In December, Fifth Street Finance (NASDAQ:FSC) finally succumbed to its inability to pay its dividend. It slashed its monthly dividend to $0.05 per share, with the goal of paying out just $0.083 per month in 2014.
Shareholders weren't exactly happy with the news. The new dividend payout represented a 13% cut, but it was necessary -- Fifth Street Finance had been paying more than it was taking in. Now, earnings show it was the right call.
Balancing the business
Investors had reason to worry about Fifth Street Finance and its ability to pay a consistent dividend. When Prospect Capital (NASDAQ:PSEC) reported earnings last week, management noted that interest rates in the sponsor-led buyout business had dropped. This is where Fifth Street Finance sources most of its deals.
However, the fourth quarter proved to be big for Fifth Street. The company reported net interest income of $0.26 per share, exceeding its $0.25 quarterly dividend rate, and a whopping $912.7 million in new originations. Fifth Street originated loans equal to more than one-third of its balance sheet in just one quarter.
The calendar year fourth quarter is historically Fifth Street's best time for originations, as deals get done before year end. Unlike other business development companies, Fifth Street Finance originates most of its lending volume from private equity sponsors. When private equity is busy, so, too, is Fifth Street Finance. Prior quarters revealed lower private equity-led deals, and investors unfairly punished the BDC for light origination volume.
The next step
Investors have yet to give Fifth Street Finance the valuation bump it deserves. Shares currently trade below net asset value, despite the fact that Fifth Street has shown it can earn its new monthly dividend.
Yielding more than 10% per year, Fifth Street Finance looks like a balanced risk-reward BDC. The company reported in its press release that its average credit was levered at fewer than five times earnings before taxes, interest, depreciation and amortization, or EBITDA, well below the middle-market norm.
Investors should remember that the quality of a lending portfolio rarely shows itself during bull markets and periods of easy credit. It shows itself in downturns. So while Fifth Street isn't knocking the ball out of the park when it comes to yields, it's also not participating in riskier mezzanine debt investments.
New developments, like a senior secured lending program similar to that of Ares Capital (NASDAQ:ARCC), make for interesting conference call developments. Investors will have to watch this develop in future quarters, but it could deliver higher yields to Fifth Street, and only strengthen the dividend going forward.
At a yield of more than 10%, Fifth Street Finance is a compelling income play. A price lower than the company's net asset value is just icing on the cake.
Jordan Wathen 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.