FS Investment Corporation Should Initiate A Large Share Repurchase

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About: FS Investment Corporation (FSIC), Includes: AINV, ARCC, CCT, CGBD, NMFC
by: Cory Burnell, CFA

Summary

FSIC's dividend yield recently surpassed 11%.

Market participants deem its NAV to be either inaccurate or deteriorating.

New loan originations cannot be as attractive as a share buyback.

FS Investment Corporation is a publicly traded business development company (BDC) that investments its capital principally in debt securities of private middle market U.S. companies. As of June 30, 2018, its $3.6 billion portfolio reportedly consisted of:

  • 67% first lien senior secured loans
  • 4% second lien senior secured loans
  • 5% senior secured bonds
  • 12% subordinated debt
  • 1 % collateralized securities
  • 11% equity investments and other investments

However, the numbers above differ from what's reported on Page 5 of FSIC's 2Q Financial Presentation linked below.

Since February of 2017, FSIC's share price has seen virtually unabated selling pressure. No doubt much of this is warranted as its Net Asset Value (NAV) per share closed the 1st Quarter of 2017 at $9.45 and closed the 2nd Quarter of 2018 at $8.87 (FSIC-Financial-Presentation-18Q2-8-9-18.pdf). Also, FSIC reduced its annual dividend by 14.7% from $0.891 to $0.76. Additional uncertainty surrounded the stock when it was announced in December of 2017 that KKR would replace GSO/Blackstone as the sub-advisor to FS Investments' BDCs. All this poor performance and uncertainty has led to its recent closing share price of $6.88, presumably $1.99 or 22.4% below the NAV on June 30th.

I use the term presumably, because the market has traded FSIC as if its reported NAV is either inaccurate or deteriorating more rapidly than reported. For example, from March 31, 2017 to June 30, 2018 the NAV declined 6.1% and the dividend was reduced 14.7%, but the share price declined 25%. Granted shares were at a 3.7% premium to NAV on March 31, 2017, but the size of the decline since then still dwarfs the NAV decline and drop in dividend yield. The market is pricing FSIC as if either the dividend will be reduced again or the NAV will decline tremendously, or both.

To add insult to injury, this price decline has occurred during an economic expansion and a rising interest rate environment. Precisely the type of environment that should make floating rate loans more attractive, not less.

During the 2018 2nd Quarter conference call, management gave every indication that dividend coverage remains strong, so there's no hint of a reduction on the horizon. If the NAV is accurate, then recent share prices and the 11% dividend yield make for a very attractive share repurchase opportunity.

If management won't do a meaningful buyback (more meaningful than the measly $50 million previously done this year), then one has to ask why. Does management think their portfolio is actually worth significantly less than $8.87 (NAV)? If so, this needs to be disclosed and accurate valuations need to be generated. Or does management think new originations will net investors a better return than an 11% dividend plus a rising share price?

Management discussed the current lending environment on their recent 2nd Quarter conference call. Essentially this is currently a borrower's marketplace wherein covenant light loans are becoming prevalent in order to get deals done. So how can such an environment produce better opportunity through new originations than the current portfolio of loans issued with solid covenants and producing a net after fees return of 11%? In general, a portfolio of loans originated today cannot be as attractive as a portfolio of loans originated just a few years ago when lending was tight and lenders were in control of the terms.

However, there's a conflict of interest faced by FSIC when deciding whether to repurchase shares, which decreases the BDC's assets. The management of FSIC is paid a 1.5% annual rate of the assets under management, and consequently is incentivized to use cash for new originations rather than share buybacks. Perhaps this is why a meaningful repurchase has yet to materialize despite its obvious advantages over new lending.

A meaningful buyback in this current borrower-friendly environment should be a $250 million authorization. New loan originations should be cut by $50 - $100 million per quarter with those funds diverted to buying shares until FSIC's share price is within a reasonable distance, perhaps 5-8%, of its NAV. There's seldom reason to originate a new loan if the current portfolio can truly be bought for 23% below NAV (as reported on 6/30/18) with a dividend yield of 11%.

Disclosure: I am/we are long FSIC.

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.