Should You Buy the Dip in Fifth Street Finance Corp.?

This high-yielding business development company might be on sale today after a new offering of common stock

Jul 11, 2014 at 1:29PM

Fifth Street Finance (NASDAQ:FSC) announced after the bell on Thursday July 10 that it had commenced a new offering of about $130 million in common stock.

This caused the share price to drop by as much as 4% the next day as investors digested the news. So, why did the price fall? Should we be worried or is this a buying opportunity?

The offering and why the market doesn't like it
Fifth Street will offer 13,250,000 shares at an offering price of $9.95, and underwriters will have the option to purchase nearly two million additional shares.

The company plans to use the proceeds to repay outstanding debt obligations under its credit facilities, but it then plans to reborrow and make more investments. In other words, Fifth Street is issuing more shares in order to expand its investment portfolio.

Doing what it does best?
If anything, I view this as a slight positive development for the company. Fifth Street's business model is to invest in the debt of small and medium-sized companies, and collect more interest on these debts than they pay to borrow.

Making additional investments will further diversify the portfolio, which is already spread among the debt of about 125 different companies. The average debt holding in the portfolio pays Fifth Street an annual yield of 10.8%, which tells us these are not top-quality companies. They aren't necessarily of bad credit quality, just riskier than say, buying investment-grade corporate bonds. The company's portfolio yield have been falling though.

And unlike many high-yielding companies, Fifth Street could actually make more money from its portfolio as interest rates rise. The vast majority of its debt holdings are at an adjustable rate (like LIBOR plus 6%), while its borrowing is at a combination of lower adjustable rates and low fixed rates.

Buy, sell, or hold?
Business development companies (BDCs) like Fifth Street have performed very well lately after a shaky start to 2014. After being de-listed from the S&P and Russell indices, which was completed in late June, the downward selling subsided and shares had risen more than 8% over the past month.

Fifth Street announced a 10% dividend increase earlier in the week and will now pay an annual yield of 11.3% based on the current share price. As the market repriced the stock to account for the new dividend and shares approached NAV, the company took this opportunity to issue more shares.

The bearish view would be that management is focused more on boosting its own fee income by growing assets. However, in my opinion, the selling pressure created by an influx of new shares is a welcome buying opportunity in this solid income-producing company.

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Matthew Frankel 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.

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