s happened in the larger deal market and could work its way down to FSC’s market.
Finally, there is the impact of credit underwriting on the results. FSC has booked a very large number of deals in recent months, even more than some BDCs with larger balance sheets. That’s very commendable, but does beg the question of whether credit standards have been maintained.
FSC’s earnings per share remain behind its dividend, but we remain optimistic that the large amount of unused capital on the company’s books will result in substantially higher earnings per share this fiscal year and next (even accounting for new equity issuance). The company’s bad debts appear to have turned a corner and should be a declining factor in months ahead, and the capital structure remains under-leveraged and capable of withstanding most any unexpected shock. Even at full leverage, FSC’s goal of maintaining a BBB rating (we assume) and debt to equity at 0.6:1.0 mitigates risk down the road. The biggest upside remains the possible impact of higher LIBOR rates on earnings, and the greatest risk a raft of bad debts.