Reprinted from the BDC Reporter: In advance of a Business Development Company's quarterly earnings release, the BDC Reporter highlights the key issue which investors should be focused on in the flurry of press release, SEC filing and Conference Call discussion. For investors who want to follow along, we provide references to the BDC's prior filings on which this analysis is based.
PennantPark Floating Rate Capital Ltd. (the "Company") ( NASDAQ : PFLT ) announced that it will report results for the first fiscal quarter ended December 31, 2016 on Thursday, February 9, 2017 after the close of the financial markets. The Company will also host a conference call at 10:00 a.m. (Eastern Time) on Friday, February 10, 2017 to discuss its financial results. All interested parties are welcome to participate. You can access the conference call by dialing (888) 297-0339 approximately 5-10 minutes prior to the call. International callers should dial (719) 325-2337. All callers should reference PennantPark Floating Rate Capital Ltd. An archived replay of the call will be available through February 24, 2017 by calling (888) 203-1112. International callers please dial (719) 457-0820. For all phone replays, please reference conference ID #2019530. From the press release.
BACKGROUND: PennantPark Floating Rate ended its fifth full fiscal year in September 2016 with Net Asset Value Per Share of $14.06, up marginally from $13.95 the year before, and marginally below its IPO price in March 2011 of $15.00. Net Investment Income Per Share in FY 2016 was $1.02, down from $1.08 and $1.12 in FY 2015 and 2014 respectively. However, the decline in recurring earnings per share is largely attributed to the impact of the August 2015 merger with MCG Capital, which increased the BDC's share count from 14.9mn to 26.7mn. The Investment Advisor has been busy in the intervening quarters-armed with the additional cash capital from the MCG Capital deal- increasing total investment assets from $359mn as of June 2015 to $599mn. As before the merger, PFLT remains focused on lending to middle market borrowers, principally at the senior secured level. The average yield on debt investments ended the fiscal year at 7.6%. Distribution-wise, the BDC has maintained the monthly pay-out of $0.095 a month, first established in April 2015, notwithstanding the reduced Net Investment Income Per Share resulting from the acquisition. PFLT's stock price, which slumped-along with the BDC market as a whole-in early 2016 to a low of $10.35, has been climbing for the past twelve months. As of January 16, 2017, PFLT traded at $14.10, close to its 52 week high, and only 4% off the all-time high achieved in 2013, and 6% off the IPO price. Net Investment Income Per Share in FY 2016 was 7.3%. The current price is 100% of NAV, 13.8x trailing recurring earnings, and the yield 8.1%.
KEY ISSUE: Will PFLT make progress in FY 2017 increasing recurring earnings per share ?
Currently, Net Investment Income Per Share ($1.02) is running behind the distribution level ($1.14) as discussed above, which caused "Undistributed Net Investment Income" on the FY 2016 balance sheet (page 46 of the 10-K) to drop from $6.9mn to $4.6mn as previously accumulated excess earnings are returned to shareholders. However, analysts and investors have been giving the BDC a pass on this issue given a substantial amount of unused borrowing capacity on the balance sheet, which PFLT has been drawing on to increase its total investment assets (up 53% in FY 2016 !). Technically PFLT still has $117mn in unused borrowing, sufficient to increase the total portfolio from under $600 at September 2016 to over $700mn. See page 66 of the 10-K. That would boost investment income, and Net Investment Income and more fully fund the distribution.
However, there are a number of headwinds which the BDC faces which might make materially boosting recurring earnings more difficult than it seems. First of all there is the spread compression underway in the leveraged loan market, with too many dollars chasing too few deals. Already in the last quarter of FY 2016, when PFLT booked over $100mn in new loans, the average yield was only 7.0% versus a portfolio average of 7.8%. (See the earnings press release). There is no reason to believe that, on an equal risk-return basis, spreads have gotten anything but tighter in the intervening months, or that there will be relief ahead in calendar 2017. Investors should keep an eye on the yield of PFLT's loans being repaid and what is coming on in the quarters ahead. A 0.5% decrease in the average yield on the existing portfolio would result in $3mn in lower Investment Income, and almost the same amount in Net Investment Income. That's $0.11 a share at play in potential lower Net Investment Income Per Share, but potentially spread over a couple of years or more. A 1% drop in the average yield may seem high, but since 2012 PFLT's average yield has dropped 0.8%, by point of comparison. See page 33 of the 10-K.
