GSBD - PennantPark Floating Rate Capital: Time To Sell This 10% Yielding BDC (Downgrade)

2024-01-12 06:44:20 ET

Summary

• PennantPark Floating Rate Capital's stock price has recently surged, but I believe it is not sustainable.
• I predict that floating-rate-focused BDCs will struggle to generate positive net interest investment income and dividend growth in a falling-rate environment.
• I suggest selling PennantPark stock due to the current rate of price growth and the potential challenges ahead.

PennantPark Floating Rate Capital (PFLT) is a floating-rate focused business development company whose stock price skyrocketed lately.

I think that floating-rate focused BDCs are going to have a much harder time to produce positive net interest investment income and dividend growth in a falling-rate environment and taking into account that PennantPark's stock is now selling for a premium to net asset value, I have made the decision to sell into the upsurge.

As a consequence, I am also modifying my stock classification to Sell, as I don't think that the present rate of price growth is sustainable.

My Rating History

PennantPark was obviously a top investment choice for passive income investors that saw the central bank's rate hikes coming in 2022. Surging inflation and higher short-term interest rates were backing up my investment thesis with respect to PennantPark which you can read over here .

With the central bank now changing tunes and being committed to lowering its key interest rates this year, I think that a potent net investment income driver is falling by the wayside. Thus, my change in stock classification as well as my decision to sell into the price upsurge.

Floating-Rate BDC Are Set For Tougher Times

The key element behind the investment thesis for PennantPark was that the central bank had a big incentive in 2022 to raise short-term interest rates in a high-inflation environment.

In the last two years, the central bank pushed up key interest rates at the fastest pace in decades, delivering a profit growth catalyst to those BDCs that developed a floating-rate focus with respect to their debt portfolios.

PennantPark is a pure floating-rate BDC, meaning 100% of its investments are floating-rate loans whose loan rates reset to the upside if the central bank hikes interest rates.

PennantPark's investment focus is the core middle market segment which primarily consists of companies that produce annual EBITDA in a range of $10-50 million and usually these companies are offering some kind of recession-proof service. Among the investments that are highly represented in PennantPark's debt portfolio are Media, Healthcare and Professional Services companies.

PennantPark's portfolio primarily consists of First Lien Senior Secured Loans which accounted for 85% of the business development company's investments as of the end of the third quarter. Other, less-important investments include Subordinated Debt and Equity which accounted for the remaining 15% of investments.

PennantPark's portfolio value as of 3Q-23 was $1,067 million, reflecting a decline of 7% since the end of 2022. The decline in portfolio was triggered by higher interest rates which have weighed on loan origination activity as well as a speedy pace of loan repayments in a high-rate environment.

Moving forward, I would expect loan repayments to slow as interest rates comes down which could help PFLT to return to net asset value growth.

Not A Great Margin Of Dividend Safety

PennantPark has not the greatest margins of dividend safety even though the BDC has seen growth in its net investment income in the last year, thanks to its floating-rate exposure.

The BDC's dividend pay-out ratio in the last twelve months was 94% compared to 72% for Blue Owl Capital (OBDC) and Goldman Sachs BDC (GSBD) had a 76% pay-out ratio. PennantPark has thus a much weaker margin of dividend safety than its peers and I think that it will be much harder for the BDC to produce dividend growth in 2024 if key interest rates decline.

Skyrocketing Valuation

Besides the very realistic near-term outlook for falling net investment income due to reasons that affect the strategic positioning of the BDC's debt portfolio, I don't think that PennantPark is properly valued at a 12% premium to net asset value. Most BDCs that also have very high floating-rate exposure, like the ones I mentioned in the pay-out section and in the valuation chart below, have much lower NAV multiples.

I don't think that this makes a lot of sense since 100% floating-rate BDCs are set to see lower net investment income in falling-rate environment. Correspondingly, with lower NII on the horizon, I would also expect the valuation multiple to compress. If I were generous, I'd say that PFLT has a stock price target of $11.13, which is the BDC's net asset value.

Why PennantPark May Outperform

I don't think that PennantPark could outperform in a lower-rate environment, but a higher-for-longer interest rate environment could be a challenge for the underlying thesis.

This environment could be made possible by a new flare-up in inflation or exceptionally strong economic growth, and thus throw cold water on the central bank's key plan to lower short-term interest rates in 2024. In this case, PennantPark may see growth in its net investment income and the margin of dividend safety might improve again.

My Conclusion

PennantPark was an attractive bet on rising short-term interest rates and higher net investment income during the early stages of the central bank's rate hiking cycle.

With that being said, the Fed shift that was communicated in 2023 and which is poised to result in lower key interest rates in 2024 is set to remove a potent profit and net investment income catalyst.

Taking into account the very real potential for lower NII and headwinds to the valuation multiple, I actually think that the present moment offers passive income investors a potentially lucrative opportunity to ditch PFLT at a very good NAV multiple.

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