PennantPark Investment: Interest Rate Pressure Increases Non-Accruals

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Overview

PennantPark Investment Corp. (NYSE:PNNT) operates as a business development company that generates its earnings through various forms of debt investments. It does this while maintaining exposure to middle market companies that operate primarily within the USA. This business development company targets investments that are profitable and steady cash flows. I previously covered PNNT at the beginning of April and wanted to revisit to discuss the updated financials, valuation, and dividend income use case. We can see that PNNT was the strongest performer out of the listed peer BDCs in total return over a three-year span.

This total return was mostly comprised of consistent high distributions provided by PNNT. The current dividend yield sits at 12.6% and distributions are issued to shareholders on a monthly basis. This monthly dividend makes PNNT highly appealing for the investors that are looking to prioritize income generation from their portfolio. This means that PNNT may be an ideal choice for the investor that is nearing or at retirement age and wants to create a supplemental stream of income to fund their lifestyle expenses. PNNT has been able to recently raise the dividend, which adds to its appeal as a long-term dividend compounder.

Business development companies have remained a great place to offset the fact that interest rates remain at their decade highs. Investors would have found great success within the BDC sector, as they are able to efficiently capitalize on this sort of interest rate environment by generating higher levels of income on the debt investments they make. As a result, we’ve seen lots of money flow into the sector, which has contributed to the increase in valuations of BDCs.

As a result, the valuation of PNNT is looking a bit expensive at the moment when comparing it against its average discount to net asset value. With the remaining uncertainty surrounding interest rates, it may be best to wait on the sidelines until a better opportunity presents itself. Therefore, let’s start by taking a look at PNNT’s investment methodology and strategies implemented.

Strategy And Diversity

PNNT’s strategy is to remain diverse in nature and gain exposure to industries that are typically recession resilient and have healthy levels of interest coverage. Since 2015, 70% of PNNT’s invested capital has gone towards companies that have an EBITDA below $50M. The style of PNNT aligns with a more value added focus so that. Management does state that they have expertise across five different industries.

• Healthcare
• Government Services
• Software & Technology
• Consumer
• Business Services

We can see that the industry breakdown does align with exposure to each of these mentioned sectors. This level of diversity is key for PNNT’s strategy, as they aim to mitigate any industry concentration risk while also remaining exposed to company that are diverse in nature themselves. PNNT strategically targets companies with low debt multiples and healthy loan to value ratios. We can see that business services make up the largest weighting at 15.7% of their portfolio.

Maintaining this focus on risk mitigation, PNNT makes the majority of their investments on a first lien senior secured basis. First lien senior secured debt sits at the top of the corporate capital structure, which means that it has the absolute highest priority in terms of repayment. PNNT’s portfolio is comprised of about 58% first lien senior secured debt. This offers a bit of protection in cases where a portfolio company may be going through a bankruptcy and forced to liquidate assets because it helps ensure that not all invested capital is lost.

However, PNNT does have a higher level of risk than some peer BDCs because of the inclusion of the equity tranche. While the equity level has the highest level of risk due to it being at the bottom of the capital structure, it also has the potential for greater gains. The remaining portion of PNNT’s portfolio consists of about 23% common and preferred equity investments, 14% subordinated debt, and 5% second lien senior secured debt.

Lastly, approximately 97% of their debt portfolio is issued out on a floating rate basis. This means that PNNT is able to better capitalize on this higher interest rate environment that we remain in. As interest rates rise, so does the potential income that can be captured from borrowers within their portfolio. However, there are also downsides to the elevated interest rates as this may put extra strain on borrowers as it now costs more to maintain and service the debt. This can chew into the borrowers profit margins and make it difficult to maintain growth if performance starts to fall behind.

Financials & Risk Profile

As of the most recent Q2 earnings report, PNNT’s performance does have some room for improvement. Net investment income landed at $0.22 per share, which is a decrease from the prior quarter and prior year’s Q2 amount. However, recent history does show us that PNNT was able to efficiently take advantage of the higher interest rates by raking in higher levels of NII per share alongside the rise of rates. We can see that NII per share hit as high as $0.35 per share back in Q3 of last fiscal year. Conditions do seem to be weakening since then, and this is why I maintain caution here.

This weakness has started to show through the BDC’s rising non-accruals. Non-accruals are portfolio companies that are significantly underperforming and are no longer able to keep up with the required debt and interest payments. As a result, these investments are no longer contributing to PNNT’s net investment income and are a reason for weakened performance. Over the quarter, PNNT added two new investments into non-accrual status, which brings their total non-accrual rates up to 3.7% at cost and 3% at fair value.

For reference, Q2 of the prior year saw non-accruals sit at 1.1% of portfolio cost and 0% at fair value. As previously mentioned, the higher interest rates can certainly have a positive effect on earnings but an equally negative effect on the individual investments. It doesn’t help that the Fed has left interest rates unchanged as of their most recent meeting, which means that rates remain at their decade high and that may cause non-accruals to rise. Just for reference, here are some of the non-accrual rates of peer BDC.

