A Few Reasons I Want To Own Fifth Street Finance

| About: Oaktree Specialty (OCSL)
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Summary

Fifth Street is now yielding 13% and trading at a huge discount-to-book.

Fifth Street has a sizable portfolio of investments in 124 companies.

I look at key metrics of the company.

All things considered I think Fifth Street is intriguing here.

Fifth Street Finance Corp (FSC) is a name that I have yet to opine on. However, when this now nearly 13% yielding company flashed on my screen that it was trading under $8.50, just a few percentage points off its 52 week low, I had to take a look. For my followers unfamiliar with this company, Fifth Street Finance is a specialty finance company known as business development company. It essentially operates like a loan shark. It finances growing companies and its goal is to make money from the interest and other terms of the loan agreements it has in place. Fifth Street lends to and invests in small and mid-sized companies, primarily in connection with investments by private equity sponsors. This business model, while risky if a company owing money goes under, generates strong margins and earnings. This allows Fifth Street to pay its sizable dividends. The purpose of this article is to get into the finances and performance of the company to determine if this sell-off is an opportunity and to determine if the company can reasonably cover its dividends going forward.

Portfolio

Fifth Street has a sizable portfolio of investments. Its portfolio consisted of investments in 124 companies. The fair value of its investment portfolio is currently estimated to be approximately $2.5 billion, as compared to $1.9 billion a year ago. This represents a 32% growth rate year-over-year. Total assets are $2.7 billion, as compared to $2.1 billion last year, growing by 29% year-over-year. Much of this growth came in the fourth quarter. During the quarter Fifth Street closed $394.4 million of investments in nine new and five existing portfolio companies, and funded $274.9 million across new and existing portfolio companies. This compares to closing $307.4 million in 10 new and seven existing portfolio companies and funding $294.4 million last year. During the quarter Fifth Street received $285.1 million in connection with the full repayments of 11 of its debt investments, The company also received an additional $123.6 million in connection with syndications of debt investments and sales of debt investments in the open market.

Income

Looking at the portfolio as a whole, its weighted average yield on debt investments at was 11.1%. This includes a cash component of 9.9%. This led to strong income in the fourth quarter, but it did follow the trend of the financial sector as a whole, missing on both revenues and earnings. Fifth Street saw total investment income of $76.2 million up from $57.1 million last year. It also saw $0.25 in net interest income in the quarter, which failed to cover the dividends paid during the quarter. For the year (up until end of Q4), total investment income is at $294.0 million up 33% from the $221.6 million raked in at that point last year. That growth cannot be ignored. This huge increase is essentially due to higher average levels of outstanding debt investments, reflecting a net increase of 15 debt investments year-over-year.

Cash

So how is the company doing cash wise? It has about $109 million in cash and cash equivalents to start Q4. Its assets are impressive though, boasting portfolio investments of around $2.5 billion. It also has $317.4 million of borrowings outstanding under its credit facilities, $115.0 million of unsecured convertible notes payable, $409.9 million of unsecured notes payable, $84.8 million of secured borrowings and unfunded commitments of $325.0 million. What strikes me is the conservative nature of the company as a whole. I have covered many companies that use leverage to increase/magnify returns. Well, Fifth Street's leverage was just 0.63:1, hitting the low end of its target guidance. Contrast this with the more risky mortgage real estate investment trusts, which average about a 6.0:1 leverage ratio. The fact that this company is conservative and still generates the earnings that it does is impressive.

Dividend Coverage

To me the dividend coverage is a risk. The company just raised its dividend in September to $0.0917 per share, or $0.2751 per quarter. Now in Q4 it paid two months of $0.083 per share, so in total Q4 dividends were $0.2577, but net interest income was only $0.25. Now dividends are even higher and so it remains questionable whether the dividend will be covered and if not, will the company cut dividends in 2015? One way to mitigate this risk potentially is to lever up; that is take on more risk to magnify returns. This play can work but if the market goes sour or interest rates move with volatility, it could backfire. Q1 here is going to be critical in terms of the future dividend announcements.

Trading at a Huge Discount

Like with mortgage real estate investment trusts, book value or net asset value, is a key predictor of share price. When making a purchase of a company like this, we need to know what we are paying relative to what the company's assets are roughly worth. When trading at a discount-to-book, it either means you are getting a deal, or the Street believes that the company's performance will worsen in the near future. In contrast, a price that is a premium-to-book often suggests that the company is expected to improve its performance and thus it trades at greater than fair value. Well, the company's book value was $9.64. At $8.50, we are getting a $1.14 or a 12% discount-to-book. While this could be interpreted as a red flag risk for future net asset value declines, with Fifth Street's growing portfolio I think the risk is minimal, especially with interest rates having been rather low/stable this quarter.

Take Home Message

Fifth Street yields 13%. It is trading just above a 52-week low. The business model appears to be successful, so long as bad debts are avoided and the interest rate environment remains favorable. The dividend coverage issue is a slight concern, but I like the growing assets, the conservative leverage ratio and the discount-to-book. All things considered I think Fifth Street is a compelling buy here.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.