3 Things to Watch in Fifth Street Finance Corp.s Earnings

By Markets Fool.com

Fifth Street Finance Corp. (NASDAQ: FSC) dropped a bomb on investors in its last earnings report, slashing its dividend from roughly $0.09 per share per month to $0.06 per share. In addition, the company wrote down several big investments, foreshadowing future losses from some of its portfolio companies.

Continue Reading Below

What's in store for the latest quarter? I'll be keeping a close eye on three things when Fifth Street Finance reports earnings on May 11, 2015.

1. What's the plan for managing its sky-high leverage?
Fifth Street Finance ended the last quarter with a debt-to-equity ratio of 0.99, significantly higher than the soft 0.85 limit for "investment-grade" BDCs. In response, Fitch cut the company's credit rating to junk. S&P held its rating at investment grade, but lowered its outlook to "stable" from "positive."

I'll be watching leverage closely this report. If Fifth Street Finance continues to operate near 1:1 leverage, I suspect its days as an investment-grade BDC will eventually come to an end. An investment-grade rating is crucial to obtaining low-cost debt financing to maintain a high spread between its funding costs and the yields on its investments.

2. What's next for troubled credits?
Fifth Street Finance has four investments on non-accrual status. These four investments all popped up as troubled in the previous earnings report. It's my view that the worst writedowns for these investments have already happened. Remember, the last calendar quarter for Fifth Street was the first for its new management team -- managers who likely wanted to start off with a "clean slate."

Its four non-accrual assets were marked down substantially from their cost basis in the fourth quarter.

Continue Reading Below

Source: SEC filings

Of these, it's my opinion that CCCG, which represented 1.2% of the total portfolio at cost and 0.7% at fair value, is probably in the worst position of the above portfolio companies. Oil service companies have been hit particularly hardby declining oil prices because they aren't necessarily hedged against oil prices like most producers are.

Another portfolio company not on the list -- Edmentum -- was restructured after the quarter ended in April. Fifth Street carried its second-lien loan at 40% of principal value in the prior quarter, compared to rivals who valued their loans at 50% and 86%. The conference call will hopefully shed light on the restructuring event, which likely led to Fifth Street swapping some of its income-producing debt investment for a nonincome-producing equity stake in the company.

3. Is the current dividend conservative enough?
Even after slashing its dividend to $0.06 per share, I'm not convinced that this is the bottom. Last quarter, Fifth Street Finance earned $0.23 in net investment income per share, easily covering its new dividend of $0.06 per month ($0.18 per quarter), but its results were juiced with one-time fee income from new originations.

Backing out the company's fee income results in a significant reduction in earnings. I estimate that Fifth Street Finance would earn about $28 million in net investment income per quarter, or about $0.18 per share, per quarter, without any contribution from fee income. That's in line with its dividend, assuming no significant change to its balance sheet.

With its assets fully deployed, new originations that create one-time fee income will be few and far between. In addition, reducing leverage to operate more conservatively will invariably result in less investment income, with only a partially offsetting reduction in interest expenses.

I'm fearful that the dividend cut to $0.06 per share per month might not be the ultimate bottom -- another dividend cut is absolutely not out of the question. This quarter will provide much-needed insight into Fifth Street Finance's "steady-state" earnings power going forward.

The article 3 Things to Watch in Fifth Street Finance Corp.s Earnings originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.