Recap of Today's Numbers
Fifth Street Finance (FSC) shares are down 17% from previous close on poor earnings.
NII for the quarter was 0.16 per share (0.02 lower than estimate of 0.18)
.02 (monthly) Payable March 31 for shareholders of record March 15
.02 (quarterly) Payable June 30 for shareholders of record June 15
.125 (quarterly) Payable September 29 for shareholders of record September 15
Now let's look at what's actually happening here with the dividend. Firstly, no - the dividend is not being cut to .02 monthly. They are retroactively cutting the dividend to .50 annual and changing to quarterly dividends and so we should expect to see .125 per quarter going forward past September (until its inevitably cut again).
Fair Value Estimate
Now that that's out of the way, we want to employ a dividend discount model to get an idea of FSC's current value. If we utilize the assumption that dividend is proportionate to NII which is proportionate to NAV, we can decline future dividends at approximately the rate of NAV decline. And so a simplistic model would be
Dx = P(1-R)^x
Where Dx is the dividend for the xth year, P the dividend for the current year and R is the rate of NAV decline.
Let's talk about the rate of NAV decline R first. One way we can project future decline, is by looking at historical data. If we consider data since 2007, we arrive at an average decline of 6.5% annually, However, keep in mind that FSC IPO'd at the height of the financial crisis - not exactly the best timing. The chart below shows NAV per share over time since 2009.
Using this time frame, we get an average annual decline of roughly 4% (including current quarter not shown).
One could argue that the actual rate is less than 4%, especially since the recent quarters accounted for a significant chunk of the decline and management has huge incentive to frontload losses at the current moment so that the "blame" can be shoved on the outgoing administration. That said, it would not be surprising to find NAV stabilize for the next few quarters and so if we consider this we could use a lower rate of decline. Management has already come out and said during their conference call that they intend to
realign our dividend to allow us to pursue lower risk, more stable investments
And so annual rate of NAV decline closer to the 2.2% experienced from 2009 to 2014 might be possible.
But, I prefer a conservative estimate so I will stick with 4%. As a good reality check, 4% is still a good bit higher than what I'd estimate is the sector average based on the other models I've done.
Now let's talk about the current year dividend P. While we could just go with 0.50 (the actual current dividend), it is not a good point to start our model.
Consider the following chart
We see for the most part (until things started to go real bad), FSC paid an annual dividend around 11% of NAV per share. So that begs the question, why is the current dividend so low relative to NAV?
Part of this is due to a high proportion of non-accruals within the portfolio. FSC addressed this issue during their conference call.
15.5% portfolio at fair value consisted of non-interest generating assets which include non-accruals and equity investments
we will seek to reduce investments on non-accrual and on our watch-list with the goal of reinvesting these proceeds into safer, interest generating loans
Non-accruals have value, but do not contribute them to income. In this sense, you can imagine them as "cash" just sitting there waiting to be deployed. Once the non-accruals are either disposed of or accruing again, income will increase relative to NAV.
Share repurchase is another reason dividends are lower at the moment, but this scenario is incredibly accretive to NAV and thus share price given the current discount to NAV and so should be viewed as a plus consideration. Using an 11% of NAV figure, we can begin our model at 0.80 current year dividend.
Now we can use the figures of P = 0.80 and R = .04 to model our future dividends. Of course, the dividend is currently 0.50 and not 0.80 and so we can lower any year dividend greater than 0.50 down to 0.50. The result is a plateau.
We can then discount these to present value. I use a discount rate of 10%. The discounted dividends for the next 30 years are worth $4.87 at present value. If we then factor in a discounted residual value (after 30 years, the shares are still worth something) we get an additional 0.10 and so we come up with an estimate fair value of $4.97.
I believe the current situation indicates a case in which negative sentiment far outpaces reality. Looking on many forums, I see overwhelming comments about the 0.02 monthly dividend - a good indicator that a significant number of people actually believe the dividend was cut 2/3 down to 0.24 annual. Moreover, there are likely some others who are selling simply because they cannot or will not wait 6 months without income.
While I'm of the "don't believe it until I see it" opinion when it comes to things FSC promises, they do mention proposing changes to the fee structure in the conference call and so we might be able to see some additional benefit here.
Lastly, the current share price represents a 37% discount to NAV. This is a historically high discount to NAV and another good indicator the stock is currently undervalued.
While arguments can be made that in the short run, the price will continue to drop, I believe now might be a good time for investors to start opening small positions in FSC. The current price of $4.62 is not grossly undervalued, especially since my model is not precise by any means and has quite a large margin of error and so I would not "bet the farm" on this one as of yet. I currently rate this stock a "buy" with some reservations and a price target of $5.00.
My previous trade on FSC, I purchased FSC $5.00 calls in November at .35 and sold them in December at .60-.65.
I reentered FSC today weighted average $4.64 per share.
Disclosure: I am/we are long FSC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.