Updated on March 27th, 2019 by Josh Arnold
At first glance, PennantPark Floating Rate Capital (PFLT) has great appeal for income investors. PennantPark is one of about 400 stocks with a 5%+ dividend yield. You can see the full list of established 5%+ yielding stocks here.
In fact, PennantPark has an 8.9% dividend yield.
Not only that, but PennantPark also pays its dividend each month. This allows investors to compound their wealth even more quickly than a stock that pays a quarterly or semi-annual dividend.
There are currently just ~40 monthly dividend stocks, which you can download from our database below:
But, as is so often the case with sky-high dividend yields, PennantPark’s attractive dividend yield may be too good to be true.
This article will discuss the company’s business model, and whether or not the payout is sustainable over the long-term.
PennantPark is a business development company, or BDC. It provides mostly debt financing, typically first line secured debt, senior notes, second lien debt, mezzanine loans, or private high-yield debt.
It specializes in making debt investments to middle market companies. To a lesser extent, it also makes preferred and common equity investments.
As of the end of 2018, PennantPark had a total investment portfolio of $980 million, consisting of 85 separate investments in 24 industries.
Source: Investor presentation, page 10
The company’s portfolio is highly diversified, with no particular industry making up more than 8% of the total mix.
In addition, the company’s portfolio is entirely floating rate, which opens up its yields to interest rate volatility. This can be good in times of rising rates, but is unfavorable should rates decline.
Source: Investor presentation, page 4
An overview of the company’s investment philosophy reveals PennantPark prefers middle market companies with $10 million to $100 million in annual EBITDA, and has a high rate of underwriting success.
Only 5 of the company’s 344 investments since inception have reached the non-accrual stage, and it has a 98% recovery rate on those non-accruals. This track record of outstanding underwriting is a key advantage for PennantPark.
Source: Investor presentation, page 14
Above is a sampling of the types of investments the company makes in target companies. Not only are the targets themselves from diverse industries and geographies, but PennantPark has a variety of instruments with which to make its investments.
First lien secured debt is the preferred instrument given its favorable repayment position, but the company will do revolvers and equity injections as well.
PennantPark has positive growth prospects given that it has demonstrated a track record of successful investments.
Source: Investor presentation, page 7
Not only has PennantPark been able to grow the size of its portfolio over time, but its average yield has risen meaningfully as well.
The company’s portfolio was well under $500 million at the end of 2015 but today, is more than double that size and is very close to $1 billion. PennantPark has been able to grow its portfolio very profitably, keeping a keen eye on credit quality throughout.
In addition, average yield has risen over time after bottoming in late 2016 at 8%. Today, the company’s average yield is north of 9% and still rising, reflecting strong investments made in recent years, as well as higher rates.
As PennantPark’s portfolio is entirely comprised of floating rate instruments – mostly tied to LIBOR – it benefits when interest rates are increasing. We see these two components – a larger portfolio and increasing rates – as the two main growth drivers moving forward for PennantPark.
PennantPark’s Q1 results showed core net investment income of $0.30 per share. The company’s investment portfolio actually shrank fractionally as it exited $190 million of positions during the quarter, while adding $181 million.
Net asset value per share was $13.66 at the end of December, down from $13.82 in the prior quarter. Still, with the share price under $13, the stock trades at a modest discount to net asset value.
While we believe PennantPark has the track record and financial means to continue growing in the coming years, we have concerns over its ability to maintain its dividend.
PennantPark pays a monthly distribution of $0.095 per share. The company recently declared its next distribution, which is in line with distributions paid monthly since early 2015. That was the last time PennantPark raised its payout, although to its credit, it hasn’t been cut, as has been the case with many other BDCs.
The stock has a very attractive annualized dividend yield of 8.9%. Even better, it makes monthly dividend payments, so investors receive their dividends more frequently than they would on a quarterly schedule.
However, it is also important to assess whether the dividend is sustainable. Abnormally high dividend yields could be an indication that the dividend is in danger.
PennantPark has earned enough in core net investment income in recent periods to cover the dividend, including the recently-reported first quarter. Core net investment income was $0.30 per share against a quarterly distribution rate of $0.285 per share.
As a result, PennantPark’s payout ratio is very close to 100%. Of course, that is to be expected to an extent for a BDC, as they are required to distribute essentially all of their income.
However, shareholders should certainly not expect a distribution increase in the near-term given how close the payout is to earnings today.
PennantPark’s ability to grow the portfolio and its average yields, while keeping expenses under control, will determine if the distribution is sustainable. Today, the outlook suggests that for the near-term, the dividend is safe.
Thus, we aren’t expecting a dividend cut, but caveat that with the note that should credit quality deteriorate, or if rates move down, PennantPark’s earnings will suffer and a dividend cut may become a reality.
The old saying “high-risk, high-reward” seems to apply to PennantPark. It certainly has an attractive dividend yield on paper, but there is more to the payout than meets the eye.
If everything goes according to plan, the stock could generate double-digit total returns on an annual basis. There is a high possibility PennantPark’s net investment income will continue to grow. Higher interest rates would be a big step in that direction, and the size of the portfolio may continue to expand.
However, there is also an elevated level of risk here. If PennantPark does not grow investment income, it could be forced to reduce the dividend at some point in the future. It is also susceptible to lower rates, even if the portfolio continues to grow.
As a result, investors should tread carefully. Only investors with a higher risk tolerance should consider buying PennantPark despite the discount to net asset value and very high yield.