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Why Fifth Street Senior Floating Is Over Valued

Posted by Nicholas Marshi, BDC Reporter on Jul 24, 2017 11:41:43 AM

INTRODUCTION

With the July 14, 2017 announcement that OakTree Capital (“Oak”) will be replacing Fifth Street Asset Management (“FSAM”) as Fifth Street Senior Floating‘s (FSFR) Investment Advisor investors have pushed the stock price up.  As recently as June 22, 2017 FSFr’s stock was trading at $7.32 a share. However, starting with the June 29, 2017 Wall Street Journal story reporting on a potential sale of the investment contracts FSFR and Fifth Street Finance (FSC) to Oak, and the formal announcement two weeks later, the price has risen 23% to over $9.0.

The BDC Reporter, which has been following the unfolding Fifth Street companies saga in its News Of the Day reporting to subscribers, asks the question as to whether the rise of FSFR’s stock price is likely to continue ?  After all, even at its new and loftier price FSFR trades at a (17%) discount to book value and below an above $10 price reached earlier in the year. If FSFR’s price matched its latest book value another 10% price increase would be in store.

However, we believe there are five reasons that will ultimately weigh down FSFR’s stock price, as we discuss below:

FIVE REASONS

1. Latest Earnings Were Low

In the IQ of 2017, FSFR earned $5,086,214 on a GAAP basis, or $0.17 a share. Over 6 months, Net Investment Income was $10,970,264 or $0.37 per share. By contrast, Distributions To Shareholders over 6 months were $12,228,709. Even when we add-back the financing expenses associated with refinancing, FSFR was earning  -on a GAAP basis- less than what was owed to shareholders. That also holds true for Taxable Income which was $5,008,421 in the last quarter and $10,705, 051 in the last 6 months. Using the 6 month data Taxable Income is (12.5%) behind the distribution.  If we compare to a year ago, Net Investment Income Per Share was (15%) down.

2. Glick JV Shrinking and Under-Performing

Like many BDCs FSFR has bet big on a joint venture vehicle. In this case , the JV is with the Glick family. Back in September of 2016 the JV had $201mn in assets in 36 companies and FSFR had invested $63mn. As of March 2017, the JV’s total assets had dropped to $147mn and 27 companies. Essentially the JV has dropped a third in size in two quarters …Just in the last quarter investment income dropped by 22% even as yields slightly grew.

Till recently the JV was an out-sized contributor to FSFR’s Investment Income. A year ago, the JV contributed (see page 37 of the 10-Q) 15.8% of all Investment Income. Even last quarter the JV was the biggest earner, contributing 12.8% of all income. However, that’s likely to drop materially in the quarters ahead if current trends persist. Last quarter the only income from from FSFR’s debt investment in the JV. The year before (the quarter ended March 2016)  its equity stake contributed $0.9mn. This last quarter the contribution was zero.

That may partly be why the JV – not surprisingly given that the assets in the vehicle are very similar to the rest of the portfolio – made a loss in the last quarter and FSFR’s value therein dropped. In fact, the $71.1mn invested by FSFR in debt and equity in the Glick JV has dropped to $61.5mn, a (14%drop) and all in less than 2.5 years.

We’re worried less about income dropping much more (all the remaining income is derived from the debt position in the JV set at LIBOR + 8.0%). What would be worse is if the third party lenders to the JV blocked the Subordinated Notes which FSFR and the Glicks hold because of a default under their loan arrangement. Overnight that would put at risk $5.6mn of annual investment income. Even if the JV was liquidated without any further erosion and all capital returned and re-invested in “regular” portfolio assets at 7.0%, Investment Income would drop by ($1.3mmn) or nearly $0.05 a share.

FSAM gave no explanation (and apparently took no questions) on the last Conference Call, so we have no idea why the JV is shrinking and what the plans of all the interested parties are. To be conservative we assume some sort of liquidation will occur and Total Investment Income will drop by $1.5mn a year and Net Investment Income will be materially lower.

3. Credit Problems at Portfolio Companies

FSFR is often considered the “Good” Fifth Street BDC from a credit perspective, when compared with sister fund FSC. That’s true in a way, but that does not mean FSFR has a spotless credit portfolio. Just last quarter FSFR recognized a ($13.5mn) loss on Answers Corporation. That brought Realized Losses in aggregate to ($24.4mn) at the end of March 2017. Back in September 2014 that number was zero.

