Description

Thesis:

We recommend shareholders short shares of PennantPark (PNNT) heading into earning (by the end of business Wednesday) as we expect a significant write-down in the quarter. Consecutive quarters of notable credit losses, combined with recent challenges from their sister BDC (PennantPark Floating Rate, PFLT), will, we believe, result in a breakdown of investor confidence, crystalizing a strong sell-off in shares. Perhaps more importantly, we see limited downside for the trade going against you—providing attractive convexity for holders.

Overview:

PennantPark was formed in January 2007, making it one of the older publicly traded BDCs. PennantPark has traditionally acted as a provider of debt capital, providing first lien, second lien, and subordinated debt. In recent years, PennantPark migrated up the capital stack with an emphasis on senior secured debt.

Led by Art Penn since inception, PNNT has had its share of credit-driven volatility with energy investments causing notable write downs in late 2015. Shares have recovered from their recent nadir after the 2015-2016 credit losses, but have not fully regained their footing, currently trading around the 73% of NAV (based on 3/31/2019 marks).

Potential Write Downs:

The company still has a number of troubled names in their portfolio which will require further write-downs in second quarter. These “problem” credits include the following:

Parq Hotels. Roughly 16% of the PNNT portfolio had been invested in a 2nd Lien loan to Parq Hotels, a Vancouver based casino, paying L+1,200. In short, regulatory changes in Canada to limit money laundering through casinos has brought a precipitous decline in the underlying business. Subsequent to calendar year 1Q, PNNT announced they had accepted a below-par take-out of their loan. Given the precarious nature of the credit—and no zero risk of bankruptcy—I would characterize the 96.5 takeout as a “win” for shareholders. However, it will nevertheless result in a NAV write-down as PNNT had marked the position par.

Based on our calculations (please see below), we believe the Parq positon will result in a $0.04 per share write down this quarter.

Although ultimately a “good” investment, the Parq deal nearly proved fatal, contributing to questions about management underwriting and judgment.

U.S. Well Services. This represents a legacy position in the PNNT portfolio—a hangover from poor Oil & Gas deals. At 3/31 the position represented 1.44% of NAV.

In short, PNNT (along with their credit investors) have equitized their U.S.-based Well positions and the stock now trades publically (ticker: USWS), providing visibility into valuation.

As the following chart reflects, USWS has had brutal performance in recent quarters, particularly over 2Q 2019:

The math here is relatively straight forward. We expect PNNT will lose $0.04 per share when they report 6/30 numbers.

Hollander Sleep Products. We expect the biggest downside driver for the company will be the position in Hollander, which represented 2.37% of NAV at 3/31.  In brief, Hollander Sleep Products is a roll-up in the mattress and sleep product manufacturing industry. On May 19th, the company filed for bankruptcy after a precipitous deterioration in operations.

PNNT marked the position at 96.50 at 12/31/2018 and 87.32 at 3/31/2019.

The point of our thesis is not to call into question the company’s marks but, notably, Hollander filed for bankruptcy just 10 days after PNNT released their 3/31 earnings. Clearly, this would suggest Hollander should have been marked lower at 3/31/2019. Show me another 1st Lien loan for a bankrupt company trading at 87, but I digress…

The latest bankruptcy agreement, announced in late July, sets aside a pool of capital for unsecured creditors (junior to PNNT’s capital). The size of this pool of is determined based on the principal recovery rates for term loan lenders (including PNNT), with payment thresholds established at 30% and 50% of original cost provided that Hollander is sold within 24 months of the final bankruptcy settlement. These thresholds represent, in our view, the mid-to-upper range of likely outcomes, and we have calculated our probability weighted exit price as follows:

Our probability-weighted price for Hollander of around 40 cents on the dollar implies a $0.14 per share hit to NAV at 6/30. Again, our calculations are based on publically available bankruptcy documents, so we believe PNNT will have a hard time defending a higher 6/30 mark.

Summarizing these readily identifiable “hits” to NAV, we expect the following negative impacts on PNNT’s book this week:

Opportunity:

An analysis of post-earnings stock movements shows mixed results; market context, however, is vital in framing this performance. For instance, following the release of 4Q15 earnings in which PNNT took energy-related write downs to the tune of $0.80 (8.1% decline in NAV), the stock rallied by $0.29 over the next two days because the stock had already traded off by 27.5% since the previous earnings release.

We feel recent trading history is more indicative of current investor sentiment and the market’s ability to capture credit-specific concerns.

