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Fifth Street Finance Corp. Message Board

  • fred2011_2012 fred2011_2012 Oct 18, 2011 9:36 AM Flag

    Request: comments re Oct newsletter

    I am interested in hearing any comments/questions from EDUCATED investors...not eternal optimists or pessimists. Thanks.

    1) In an earlier newsletter,b4 the 2nd quarter end, FSC indicated a preview of earnings. Why do u think they did not indicate a range this time around?
    2) does the spread indicated post labor day of 2% help them compared to last year?
    3) Any other educated insights/comments are appreciated.

    Thanks to all

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    • RC - Greatly appreciate your analysis, it has been most helpful. I am also a share holder and weighing out the concern reflected by today's downgrade by Wells Fargo, who downgraded FSC and few others, where they feel there is likely going to be a reduction of the dividend. It seems you are optimistic that won't be necessary, but have your reviewed the downgrade and do you have a comment?


      • 2 Replies to jameswillsurf
      • ....Cannot find a downgrade by WFC?

      • <<<<....they feel there is likely going to be a reduction of the dividend. It seems you are optimistic that won't be necessary......>>>>

        I can't say with certainty they won't cut the dividend.

        FSC has a lot more taxable income than is reflected in NII and FSC is paying out virtually all of their taxable income to shareholders. I wish WFC would have made some reference to the NII vs taxable income issue just so I would know if they have taken this into consideration in their analysis.

        It would be a more conservative approach for FSC to just pay out what is reflected in NII, and if they were required to pay out more at the end of the year than they had earned in taxable income, they could pay shareholders a special dividend to meet their payout requirements.

        With this approach, FSC could also retain some of their income for future investments. As a BDC they are only required to pay out as little as 90% or their ordinary income. They'd pay a 4% excise tax on the retained amount, but would be able to keep that portion of their earned capital, which at times like now when BDC's are hindered from raising new capital because they are trading below BV, has definite appeal.

        By my estimation, FSC paid out virtually all of their taxable income in this fiscal year (ended Sept. 30th). However, it's worth noting that FSC began this fiscal year with an $11mm carryover of undistributed NII from 2010.

        They do need to improve dividend coverage from NII, and if not for issuing those Convertible Notes earlier this year, they would have made decent progress year over year in this regard. The additional cost of those Notes is why FSC's NII dropped $0.02 last quarter. It's the most expensive debt on their balance sheet by about 200 bps.

        I think we're going to see improving NII per share over the next few quarters for several reasons:

        1.) FSC is not going to be issuing any new shares for a while. They are an under-leveraged BDC with access to plenty of available capital through their 3 bank facilities. Not issuing any new shares to raise capital forces them to use some leverage which is what they need to do anyway.

        2.)Continued growth in the investment portfolio. FSC has has Net Portfolio Growth of between $100mm to over $200mm in each of the last 4 quarters.It grew by $116mm in Q3

        3.)Yes, they had increased borrowing costs in Q2 (the Convertible Notes) but that's last quarters news. This quarters news is some reduced borrowing costs. The new Sumitomo credit facility is priced 75-100 bps less than their other two bank facilities, about 275 bps less than their Convertible Notes, and about 150 bps less than their SBIC debt, not to mention it's a 7 year facility.

        4.)Minor point, but as mentioned by FSC, they bought back, at less than par, $17mm of those Convertible Notes.

        5.)Their second SBIC license will be approved soon. This will give them another $75mm of available credit that does not count against their debt to equity ratio requirement.

        I think FSC comes in at $0.27 NII this quarter, a penny more than WFC estimates.

        If FSC decides to get more conservative with their dividend policy, they could cut the dividend a bit, but I don't think it's inevitable.


    • Great questions. Yes better spreads helps on new originations while existing portfolio it does nothing for them, so slight positive. Reason they did not lay out earnings is because fiscal year end. Takes longer.

      Overall they not yet earning the dividend purely on nii but investment gains help and are real cash profits. If you own you can do math on yield be based on what they are paying or be conservative take current nii as what you getting safely. Either way great yields

      And if ever interest rates go up fsc has most floating rates of any co

      • 1 Reply to lucky_lucy12361
      • <<<<......Overall they not yet earning the dividend purely on nii but investment gains help and are real cash profits....>>>>


        I think you and me are on the same side with regard to FSC but I disagree with your comment above as to how FSC covers their dividend.

        FSC is invested about 98% in debt securities. When these investments exit/prepay, FSC receives par (assuming everything goes well). They do not realize investment gains from these exits.

        FSC has had a number of troubled investments that they either exited at a loss or restructured and took a loss on the restructuring. No investment gains here either. As a matter of fact they show $61mm in NET REALIZED losses in the last 10-Q.

        If you can show me examples of realized investment gains I would like to see them.

        Here's the explanation of FSC's dividend coverage, which I posted on this board back in June 2011 so the references to numbers are based on Q410 & Q111, but the explanation is accurate.

        "With regard to dividend coverage, BDC dividend requirements are based on taxable income, not NII.

        Because FSC has been originating new loans at such a rapid pace they have received a significant amount of taxable income that hasn't been reflected as investment income yet.

        This is because when FSC originates a loan they receive a 2-3% origination fee. FSC collects this fee in cash at the beginning of each new loan. But, FSC does not reflect the entire origination fee on the balance sheet in the quarter the loan was originated.

        Instead they amortize this 2-3% origination fee over the life of the loan, so it shows up as investment income a little bit each quarter.

        At the same time, the full amount of that origination fee is taxable income in the year it was received.

        For example, let's say FSC originates a $10mm loan with a 4 year term to maturity. Assuming the origination fee was 2% (it could be higher but it wouldn't be lower), they collected a $200K origination fee at the beginning of the loan.

        Because they amortize that origination fee into investment income over the life of the loan, it means $12,500 is reflected into investment income each quarter. At the end of the 4 year term of that loan, the entire origination fee has been accounted for in investment income.

        Now consider that in the last 2 quarters FSC has originated about $521mm in new deals. Even using only a 2% origination fee, this means FSC would have collected $10.4mm in origination fees and less than $1mm of that would have been amortized into investment income, yet the other $9.4mm is taxable income for the current fiscal year.

        I'm not arguing that FSC shouldn't work toward 100% dividend coverage via NII, because they should, and they've stated they are working toward that goal.

        Just pointing out that while their dividend coverage policy is a bit aggressive, during this high growth period FSC has an unusually large amount of taxable income over and above what's shown in NII and that they are covering the dividend with taxable income. There is no ROC component to FSC's dividend and they will likely end the year with a modest amount of spillover as they did last year."

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