A value investor friend of mine recently told me he liked PennantPark (pnnt) and asked me to take a look. I did and decided its a pass, but I figure ill share some of my thoughts here.
Pennantpark is an investment company that borrows money from its banks and reinvests in high yield bonds to small cap companies and private companies that couldn’t get financing in conventional means. The CEO and guy who makes the majority of the decisions, Arthur Penn, is the cofounder of Apollo investment co. which basically does the exact same thing. A few years ago he left to do his own thing. He has a lot of experience in this field and seems decent at his job, shown by their lower than average default rate on investments. Pennantpark is a regulated investment company, which basically means they pay little or no taxes but have to give the majority of their income out as dividends. This makes it hard to grow from internally generated funds.
So my friend believed they were undervalued for two reasons. The first is their borrowing terms. They locked in a rate of libor+ 100bps for 5 years in jan 2007. This gives them a competitive advantage over rivals who have to pay libor +300 to 500 bps. This should lead to much higher roe.
The second advantage is that they are trading slightly below NAV when all their competitors trade 1.1 to 1.5 times NAV. For investment companies NAV is an extremely important benchmark to trade around since you are essentially buying a piece of all their investments.
Their average loanable funds rate is 13.3%. Libor +100bps is about 1.3% right now, so they are making a net interest margin (NIM) of 12%. Since most of these companies use leverage you would expect a pretty good roe (roe = roa * d/e). However, they are currently at 245 million borrowed on their 300 million credit facility. So while they can make a lot of NIM right now, they wont be able to scale this at all until they renew their credit facility at a higher rate of interest 1.75 years from now which will bring down their NIM to a normal rate of maybe 9.5-10.5%. This competitive advantage of theirs is unscalable and not lasting so I put very little value in it.
The other problem is their actual equity. You look at 300 mil equity and 1.75 debt ratio and think, 12% return on that is 63 million, market cap is 288 mil, that’s a pretty amazing return. A few problems. First is normal default rates. Historically on high yield bonds these are about 5.5%. Lets assume that management has great skill in making investments and they can get this number down to 3%. This brings NIM down to 9% and income down to 47.25 million. Next is that management charges 2 and 20, or 2% of all assets managed every year plus 20% of profits. That adds up a lot over the years. For the 2 years reporting those totaled 13.4 million 2009, and 11 million 2008. A big part of profits. SG&A came to about 4.4 million each year. So right away that take income down to about 29.5 million, or about 10% yield. Not looking as good since such a huge chunk went to pay those high management fees, but still pretty good return for a company that trades at 288 million market cap. However in less than 2 years net interest marking will drop off to about 7 % after defaults. Lowering the variable part of their fee structure to account for this it works out to about 21 million in profits a year, much lower.
Now the other main problem. They discount their own credit facility borrowing to fair value and count the difference as equity. That is really really ridiculous for a public company to do. They are basically saying there is a good chance we will not pay what we owe (go bankrupt) and thus it makes sense to use fair market accounting on the balance sheet. No other company in their industry does this (for good reason). To me it seems like a bs (albeit GAAP conforming) way to increase stated equity. The amount of this overstated equity is about 45 million according to their latest Q-10. This amounted to about 45 million of extra equity that shouldn’t be on their balance sheet which pushes down their NAV to 260 million and gives them a market cap/ nav ratio right among their peers. So no more discount.
So I didn’t do a huge cash flow analysis but basically it seems to me the best they can do is make about 30 million a year on about 288 mil market cap which works out to a yield of 10.4%. This is pretty good except there is very little chance for growth in the near term (without diluting equity, which they recently voted to do) given that they are close to maxing out their credit facility and cant reinvest earnings, and when they have to go back to normal borrowing costs (in 1.75 years) they will only make about 21 mil a year or 7.3% yield. As well, since all the income they generate is given out as dividends, you will still have to pay taxes on that.
So basically its an ok investment for the fixed income part of your portfolio but by no means anything special at all, and I definitely wouldn’t consider it for a value investor. Also I don’t like it when I see management do something really aggressive like the way they increased their stated equity.
So hope this is interesting to some. Its obviously not a super deep analysis but was enough to let me pass.