One of the capital raisers is Fifth Street Finance (ticker: “FSC”), which announced its intention to offer 10mn shares (plus 1.5mn shares for over-allotments) on January 23^rd.  At time of writing, the final price for the new stock was not set but should be around $10.0, which suggests FSC will be raising around $115.0.  That will grow the share count by over 15%.  It’s quite an accomplishment for a company that was notable in 2011 for being one of the very few BDCs to cut it’s dividend.  Moreover, stock price action has been dramatic. After peaking just below $14.0, FSC’s stock price dropped as low as $8.38 : a 40% decline in just 6 months. Even today, after recovering from its August low, FSC still trades 30% below the 52 week high.

View the full FSC chart at Wikinvest

 GRAB WITH BOTH HANDS

FSC is raising a boatload of cash, but does not have any pressing need to put the money to work. As the company’s own newsletter reveals, financing activity has shrunk in recent months (as you’d expect) with new lending almost completely offset by repayments.  However, FSC says it makes money by turning over its portfolio from front-end fees, back-end fees and syndications to other lenders. As we’ve noted in earlier posts, though, the wise BDC knows to grab the chance to raise new equity if the opportunity presents itself and this is such a time.

Presumably investors are drawn to the fact that the company is trading at the discounts mentioned above, and the fact that loan spreads are elevated after months of market turmoil, dire predictions about double dip recessions and less competition from banks concerned about capital ratios and maintaining solvency. The analysts were projecting higher earnings in fiscal 2012 (which ends in September) than in fiscal 2011, and another increase in FY 2013. Valuing FSC as a multiple of FY 2013 earnings per share of $1.19, the $10.0 stock price for new shares implies a forward multiple of just 8.4x. As of September 2011 the Net Asset Value was $10.07, and will probably be close to that when the December results are announced.

 WORRIED ABOUT THE DIVIDEND

FSC has a chequered history when it comes to paying a steady dividend. Twice in recent years the dividend has been cut as the dividend liability increased faster than the company’s ability to pay. Recently FSC’s management has promised to keep its payouts in line with earnings.  However, 11.5mn new shares to “feed” in an anemic new loan environment may put pressure on the company’s ability to keep paying the current monthly dividend $0.0958 ($1.15 annually)  as recurring earnings per share will probably drop in the next  couple of quarters until the new capital is deployed. In the longer run, assuming FSC steers clear of adding new non-performing loans, earnings per share and dividends should increase, if only modestly.

WE ARE LONG FSC

View the full FSC chart at Wikinvest

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

View the full SLRC chart at Wikinvest

The BDC Reporter’s Two Cents: There was nothing very dramatic or obvious in Solar Capital’s results-good or bad-to comment on at great length. We had a quick look at the 10-Q, but we’ll undertake a more in-depth review shortly to confirm that suspicion. Here are the main preliminary thoughts:

1. Asset values dropped because Solar Capital (like Apollo Investment, BlackRock Kelso and Ares Capital amongst others) invests in larger company loans, many of which are traded. The Unrealized Depreciation for the period was $75mn, or just over $2.0 a share of paper loss. That’s a 6% write-down of Solar’s portfolio from cost. When it comes time to mark-to-market at the end of the quarter Solar has to use these market prices in valuing its own portfolio, even if assets are being held for the long term. We predicted in our blog of October 11th when we previewed third quarter BDC results that there would be  a reduction in asset values. We had a ballpark figure of 8-10%  (which we picked by looking at market price reductions in the junk bond and leveraged finance market).

We can’t take these so-called market prices too seriously because on any given day the price can go up or down based on macro factors (i.e. if Greece is misbehaving so might the price). Moreover, as BlackRock Kelso pointed out on their Conference Call the number of deals actually traded is very limited, which affects pricing. We’ve heard from several BDCs that market prices have jumped since September 30th as market optimism has rebounded.

What matters is if there is any material change in the fundamental performance of any of Solar’s portfolio companies. That’s much harder to tell, but the Company says all is well on that front. That’s the argument propounded by Solar’s CEO on Jim Cramer’s CNBC program (he’s a SLRC booster). He seems to comfortable with that line of reasoning, as the link shows. What’s more the analyst community has SLRC earning $2.27 a share this year and $2.48 next year. On today’s price (already up due to the Cramer plug) SLRC is trading at just 8.9x 2012 earnings. Our initial review of the 10-Q shows us that there are 6 companies in portfolio that have reduced enough in value over cost to be placed on our Watch List. However, none of the loans are on non-accrual.

TO BUY OR NOT TO BUY THAT IS THE ETERNAL QUESTION

We don’t disagree with Mr Cramer, or agree for that matter. On one hand,  in 2007-2008 increases in Unrealized Depreciation were an early indicator of the trouble that was to follow. Many of the companies which were written down on paper initially ended up defaulting and going into bankruptcy or being restructured. Unrealized Losses became Realized Losses, often with several quarters of delay between the two. The third quarter was the first since the Great Recession where we had such a sharp market pull-back and almost across the board Unrealized Depreciation. On the other hand, this could be a passing cloud, in line with the apparent bounce back in the outlook for U.S. GDP.

WHAT WE WOULD SAY IF WE HAD OUR OWN TV SHOW AND WERE LESS SUCCINCT THAN JIM CRAMER

Our argument, which is nowhere near as helpful and cut and dried as Mr Cramer’s, is that there’s no way to know what’s going to happen next to Solar Capital’s credit worthiness or earnings.  Solar has loans and investments in over 40 companies in a wide variety of industries, each in their own economic micro-system. Moreover, the bulk of their investments are in higher risk subordinated loans, which can be valueless if the borrower tanks. Moreover, Solar is continuously adding and selling portfolio companies, so the picture is in constant flux. BDCs do provide a huge degree of transparency to investors. Moreover,  Solar’s management has access to the monthly financials of all its portfolio companies, as well as access to each entity’s management, and even they cannot be certain what the next few quarters will bring. You could be pessimistic, sell out today (or fail to invest) and then watch as economic conditions ameliorate, and lose out on both a near 12.0% yield and a 10-30% run up in the stock price. Or, you could get jump in and find out that the economy will point downwards and see several of SLRC’s portfolio companies slip from under-performance to non-accruing to Realized Loss. The stock price, which is close to AV even now, could drop substantially.

2. Net Investment Income Per Share was 57 cents, versus a dividend of 60 cents. Like many of the larger BDCs, Solar Capital has been comfortable allowing a significant gap between the dividend being paid out (which is supposed to be essentially its entire taxable earnings) and actual GAAP earnings (which is a different number).  Solar has been in ramp up mode in a relatively benign economic environment since going public. Management’s approach has been to gradually build up the balance sheet and earnings to meet a dividend which has been unchanged  for 7 quarters in a row. We’re comfortable that Solar Capital should be able to continue to boost net investment assets given that net debt to equity is still only 0.3 to 1.0. There’s plenty of availability under the Company’s well priced Revolver and there are opportunities to invest in both new deals and primary deals at good rates. Fully invested, and assuming no drag from bad debts, Solar should earn over $0.60 a quarter, which bodes well for a dividend increase next year if economic conditions do not suddenly deteriorate.