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Stock Watch : PennantPark Floating Rate Drops

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INTRODUCTION

After PennantPark Floating Rate Capital (PFLT) announced its results on Thursday February 8, 2018 and held its Conference Call, the stock price began to drop. The subject was even raised on the Conference Call with an analyst – over optimistically – asking the CEO of the BDC for an explanation. He – reasonably enough – demurred. To-day – Friday February 9 – the stock continues its downward trend, reaching a new 52 Week Low of $12.0, from a 52 Week High of $14.65. The BDC Reporter has a look at whether the PFLT slump might be opportunity or not for investors.

RESEARCH

For our purposes, we read the earnings press release and the 10-Q for the quarter ended December 31, 2017. The most likely factor causing investors to dump PFLT is the negative Net Investment Income in the period, and a slight drop in Net Asset Value. The two issues are related. Moreover, the BDC booked a Realized Loss in the fourth quarter. Like several other BDCs, PFLT had exposure to troubled – and now bankruptcy court protected – retailer Charming Charlie. A restructuring is underway at the company, which many lenders may be involved in. PFLT, though, opted to take the loss and walk away.

FUNDAMENTALS

Otherwise, though, fundamentals that caused the BDC to trade at or above NAV and allowed the Investment Advisor to raise new equity capital back in October of 2017 do not appear to have changed. The quarter’s recurring earnings loss was almost exclusively due – as management reiterated multiple times in the Conference Call – to the fees associated with resetting its Revolver and issuing Unsecured Notes in Israel last quarter.

The rate at which the BDC borrows on both the senior debt and the Unsecured Notes is very attractive. Going forward PFLT should benefit from having its financing set for the next two years and in favorable terms. If rates continue to rise, a portion of the debt liabilities are already fixed and most of the BDCs investment assets are tied to LIBOR and will increase correspondingly. (We’re not forgetting that spread compression will – most likely – rob PFLT and other BDC lenders of some or all the benefit of higher LIBOR, but that’s another issue).

On an adjusted basis PFLT’s Net Investment Income Per Share was $0.25 in the quarter, after all those one-time costs are added back in. That’s still below the $0.28 distribution level. Some investors may be worrying that the dividend may be cut in the quarters ahead.

The BDC Reporter has a Dividend Outlook of UNCHANGED, which we re-affirm after reviewing the latest data. Several factors should allow PFLT to continue to pay the same – or an even higher – dividend:

1. After the debt raise, the BDC has $128mn of cash on the balance sheet to invest. That’s equal to a prospective 17% increase in the total investment portfolio once deployed, and will provide a major boost to earnings.

2. The BDC has a JV underway called the PennantPark  Senior Loan  Fund I which has not yet reached its full earnings potential. PFLT and it’s JV partner have funded a good portion of their commitment to the JV but maximum use of third party leverage has not yet occurred. As the JV matures and reaches its intended portfolio size, PFLT claims the effective yield on its capital at risk in the structure will be in the mid-teens. That’s quite a premium for a BDC whose average yield for regular on balance sheet loans is just 8.0%. Moreover, as the Investment Advisor points out on every Conference Call – the BDC has plenty of  room to grow this JV- or a similar structure – within the capacity allowed by the BDC rules. Several other BDCs – including Goldman Sachs BDC and Apollo Investment – are using a similar approach of having both on balance sheet and off balance sheets with some success. There’s no reason that PFLT – with its growing deal origination footprint – should not be able to follow in their peers footsteps.

3. CEO Arthur Penn has not been shy on Conference Calls to indicate that the Investment Advisor is confident recurring earnings will eventually catch up with the dividend. The BDC Reporter hardly takes everything said by BDC managers as gospel, but Mr Penn is a veteran of this sector with two BDCs under management, and is unlikely to make such comments lightly. Mr Penn reiterated that confidence on the latest Conference Call.

4. Credit quality remains in very good shape. We reviewed the 10-Q and identified only 3 problematic credits in the 84 company portfolio. One is PFLT’s only non-accrual credit remaining, with a FMV of  0.2% of the total. The other two are a loan facility and a non income producing Preferred position. Likewise, the credit quality at the JV seems squeaky clean too. We’ve reviewed numerous BDC portfolios over the years in great detail and PFLT;s current credit quality ranks amongst the very highest. As a rule, we’ve rarely ever seen a BDC reduce its distribution absent credit problems. Nor is PFLT in the midst of those strategic repositioning that some of its peers have adopted – shifting from higher risk assets to lower risk- which might cause a reassessment of future earnings potential and a dividend cut.

CONCLUSION

As mentioned earlier, we affirm our Dividend Outlook of UNCHANGED for 2018.

‘For investors seeking a reliable dividend payer, with a long track record of unchanged pay-outs; a lower than most risk profile and potential earnings upside, PFLT fits the bill. The yield – as we write with the stock at $12.31 is 9.1%, our long term estimate of average annual Total Return is 9.4% and the short term upside , should PFLT eventually bounce back to its prior 52 Week High is 19%.

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