3 Things to Take Away From Fifth Street Finance Earnings

Fifth Street Finance investors saw their shares pop after the company reported better-than-expected fiscal third-quarter earnings. The company reported net investment income of $0.21 per share, while net income -- which includes capital gains and losses -- came to $0.13 per share during the quarter.

Here are three items investors should give extra attention to.

1. Net investment income covered its distributionsOne of the best parts of Fifth Street Finance's earnings release was that, for the first time in several quarters, its net investment income finally topped its monthly distribution. The company currently pays a dividend rate equivalent to $0.18 per quarter, and its $0.21 of net investment income per share easily exceeded its distributions to shareholders.

Of course, that isn't to say that Fifth Street Finance is in the clear just yet. Its net asset value, or book value, fell again on a per-share basis, declining to $9.13 per share. In a sign of investor discontent, its shares currently trade at a 28% discount to book value, even after an 8% increase in its share price after its earnings report.

2. NAV is declining due to a couple of losing portfolio companiesTwo portfolio companies became the subject of discussion on the company's conference call. JTC Education, a for-profit education company, is now marked at a value of $461,000 against a cost basis of $15 million.

Similarly, investments in Answers Corporation are held at a combined value of $33.2 million compared to their cost basis of $41.1 million. Both companies incurred significant reductions in their carrying values this quarter. Management was optimistic that its valuation of JTC Education was conservative, but given that the company is held at a 97% discount to its original cost, it's hard to believe there's much upside to capture. Even if it were held at 50% of its true value, Fifth Street would have lost more than 90% of its investment in the company.

3. Making shareholders No. 1For a long time, Fifth Street Finance offered shareholders the double whammy of failing to earn its dividend and notching increasing losses on its balance sheet. Its external manager has received millions of dollars in incentive compensation despite the fact that shareholder performance has been poor.

There hasn't been much change here. Management fees tallied to $20.1 million this quarter, whereas shareholders saw their collective wealth grow by only $20.5 million during the same period.It's fair to say that management is doing much better than shareholders, who take on all the risk for what amounts to roughly half of the pre-fee profits.

That said, Fifth Street Finance is taking small steps to win back its shareholder base. For one, it maintains a $100 million repurchase agreement, which, if used, would help drive up net asset value per share by buying back stock at a discount. Likewise, the company agreed to lower fees on new capital it raises to 1% of assets, down from the current fee of 2% of assets.

Given that Fifth Street Finance is in no position to raise new capital, the repurchase agreement is the only noteworthy method for improving shareholder returns at present -- and after the conference call, it seems unlikely that it will repurchase shares in any meaningful amount: The company only committed to allocating excess profits to repurchasing shares. In effect, what isn't paid out as a dividend will be used to buy back stock. In an ideal world, Fifth Street Finance would use the proceeds from prepayments and asset sales to repurchase stock at the current discount.

Given the stock's 28% discount to book value, repurchasing shares would be like buying back a portfolio it values at $1 for just $0.72. Unless Fifth Street Finance repurchases shares in bulk or amends its management agreement to align the interests of investors and its managers, it's hard to see how its share price ever makes its way back to book value.

The article 3 Things to Take Away From Fifth Street Finance Earnings originally appeared on Fool.com.

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