|Shares Out. (in M):||75||P/E||8||0|
|Market Cap (in $M):||681||P/FCF||NA||0|
|Net Debt (in $M):||542||EBIT||0||0|
I am recommending a long position in PennantPark Investment Corporation (PNNT), which I believe can generate a roughly 50% total return over the next two years with comparatively modest downside risk. PNNT is a BDC focused on middle market financial sponsors and is run by experienced credit investors with a strong track record of underwriting as evidenced by their performance through the financial crisis. At a recent price of $9.07, PNNT trades at a 13% discount to NAV of $10.43, which we believe is conservatively stated, and offers a 12.3% current yield.
PNNT went public in April 2007, and in its seven full fiscal years (September fiscal year) since then has paid a total of $7.32 in dividends without ever cutting the dividend. The firm’s bread and butter is backing middle market financial sponsors. Since inception, the firm has funded $4.3 billion in 350 companies across its platform (which also includes PFLT, another BDC focused exclusively on floating rate loans) involving some 145 different financial sponsors. PNNT is run by Art Penn, who co-founded Apollo’s BDC (AINV) and has worked in senior debt capital markets positions for virtually his entire 25+-year career on Wall Street. I have personally worked with Art in my previous life as a middle market private equity investor and can attest to his integrity and competence.
VIC is quite familiar with BDCs as many have been posted over the years, including two quite recently (White Horse Finance and New Mountain Finance). I especially like PNNT given its prudent management and track record of underwriting success, including crucially through the financial crisis. Credit underwriting can be judged only across a full credit cycle; as Buffett says, you only see who’s been swimming naked when the tide goes out, and this is especially true for credit underwriting where your upside is capped but losses are not.
Art Penn has established a strong credit culture at PNNT that is reflected in comments he made on the most recent earnings call:
Our focus continues to be on companies or structures that are more defensive, have low leverage, strong covenants and high returns….As credit investors, one of our primary goals is preservation of capital. If we preserve capital, usually the upside takes care of itself….We have met our goal of a steady, stable and consistent dividend stream since our IPO nearly 8 years ago, despite the overall economic and market turmoil throughout that time period…Our overall portfolio is constructed to withstand market and economic volatility.
PNNT’s current portfolio consists of $1.3 billion invested in 66 companies across 29 industries with 32% in first lien senior secured loans, 44% in second lien secured debt, 16% in subordinated debt and the balance of 8% in preferred and common stock, typically in companies in which PNNT is invested in anjpther portion of the capital structure. The weighted average debt/EBITDA through PNNT’s security is 4.8x while on average its borrowers have a cash interest coverage ratio of 2.5x. The weighted average yield on PNNT’s portfolio is 12.5% with approximately 70% of assets floating rate, typically with a LIBOR floor. Having completed equity ($100mm) and debt ($250mm) offerings just six months ago, PNNT has over $500 million of available liquidity.
Evidencing their strong credit underwriting performance, PNNT has only had 9 of its 350 investments become non-accrual, and the realization on even these 9 has been 94% to date (including positions still held and marked at market). Currently, PNNT has only two investments that are non-accrual, one of which was added in the most recent quarter and together with the carnage in the leveraged energy sector, has created this buying opportunity in PNNT shares.
For most of the past three years, PNNT has traded at a small premium to NAV. However, the decline in oil prices that started last summer sparked a selloff in the broader high yield and leveraged loan markets where energy is the largest component of the market. By early February, just prior to reporting results for the fiscal first quarter ended December, PNNT traded as low as 75% of NAV, though very few shares traded hands near this nadir. It has since rebounded to the current 13% discount to NAV but remains well below the +/-5% premium/discount at which it has traded for most of the post-crisis years.
Between the September and December quarters, NAV declined from $11.03 to $10.43, largely reflecting PNNT’s lower marks on its oil & gas book, which is approximately 7% of the portfolio, as well as a company-specific mark on Jones & Frank, the gas pump distribution business that went non-accrual in the quarter. As an aside, PNNT marks its investments to market each quarter utilizing a third-party valuation firm in a process that is overseen by a committee of its board. Moreover, every investment the company has extended is scheduled each quarter with the cost and current mark. This level of transparency and disclosure should provide comfort to investors and also facilitates further due diligence, though the businesses PNNT finances tend to be private and modestly sized.
PNNT’s largest investment, RAM Energy (which owns low-decline, conventional oil & gas properties in the Ark-La-Tex and Midland basins), is worth mentioning because it accounted for nearly $0.11 of the NAV decline as PNNT marked the position down from roughly par to $0.92. When marking to market, convention requires a heavy reliance on trading of comparable credits, which obviously cratered in the fourth quarter with the precipitous drop in oil prices. On PNNT’s earnings call last month, CEO Art Penn had this to say about RAM:
In RAM Energy, we are backing an experienced management team, who has performed well for [PNNT] in the past. We are first lien position, and the company has hedged most of its oil production at over $75 per barrel for the next 3.5 years….really, it’s more of a traditional play. They focus on operational improvements in drilling low-cost vertical wells. They will opportunistically seek to divest noncore assets, and we think there’s great asset value in this particular situation….It’s great to have that kind of structure where we do have a maturity [a tranche of the PNNT debt matures in July 2015], which gives us a real seat at the table here in the coming handful of months. So as we say, the company’s got great asset value. The company generates nice cash flow, so we’re optimistic that things work out well for RAM Energy.
In response to a subsequent question about RAM, he indicated that “we still think we’re at least getting 100 cents on the dollar back” in RAM, explaining the difference between marking to market based on comparables versus ultimate realization, which is obviously much more important over the long run.
The situation with RAM and energy more broadly highlights one of the attractive things about trading BDCs for investors who are patient and disciplined. The companies tend to trade for premiums when the broader leveraged credit markets are hot, spreads compressed, and complacency high. Conversely, the BDCs tend to selloff and trade at discounts when uncertainty increases and spreads widen. In such times, it is possible to really get a double discount—the underlying positions have been marked down to reflect a weaker market and the BDC itself sells at a discount to its now-discounted NAV. We believe PNNT presents just such an opportunity. We believe that over the next two years, investors are likely to see NAV rise to back over $11, where it stood just six months ago, while also collecting $2.24 of dividends, for a total return of some 50%. The principal risk to this scenario is a credit downcycle, which typically occurs in recession, which if it comes to pass in the next two years will pose much larger challenges for equity investors. Even in the downside scenario, PNNT’s track record suggests its actual losses will be quite modest while it maintains its distribution and deploys capital into attractive new opportunities such cycles present to those with capital and discipline.
I will be happy to address more specific questions in the Q&A.
Continued distributions and recovery in NAV.