PennantPark Stock Remains Attractive After Solid Q4 Results (NYSE:PNNT)

I started coverage of PennantPark Investment (NYSE:PNNT) back in mid-October with a “Buy” rating, saying the stock looked attractive as it has been benefiting from high interests due to its floating rate investments. The high yielding stock has generated an over 8% return since then. With the firm reporting its earnings earlier this month, let’s catch up on the name.

Company Profile

As a reminder, PNNT is a business development corp (“BDC”) that invests in the debt and equity of smaller middle-market companies with EBITDA typically between $10-50 million. At the end of December, about 58% of its investments were in first lien secured debt, 22% was in equity, 13% was in subordinated debt, and 7% was in second lien debt.

The firm also has a joint venture called PennantPark Senior Loan Fund (“PSFL”) with Pantheon that invests in directly originated, first lien middle market loans.

Fiscal Q1 Earnings

For its fiscal first quarter, PNNT saw its total investment income increase 14% to $34.4 million from $30.0 million a year ago. Investment income was up 1% sequentially from $34.0 in fiscal Q4.

Net investment income (“NII”) surged nearly 52% to $15.7 million and was up slightly from $15.6 million in Q4. On a per share basis, NII jumped 50% to 24 cents from 16 cents and was unchanged quarter over quarter. Core NII, which excludes one-time non-recurring investment gains and expenses, was also 24 cents.

PNNT paid out 21 cents in dividends in the quarter, with a monthly dividend of 7 cents. As such, its dividend coverage ratio was 1.14x.

With rates looking like they will stay higher for a bit longer, I’d expect PNNT’s NII to stay around current levels through the next couple of quarters. When the Fed starts cutting rates, though, it should gradually start to come down. The Fed is still projected to lower rates three times in 2024 even after they held rates steady in late January, but the first cut isn’t expected until June or later now.

During the quarter, the company booked $1.8 million in realized gains on its portfolio. It had -$5.0 million in unrealized depreciation on its investments in the quarter, and $2.0 million in unrealized appreciation of its Truist Credit facility.

The company ended the quarter with a net asset value per share of $7.65. That was down from $7.70 at the end of September.

PNNT bought $231.1 million in investment in the quarter and received $71.0 million from sales and repayments. It made investments in 12 new and 32 existing portfolio companies, with a weighted average yield on debt investments of 11.9%.

Within its PennantPark Senior Loan Fund (“PSFL”) it made $81.0 million in investments and received $29.1 million from sales and repayments. It made investments in five new and seven existing portfolio companies, with a weighted average yield on debt investments of 12.7%.

The firm had $1.21 billion in total investments. That was a 16% increase from the prior quarter.

At the end of December, it had 139 companies in its portfolio with an average investment size of $8.3 million. The weighted average yield on its interest bearing debt investments was 12.6%. That compares to 11.9% a year ago and 13.0% at the end of Q4. PSLF’s portfolio totaled $857.9 million, consisting of 93 companies with a weighted average yield on its debt investments of 12.1%.

The firm had one investment on non-accrual status, representing 1.0% of its portfolio on a cost basis and 0% on a fair value basis. No investments were put on non-accrual status during the quarter. However, management did say on the conference call that if base rates remained where they were, there would likely need to be some amendments and extensions to help give some portfolio companies relief from high rates.

Strong credit quality has always been a hallmark of PNNT, even during Covid and the financial crisis, so I’d expect it to remain solid overall, even if it ticks up slightly from current levels. But with Fed rate drops likely pushed back due to inflation staying elevated, the high variable rates will likely hurt some of its portfolio companies and there will be some amendments.

PNNT ended the quarter with regulatory debt to equity of 1.41x. That was up from 1.05x at the end of fiscal Q4 in September and higher than its 1.25x target. Its weighted average leverage was 4.9x and its weighted average interest coverage ratio was 2.2x.

Discussing the current state of the market on its earnings call, CEO Arthur Penn said:

“We continue to believe that the current vintage of core middle market directly originated loans is excellent. Leverage is lower, spreads and upfront OID are higher, and covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market in the core middle market, we are still getting meaningful covenant protections. … With regard to covenants unlike the erosion in the upper middle market virtually all of our originated first lien loans have meaningful covenants, which help protect our capital. This is a significant reason why we believe we are well-positioned in this environment. Many of our peers who focus on the upper middle market state that those bigger companies are less risky. That is a perception it may make some intuitive sense, but the reality is different. According to S&P loans to the companies with less than $50 million of EBITDA and a lower default rate and higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring have been an important part of this differentiated performance.”

This was a solid quarter from PNNT. Its NAV stayed relatively steady while once again it saw no new investments go on non-accrual status. Strong underwriting and credit quality have been a hallmark on PNNT, and it continued once again in this quarter.

Now the firm does see the potential that some minor credit quality issues could arise if rates stay elevated. However, it is expecting to see less of an impact than BDCs that invest in larger middle market companies, as its investments in smaller companies come with strong protection covenants. PNNT’s track record in this area has been outstanding, so it isn’t something I’d worry about.

The BDC did take leverage up some, although it will look to lower it as it moves some investments into its JV. If interest rates do head lower, it likely would need to have leverage a bit higher to maintain its NII around current levels. Lower rates, could help with credit quality though, as it would be less of a burden on its portfolio companies.

Conclusion

While the Fed has indicated it likely will lower rates this year, it does appear those rate hikes are getting pushed back after a higher than expected inflation report. That’s good for PNNT’s NII, but it will have to navigate a tougher credit quality environment, as some portfolio companies will undoubtedly see some stress with the interest rates on their debt elevated for longer. As such, PNNT is walking a fine line.

However, this is a well-managed company, and its niche of investments in smaller companies with tighter covenants has boded well for it in the past. While these could be some stress, I’d expect it to be minor.

Like other investment portfolio companies, BDCs typically are valued at a price to book or NAV. Based on the mid-point of its estimated year-end NAV, it trades at a 0.87x NAV with a 12.7% yield. According to BDCInvestor.com, BDCC has the 17th lowest P/NAV of the 48 BDCs it tracks, while its yield is the 13th highest. It had a 1.14x coverage ratio at the end of FQ1 and has leveraged up a bit, so there is some wiggle room to keep the dividend in place if rates slowly head down.

I rate the stock a “Buy” with a $7.50 price target, which is a price around the value of its portfolio and also around the medium value BDCs currently trade at. Given its strong history of credit quality, there is no reason for it to trade in the lower third of BDC values.

The biggest risks to PNNT are if its credit quality takes a turn for the worse, or if Fed rate cuts push down its NII, which could lead to a lower dividend down the road. The dividend likely gets lowered a bit at some point, but I think it should be able to maintain it for a while.