In early February of this year, PNNT released earnings for the period ending December 31, 2018, which (along with virtually every other BDC) included write downs driven by the broad-based fourth quarter market sell-off. Although these were largely anticipated, the decline in NAV of $0.05 caused the stock to decline by $0.25 over the subsequent two trading days—an NAV decline capture rate approaching 500%.

The strongly negative market reaction to “cracks” in the PNNT portfolio, in our opinion, marked the beginning of a decline in investor confidence.

PNNT’s 3/31/2019 earnings in early May further damaged investor confidence. The company reported an NAV decline of $0.22 per share driven by significant credit issues in two portfolio companies: Affinion and Parq Hotels.

Affinion. The recapitalization of Affinion—resulting in an NAV loss of $0.22 per share for PNNT—was publicly announced in early March, but was not ultimately captured by the market until after the 3/31/2019 earnings release, as reflected in the trading history below: 

In our view, the Affinion write-down (again, announced in March, but not reflected in the PNNT share price until after the earnings release in May) demonstrates that BDC’s do not fully reflect all available public inform until after earnings. Yes, I appreciate this flies in the face of all efficient market theorists. However, BDC’s often own hundreds of different debt investments. Few investors have the capacity to look through these portfolios to the underlying collateral. Plus, with only around 1/3 of shares held by institutions, the core retail holding base of BDC’s amplifies this dynamic. Retail investors simply do not have the capability of anticipating changes in NAV’s. Hence the opportunity.

In addition to Affinion, PNNT’s 3/31/2019 NAV decline also reflected the deterioration of their Parq Hotels position, which was marked from 108 at 12/31/2018 to 100 in the period. Like Affinion, the challenges to Parq had been widely reported, but were nevertheless not reflected in the share price until after earnings. After 3/31/2019 earnings, PNNT’s shares declined by $0.27, or 122% of the $0.22 NAV decline.

The PNNT stock continued to decline during calendar year Q2 as details of the Parq settlement were released, the stock of U.S. Well Services continued to decline, and Hollander entered bankruptcy. However, PNNT suddenly rallied by 5% on July 16th, trading from $6.31 to $6.63. We strongly suspect that a report issued by High Dividend Opportunities prompted significant retail investor activity in the name. Again, hence the opportunity. These new retail buyers are unlikely to prove strong hands after PNNT announces further write-downs on Wednesday.

The PNNT share price as of 8/5 of $6.42 reflects the following:

§  A $0.19 rise from the intra-quarter bottom of $6.23, with little-to -no justification for the rally

§  A $0.26 decline since PNNT released 3/31/2019 earnings in May. We would posit this deterioration reflect some, but not all, of our expected NAV deterioration as BDCs have traded off, broadly. Again, the market did not fully anticipate Affinion and Parq. There is not reason to expect it will be different this quarter.

We use the benchmark “NAV capture rate” to measure the market’s reaction to announced changes in book value per share. Again, we expect 6/30/2019 will reflect the third consecutive quarter of write-down for PNNT.

Additionally, PennantPark also external manages PennantPark Floating Rate Capital (PFLT). At 3/31, PFLT announced a NAV decline of 3.1% to $13.24 from $13.66 (30 cents related to portfolio deprecation and 14 cents due to of market-to-market unrealized appreciation of their liabilities). More notably, the company placed four new investments on non-accrual (representing 3.2% of cost). PFLT’s recent woes have further rattled market confidence in PNNT and its managers.

Hence, we conservatively expect PNNT will reflect a capture rate of 150% of NAV after it releases 2Q earnings on Wednesday; the increase from the 122% at 3/31/2019 reflects this deterioration of sentiment.  Our 150% of our expected $0.22 NAV write down would imply a return of ~5.3% for our short thesis. However, we believe the suddenly weak market backdrop could trigger an even more dramatic sell-off.

A key element of this trade is its positive convexity. Unlike shorting most stocks, you have limited risk of this thing blowing up in your face. For example, by shorting most stocks you take on M&A risk. BDCs, however, very rarely get acquired. Also, shares repurchased tend to be modest by BDC’s because they reduce management fees in the near-term so there is little risk of a massive share repurchase announcement. Further, as of this morning, PNNT had 0.0% short interest so there’s no risk of a short-squeeze.

To be clear, this is a trade, not an investment. We will short into earnings and then look to cover. We believe the backdrop sets up uniquely well for the short side.

Risk to our thesis:

1.       PNNT could inflate their marks, but given the public data, we believe this is a small risk.

2.       There could be an NAV positive “surprise” that we have not identified and anticipated.

3.       There could be a relief rally if there are mark-ups to offset the expected markdowns.  

Catalyst

Poor earnings this afternoon