Unfortunately, and despite the Answers deal getting taken off the books, FSFR still had 6 companies (besides the Glick JV) on our Watch List. One company (Metamorph US 3) is already on PIK non accrual ($71,041 last quarter). However, cash interest income is $441,466 (over $1.7mn annually) and that could – presumably – happen at any time.

Also worrying is FSFR’s exposure to My Alarm Center. This security company roll-up which the BDC has lent nearly $19mn to in various tranches earns about $1.7mn in annualized income. We know from Saratoga Investment‘s (SAR) earnings that My Alarm Center has had financial difficulties and was written down materially. If this debt goes on non-accrual, as we believe has already happened, FSFR’s income will be affected until a restructuring of some kind is completed.

We will be keeping an eye on Ameritox Ltd, which was restructured and recapitalized last year, with FSFR taking an equity interest. Total exposure at cost is $18mn, and the FMV $13.4mn. Last quarter the Class A units which cost $5.9mn and were previously valued at $1.3mn at year end 2016 dropped by 50% in value. Worrying.

In toto, these 3 deals have a FMV of $40.6mn.

There are 3 other credits we are watching including NextCare,Inc. ; New Trident Holdcorp and Verdesian Life Sciences,LLC.

In toto these 3 Watch List names aggregate $23mn at FMV.

In the most extreme terms there is $2 per share of NAV at risk. More importantly, we worry about the risk to income from the 3 Worry List names, which threaten 12%  of Net Investment Income, not even including the Glick JV.

4. Lower Fees And Higher Costs Coming  

A portion of FSFR’s income is derived from fees from new originations. However, with management otherwise engaged in recent months and preparing for many more weeks before a handover, we guess new deal activity will be modest, as will new fees booked. A year ago, quarterly fee income was $0.7mn. Last quarter the number was $0.3mn, and that could drop further.

Just as FSFR was getting from under huge legal bills related to the struggle with the so-called “activist investor” last year here comes the change of Investment Advisor. Yes, Oaktree and FSAM will be footing the bill for the Proxy and the change to the new Investment Advisor. However, there will be other costs – all of which get billed to the BDC’s shareholders. Existing debt facilities will be amended initially and renegotiated. That’s likely to involve fees and more fees, not to mention the non-cash write-off of any amortizing costs from when the financings were first put into place.

We would also imagine there will be other professional costs (including a more frequent valuation of the portfolio by third parties) in the first few quarters after the acquisition that will erode some measure of profitability.

Between lower fee income and higher costs FSFR’s Net Investment Income could drop by $0.4-$0.5mn a quarter.

5. Valuations Are Already High

As a multiple of Taxable Income FSFR’s stock price is already high by most standards. At the close on July 17, the stock price was at $8.97. Taxable Income Per Share was $0.17 or $0.68 annualized. That’s already a Price To Current Earnings multiple of 13.2x. If we assume – with our readers indulgence – that a combination of the factors listed above reduces Net Investment Income Per Share to $0.60, the multiple will be 15x. That’s almost the same multiple as Golub Capital (GBDC) with a much better track record and corporate history, is trading for. Of course, the market can pay whatever multiple it sees fit but we’d surmise a multiple of 10x would be more plausible after the good feelings accompanying the Oaktree deal wear off and as investors face the realities of the FSFR business model, whoever it at the helm. At that multiple FSFR would trade at $6.0 to $6.8. Coincidentally or otherwise that was the valuation given FSFR back in February 2016 when BDC investors everywhere were sharpening their pencils and having a hard look at values.

That’s a potential (25%) downdraft. Is that worth the risk for a BDC – Oaktree’s new found role notwithstanding – paying a dividend currently of $0.76, or an 8.4% yield, some of which is probably return of capital ?

CONCLUSION

We don’t think so and expect the market will eventually agree once the BDC falls out of the headlines for awhile. Of course, we can’t say when this shift might occur but we believe the stock is over valued and due for a fall. However, in this over heated market where even BDCs with very real challenges, falling earnings and leveraged to the max can attract buyers the Day Of Reckoning may be some way off, and could be determined by a much broader investor sentiment regarding leveraged debt and credit investments.

DISCLOSURE

BDC Reporter has no position in FSFR but may short the stock as part of our Special Situations investing should the stock price continue to rise in the face of the unchanged risks described above. 

 

 

 

 

 

Topics: BDC


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