November 15, 2011: Fifth Street Finance (ticker: FSC) has a fiscal year which ends in September, so the annual filing lags behind most BDCs which have already reported quarterly earnings. Out of the blue yesterday Fifth Street issued a press release two weeks in advance of the official November 29th earnings release to provide a sneak peek at a few key metrics. The Company revealed the full fiscal year Net Investment Income for 2011 was coming in at a range of $1.04-$1.06. For the quarter, the NII was projected to be between $0.27-$0.29. Actually those numbers are in the high range of what the market was expecting, according to the data in Yahoo Finance.
DIVIDEND REDUCTION COMING UP
The Company’s real purpose, though, was to use the press release to announce the next 3 months of dividends. [FSC is a monthly dividend payer]. The Company indicated the monthly pay-out will be reduced, starting in calendar 2012, from 10.66 cents to 9.58 cents. That’s a non-dramatic 10% drop in the pay-out.
HERE IS WHY
We found the explanatory language in the press release interesting. Here’s a portion of the release:
“Fifth Street’s dividend policy is based on the following key principles:
-- pay dividends consistent with Fifth Street's current and future earnings potential; -- set dividend rates that are projected to be stable and growing over time reflecting confidence in Fifth Street's future financial performance; and -- provide clarity that Fifth Street intends to cover its dividend payout level with NII.The analysts’ consensus projected NII estimate for the fiscal year ending September 30, 2012 is $1.16 per share. Fifth Street believes that such estimate is reasonable.”
BDC REPORTER’S TWO CENTS: Two points worth making, and a closing conclusion. First, we find it disconcerting that Fifth Street can both be projecting higher earnings in 2012 over 2011 while SIMULTANEOUSLY reducing the dividend. That represents a first in the BDC space.
Second, FSC appears to be leaning on the analyst consensus for FY 2012 to determine the level of the dividend next year. Usually a company provides guidance, and key assumptions underlying the guidance and the analysts come up with their estimates thereon. Here the situation is topsy turvy. What happens if FSC does not achieve $1.16 in earnings per share next year. Will the Company blame the analysts ?
WHY HAVE A BLOG IF YOU CAN’T COMPLAIN ONCE IN AWHILE
As for the BDC Reporter’s conclusion: Fifth Street’s dividend policy management is chaotic, and shareholders deserve better. This is not the first time the Company has changed course and surprised investors. Through May 2010 the Company was paying a quarterly dividend (which annualized out at $1.28 at the apex). Then the Company switched to a monthly pay-out but left a gap between dividend announcements, which served as an effective dividend reduction. At the time, the press release quoted the CEO Leonard Tannenbaum explaining that the change in dividend policy was partly aimed at providing shareholders with “a consistent and stable payout”. That was just over a year ago. In the last few months the dividend had built back to the level of 2010, and now it’s down again.
CONSTRUCTIVE SUGGESTION
Admittedly there are a wide variety of dividend policies in the BDC community, but annual jags up and down are not in anyone’s playbook. Shareholders would be better served with an approach in line with that of companies like THL Credit (TCRD) or PennantPark Investment (PNNT) who set a dividend a few cents underneath current GAAP earnings levels, and only increase the pay-out when there is a pronounced and “permanent” increase in earnings. We’ve included a link here to the PNNT dividend page on their website which illustrates what we’re talking about. To their credit, PNNT managed to navigate through the Great Recession without any reduction in the dividend, providing a “consistent and stable pay-out” in very difficult circumstances.
PLACING THE DIVIDEND CUT IN CONTEXT
All the above notwithstanding, this change in the dividend is not a serious blow to Fifth Street. Some investors may even be impressed that management seems to be promising to keep its earnings and dividend in line going forward. Skepticism about FSC’s ability to “earn” its way into the prior dividend level has been rife, and many investors will probably just shrug their shoulders. We used to be believers that Fifth Street’s vigorous adding of new loans in 2010 and early 2011 would ultimately allow the Company to boost earnings to be in line with its pay-out. However, two factors have changed over the last 6-8 months. First, FSC boosted its capital structure with long term Convertible and SBIC debt. We applauded that move then in an article on April 8, 2011, as we do now. However, we pointed out that there is no free lunch and the cost of better matching assets and liabilities, and maintaining a BBB rated balance sheet, is higher interest cost. That probably cost FSC 6 cents of earnings. Second, the Company has shifted its new loan production to “safer”, but lower yielding senior loans. This hit the all-in yield that FSC booked. In just 1 year, between June 2010 and June 2011 the yield dropped from 14.9% to 12.6%. Given that FSC has roughly a billion dollars in loan assets that’s a lot of investment income to give up for less credit write-offs down the road. Like many others, we have come to acknowledge that you can’t have your cake and eat it too, and that FSC’s moves to strengthen its credit and capital structure would result in lower earnings and dividend. Unfortunately management has not done a good job of making that case up front and will have surprised some of its investor base with the dividend cut. Whether that will hurt FSC’s ability to raise new capital in the future or cause any material drop in the share price remains to be seen.
WE ARE LONG FSC
Not paying out dividends which exceed the company’s earnings sounds like sound advise (aka common sense) to me. If anything, this policy only adds to my faith in the companies decision making ability and future profitability.
In a later conference call they said that they had reduced to dividend to placate some institutional holder of FSC. The institutions had a policy of not holding any investment where the company paid out dividends which exceeded the company’s earnings. FSC has more institutional holders than most BDC.