PennantPark Investment Corp.: Don't Buy The Drop

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About: PennantPark Investment (PNNT), Includes: PFLT
by: Achilles Research
Summary

PennantPark Investment's shares dropped off after the BDC's release of first-quarter earnings last month.

Large floating-rate asset base makes PNNT vulnerable to a decrease in interest rates. The Fed's more dovish stance on rate hikes challenges my previous investment thesis.

Though shares are close to being oversold and sell for a large discount to NAV, I am not recommending this BDC anymore.

An investment in PNNT at today's price point yields 11.0 percent.

PennantPark Investment Corporation (PNNT) may have a defensively positioned debt investment portfolio, but risks to BDCs with large floating-rate asset bases have significantly increased lately. Further, PennantPark has only a weak dividend coverage, which makes the BDC's dividend one that could get cut in case of an economic downturn. Though shares now sell for a considerable discount to net asset value, I don't recommend PNNT anymore as an income vehicle.

Stock Sell-Off

PennantPark's share price tumbled after the business development company reported a drop in net asset value in the last quarter and investor sentiment took a hit in May amid escalating trade tensions between the United States and China. Since the release of Q1-2019 earnings on May 9, 2019, PNNT is down 6.2 percent. Year-to-date, however, it is still up 2.4 percent. PNNT, according to the Relative Strength Index, or RSI, is still close to being oversold.

Source: StockCharts

Portfolio Overview

PennantPark Investment has a defensively positioned debt investment portfolio with a large allocation of funds to relatively safe first- and second-lien debt. Secured debt made up more than 80 percent of the BDC's investment portfolio.

First- and second-lien debt is typically floating rate and provides PNNT with recurring net interest income. Subordinated debt and equity investments provide the company with earnings upside potential.

First liens are by far the biggest asset class for PNNT, accounting for 55 percent of portfolio investments (based on fair value), followed by second liens (28 percent), preferred and common equity investments (13 percent) and subordinated financings (4 percent).

Source: PennantPark Investment Corp. 10-Q Filing

PennantPark is moderately diversified in terms of industries, limiting the impact of any specific sector downturn. Healthcare, education and childcare have the largest industry representation in PNNT's debt investment portfolio, accounting for 13 percent of investments, down from 15 percent six months ago. I like that PNNT has little exposure to the volatile oil and gas industry (3 percent).

Source: PennantPark Investment Corp.

Floating-Rate Investments And Associated Risk

Like its sister business development company, PennantPark Floating Rate Capital Ltd. (PFLT), PennantPark Investment Corp. has pushed the origination of variable-rate debt which provides the company with significant NII-upside potential in a rising rate environment. Floating-rate loans produce higher net interest income in case short-term interest rates rise which was the case in the last three years.

Interest rates have gone nowhere but up.

PennantPark Investment Corp.'s exposure to floating-rate loans is not as high as PennantPark Floating Rate Capital Ltd.'s exposure (almost 100 percent), but it is still significant at 89 percent.

Source: PennantPark Investment Corp.

The problem here, in my opinion, is that the appeal of large floating-rate debt investments decreases quickly as soon as a rate hiking cycle ends. A decrease in interest rates will have a significantly negative effect on PennantPark Investment Corp.'s net interest income.

Here's a sensitivity table laying out the upside/downside potential in terms of NII based on different interest rate paths.

Source: PennantPark Investment Corp.

Distribution Coverage

Two things about PennantPark Investment Corp.'s distribution coverage:

1. PNNT underearned its payout with net investment income in the first quarter (NII: $0.16/share; distribution: $0.18/share) due to debt issuance costs and depreciation of $0.03/share (net of incentive fees). The BDC covered its Q1-2019 payout with adjusted net investment income of $0.19/share but only narrowly.

2. PNNT continues to have a thin margin of dividend safety, which puts the dividend at risk in case the U.S. economy starts to slow down.

In the last six quarters, PennantPark's dividend coverage ratio was just 102 percent, indicating a high-risk dividend (quarters below depict calendar quarters).

Source: Achilles Research

Valuation

A 26 percent discount to net asset value is usually something I am getting excited about, especially after a quick drop in share price. That being said, though, due to growing risks of a rate cut, I am not buying the drop.

PennantPark Investment Corp.'s shares today sell for 0.74x net asset value, while its sister BDC, PennantPark Floating Rate Capital Ltd., sells for 0.88x net asset value.

NAV Drop

PennantPark Investment Corp.'s net asset value decreased from $9.05/share to $8.83/share in the last quarter, reflecting a decrease of 2.4 percent due to costs primarily associated with the issuance of new debt and depreciation. One portfolio company was on non-accrual in the first calendar quarter, representing 1.4 percent of the BDC's portfolio investments (September quarter: zero non-accruals).

The NAV drop was the most severe drop in at least five quarters and, together with a slight decrease in portfolio quality, stoked investors' fears of a continued decline in NAV in a recession scenario.

Source: Achilles Research

Changing Investment Thesis

In my last article on PennantPark Investment Corp., titled "PennantPark Investment Corp.: Should You Buy This 10.3%-Yielding BDC?", published two months ago, I said that PNNT retains NII upside in a rising rate environment, which is still true. However, the odds of a scenario with rising interest rates have significantly decreased in the last two months as the trade war between the U.S. and China escalated.

Further, Fed Chairman Jerome Powell has essentially signaled that the central bank is prepared to cut rates in order to sustain the current economy expansion, which would bring the current rate hiking cycle to a definitive end. In light of growing risks of a rate cut and considering that 90 percent of PNNT's debt investments are linked to floating rates, I no longer recommend PennantPark Investment Corp.

Your Takeaway

PennantPark Investment Corp. may have a defensively-positioned debt investment portfolio and the NAV discount is quite large today, but I do not recommend buying the drop. More pain is likely to come for BDCs with large variable rate investments, and PennantPark Investment Corp.'s margin of dividend safety is extremely thin, raising the odds of a distribution cut during an economic downturn. PNNT's large floating-rate asset base also most likely will not produce the NII upside I previously indicated if growth slows and the Fed starts to lower interest rates again. Hence, I don't recommend PNNT anymore.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.