BEWARE WHAT YOU WISH FOR
Second, the recent increase in the 3 month LIBOR rate on which many leveraged loans are fixed may not be the godsend in the short run that investors foresee. PFLT's investment portfolio will likely not see any benefit from LIBOR's increase from 0.85% at the end of September 2016 to 1.0% at the end of the year, given the fact that virtually all loans have a corresponding 1% floor (or higher). However, PFLT's Revolver has no floor and the funding cost will have increased by 17%. Add 0.2% to roughly $250mn (or more) of Revolver borrowings and you've got $0.5mn in incremental higher interest expense over a year and $0.125mn in the quarter. On an annual basis that's a not inconsequential 1.8 cents a share. On the plus side, PFLT expensed $0.9mn in loan amendment costs last year which may not be repeated in FY 2017. (See page 38 of the 10-K).
Also, if rates do increase more dramatically down the road PFLT, and its shareholders, should stand to benefit. Still, we point our readers to page 41 of PFLT's 10-K which shows that a 1% increase in interest rates from the level at September 2016 has a negligible benefit (1 cent a share). At September 2016 , LIBOR was at 0.85%, as we showed before. It's a long way to a rate of 1.85% or higher that might result in the earnings windfall that some investors are foreseeing as the Fed talks about three rate rises in 2017. However, even if that should come to pass and LIBOR moves in step, little benefit will accrue to PFLT this fiscal year. Rather the opposite in the short term.
Third, PFLT's earnings in FY 2016 benefited from a non-recurring income item ( a legal settlement worth $3.3mn, and explicitly called out by the Investment Advisor and the financial statements-see page 47). Other Income, too, was beefed up in FY 2016 as all those new loans were booked. As PFLT reaches fully invested status, those fees might be more akin to what was earned in FY 2014, about $1.2mn lower. In toto, there might be $4.5mn in non-recurring income PFLT will have to make up just to tread in place.
How much can the BDC hope to make from booking new loans, and how much of that will percolate down to shareholders ? PFLT could add $100mn (but $50mn is more likely due to leverage/liquidity concerns). If we take the full $100mn (which would push up Debt To Equity to 0.9x) and project the new loans will yield 7.0%, and deduct out 1% for the Management Fee and 3% for the interest expense, and 0.5% for incremental operating costs, the contribution is 3.5%. Should the Investment Advisor receive its 20% Incentive Fee, the net contribution will be 2.8% or $2.8mn, or over 10 cents a share. Will that additional source of income be sufficient to make up for the absence of one-time and unusual income; potentially higher borrowing costs and loan spread compression ?
This quarter's results will not tell the full answer to the question but will give clues.
If there is a gap between what PFLT is earning on a recurring basis and what the current dividend "liability" is, the Investment Advisor will have a series of decisions to make, all of which revolve around the risk-reward analysis at the heart of BDC investing. Portfolio yield could be boosted by taking on a bigger proportion of second lien loans, but increasing default risk down the road. Leverage could be pushed to the limit to maximize income while remaining in the "safer" senior secured loans that has been the BDC's very successful bread and butter for over 5 years, or an off balance sheet JV could be engineered (the current BDC favorite for keeping income high). Or, the Investment Advisor could right size the distribution with a cut commensurate with the shortfall. We can hear shareholders complaining about that last option from here, but there is calculated risk in every approach.
Since going public in 2011, PFLT's Investment Advisor has been sensible about capital raising (no equity raised below NAV and no expensive debt), portfolio formation (98 different borrowers or just $6mn on average), credit underwriting (Realized Losses of only $1.4mn); compensation policy (a 1% Management Fee and a 20% Incentive with a 50% catch up provision) and has avoided many of the dramas and controversies going on elsewhere. Distribution policy, too, has been reasonably conducted, although the BDC Reporter is not a great fan of squirreling away "excess income" on the balance sheet.
WATCH WHAT THEY DO
However in FY 2017, if recurring earnings fall short of what the BDC hoped for when making the MCGC acquisition, how the Investment Advisor will behave will tell shareholders a lot-both about the likely course of their distributions (most investors favorite subject) but also about PFLT's attitude towards BDC governance. Will the Investment Advisor continue to harvest the full benefits of the increase in PFLT's assets which has already greatly boosted management and incentive fees while simultaneously potentially cutting the distribution (blaming loan spreads, or increased conservatism or whatever) ? Or will a portion of fees be waived or permanently reduced, as a few other BDCs have done-some with the greatest of reluctance-to be "shareholder friendly ? Or will the Investment Advisor deviate from its historic business model and take on more risk to satisfy (for a time) both its shareholders and itself ?
The BDC Reporter will post a follow-up post after the PFLT earnings release with an early assessment of which direction the BDC appears to have chosen.