How Low Can PennantPark Investment Corp. Go?

The market is punishing oil-heavy BDCs in 2015. PennantPark Investment (PNNT 0.44%) shares have lost nearly 30% of their value in 2015 due to its hefty allocation to the sector -- 7.6% and 6.5% of its investments are given "oil and gas" and "energy and utility" classifications, respectively.

But if there's one thing that shareholders should know it's that the absolute worst has likely passed. PennantPark Investment is priced as if all of its oil-and-gas and energy-and-utility investments will go to zero.

Peek into the portfolio
PennantPark has endured a number of energy-related writedowns as low energy prices weigh on the earnings of its portfolio companies. But the market may have gone too far; most of its riskiest positions have already been written down to zero.

I've built a basic sensitivity analysis to show the impact of continued losses on its net asset value (NAV), or book value, per share. The table below shows how PennantPark Investment's NAV would change based on varying declines in the value of its energy investments.

Source: SEC filings, with calculations by the author. All calculations are based on the 14.1% of the investment portfolio at fair value invested in "oil and gas" and "energy and utility" industry classifications.

The first column shows what would happen if PennantPark takes no additional losses. The NAV figure of $10.04 is equal to the current NAV per share. If no losses occur, NAV obviously won't change due to capital losses.

The rightmost column shows what would happen if it recorded a 100% loss on its oil-and-gas and energy-and-utility investments. Though unlikely, the result would be that NAV per share would fall to $7.59, down from $10.04, a decrease of 24%.

Notably, the worst case of $7.59 in NAV per share is still higher than where shares currently trade, about $6.80 at the time of writing. The market is pricing in a complete loss in commodity investments and then some, assuming PennantPark is otherwise a BDC that would trade at NAV.

How risky is its energy book?
No two investments will share the exact same risk profile. Some energy companies are hedged to price fluctuations. Some have so little debt that they should manage to scrape through prolonged periods of low prices. Others are so highly leveraged they're almost certainly going to zero.

Being private companies, we don't have this level of detail about its portfolio companies. So, let's stick to what's knowable.

A good way to understand PennantPark Investment's portfolio is to look at where in the capital structure the company invests. First-lien loans have first claim to a company's assets in liquidation, thus they're generally safer. Subordinated debt sits behind first- and second-lien positions, and is thus a riskier security. And, of course, the many flavors of equity -- preferred, common, and equity warrants -- are the riskiest, as they're always last to see anything at all.

Most of PennantPark's losses in the commodity department have been in the riskiest tranches. It marks its first-lien positions at a slight discount to par. By contrast, its second-lien, sub debt, and equity positions have been hit hard, as the table below shows.

Source: SEC filings, with calculations by the author.

The majority of the remaining commodity-related assets by fair value (roughly 95%) are concentrated in first- and second-lien positions, which should be better protected than its subordinated debt and equity investments. First-lien loans to commodity companies currently compromise 8.1% of the total portfolio at fair value. Second-lien positions compromise 5.3% of the portfolio at fair value. Everything else adds up to less than 1%.

Though PennantPark is priced as if the market expects a complete and total loss, the fact is that the overwhelming majority of remaining fair value is in a safer position than investments that have already been written off. In my view, that should take the worst-case scenario out of the realm of possibility.

I'm not ruling out a dividend cut. I think that it's likely to happen if oil prices stay low, and the market seems to agree, given the stock yields about 17% per year. When and if a cut happens, PennantPark will make for an interesting risk-reward bet, as it seems no dividend cut is truly priced in before it occurs.

Keep this one on your watchlist. Once investors have clarity on its dividend, it could offer a very compelling risk-reward wager for investors with a higher risk tolerance.