Nothing is worse than a dividend stock that doesn't earn its dividend. When earnings trail the number necessary to make quarterly payouts, share prices often dive.
This was the case at Fifth Street Finance in December, and now, THL Credit (FCRD), after its annual earnings report. THL Credit failed to earn its beastly, $0.34 quarterly dividend, earning only $0.27 in net investment income per share in the fourth quarter.
Is it time to worry?
THL Credit is a favorite among income investors. The company's track record is excellent, with gains in its investment portfolio easily exceeding losses. That's the one quality all great BDCs share.
Unfortunately, THL Credit is stuck in a pattern of lower and lower investment yields.
The company's presentation includes a chart worth 1,000 words. Here's THL Credit's portfolio composition, and yields, since 2012.
In the past two years, the company has moved to "safer" first-lien securities, driving down its investment yields. THL Credit's portfolio yielded as much as 14.2% in 2012, and since then, the portfolio's yield has plummeted to 11.7%.
Is the dividend safe?
Ultimately, BDCs are valued on their dividend. The dividend is the best way to get a reasonable, long-term return for a BDC, since price appreciation is usually capped by the issuance of new stock to grow the balance sheet.
The company has about $0.10 per share in retained earnings, so to speak, which provides a temporary buffer.
With quarter-end liquidity of $128.5 million from cash and its credit facility, THL Credit should be able to generate sufficient earnings by leveraging its portfolio. The portfolio is currently leveraged at about 1.5 times equity.
Adding more leverage adds low-cost capital at a price between 3-4% per year, to fund investments yielding more than 11%. THL Credit needs to earn $11.6 million per quarter in net investment income to meet its quarterly dividend, some $2.5 million more than it earned in the fourth quarter.
It's possible to earn the dividend with higher leverage. However, if I were a betting man, I wouldn't put my money on it.
A dividend cut, so what?
It's more likely THL Credit will have to reduce its quarterly dividend, failing any new major portfolio exits. The simple fact is middle-market yields are compressing, THL Credit's underwriting is more risk-adverse than in the past, and its lofty dividend yield probably isn't sustainable if its portfolio continues to shift toward first-lien debt.
Management and shareholders will just have to own up to the reality of lower yields. Will it happen this quarter, or even this year? It's tough to say. THL Credit's dividend has typically followed earnings up, never down. And first quarter dividends have been declared, and will be paid on March 31, 2014.
There's no real historical precedence at THL Credit to forecast the next dividend, but if the dividend is cut, it probably won't be due to poor performance. It'll be due to tougher underwriting and lower yields on safer securities. There's no need to punish a stock for management's prudence.