• PennantPark Floating Rate Capital (PFLT): 0.4% non-accrual rate at cost.
• Ares Capital (ARCC): 1.7% non-accrual rate at cost.
• Oaktree Specialty Lending (OCSL):4.3% non-accrual rate at cost.

On a positive note, at least PNNT continues to prioritize making new investments in order to fuel additional growth of their portfolio. They invested $58.3M into six new portfolio companies and 34 already existing portfolio companies, which can help growth.

I would ideally like to see a higher percentage of this capital being allocated towards new portfolio companies, but with interest rates at decade highs, there are a fewer amount of companies out there willing to take out debt financing. This $58.3M was invested at a weighted average yield of 11.8%, while sales and repayments totaled $114.2M. On a more positive note, liquidity remains solid at the moment with cash and equivalents sitting at $35.4M.

Dividend

In early May, PNNT was able to raise their dividend by a hefty 14.3%. This is already impressive for a double-digit yielding asset, and further reinforces PNNT’s ability to be an efficient dividend compounder. As of the latest declared monthly dividend of $0.08 per share, the current dividend yield sits at 12.6%. Despite the recent raise, the dividend coverage seems to be a bit thin at the moment when comparing it to net investment income levels. As previously mentioned, NII per share landed at $0.22 per share for the quarter, which means that net investment income doesn’t currently cover the entire distribution by itself. While this presents too much risk for me personally, we did get some reassurance over the last earnings call that spillover from prior performance was able to fill the gap here.

We believe that based on the performance of the portfolio based on continued growth of the joint venture that, that $0.24 is achievable on a recurring basis anyway. So that led us to the dividend increase. – Art Penn, CEO

I would like to first see this projected $0.24 per share actually reported over the next quarter before initiating a position. In my opinion, this raise could have waited and would have been more impactful after presenting shareholders with an improved net investment income. Therefore, I am choosing to remain on the sidelines until we get a glimpse of whether or not management’s confidence can be taken at face value. Suppose interest rates get cut and NII gets drastically reduced as a result. Or perhaps non-accruals rise even higher and these factors affect the income generated from PNNT.

To PNNT’s credit, though, it has been a solid dividend compounder when held over a long period of time. Using Portfolio Visualizer, we can see how an initial investment of $10,000 a decade ago would have resulted in a growing stream of dividend income that continued to compound. Due to the higher earnings pulled in from higher interest rates, PNNT was able to increase their dividend at a CAGR (compound annual growth rate) of 7.84% over the last five-year period.

This graph assumes that all dividends were reinvested back into PNNT, in addition to a fixed monthly contribution of $500 throughout the entire holding period. In 2015, your dividend income would have totaled$1,674. Fast forwarding to 2023, we would have witnessed the annual dividend income grow to $13,856. However, it should be noted that the distributions received from PNNT are typically classified as ordinary dividends. Therefore, distributions here would have more unfavorable tax consequences compared to the dividend received from traditional dividend growth stocks.

Valuation

Since PNNT operates as a BDC, the price can vary from the actual value of the underlying assets. The last time I covered PNNT, the price traded at a more attractive 10% discount to net asset value. However, the price and NAV have both moved upward, despite the lower net investment income and rising non-accruals. The price now trades at almost fair value, with an almost nonexistent discount to NAV of 0.91%. Therefore, I believe PNNT to be priced unfavorably right now when considering the lower NII per share and the price already moving up significantly.

If interest rates come down, it’s possible that we see a negative impact on earnings, which may result in a price decline. Lower interest rates would directly translate to lower net investment income that can be pulled in from their debt investments. However, it can be difficult to gauge how this ultimately plays out because lower interest rates also have the potential to make the volume of borrowers rise as it would now be more cost-efficient to maintain debt.

Wall St. seems to agree with this consensus, since their average price target sits at $7.21 per share. This represents a potential downside of 6% from the current price level. The highest price target sits at $8 per share and the lowest is at $6.50 per share. Ultimately, I am deciding to remain on the sidelines here and wait to see how NII improves over the next several quarters and how PNNT reacts to future interest rate cuts.

Takeaway

In conclusion, I maintain my hold rating on PNNT. Net investment income per share has decreased alongside the rise of non-accruals. As we remain in a prolonged environment of elevated interest rates, there’s a possibility that non-accruals will continue to increase until interest rates start to come down. A lower interest rate may provide some relief to portfolio companies, but it may also negatively impact the level of NII we see. Additionally, PNNT’s price has moved up quite a bit, and now the stock no longer trades at a meaningful discount to NAV. As a result, I plan to await on the sidelines and observe how PNNT improves going forward and if they can truly obtain that $0.24 per share NII level that management expects.