At first glance, PennantPark Floating Rate Capital (PFLT) has great appeal for income investors. PFLT is one of 400 stocks with a 5%+ dividend yield. 

In fact, PFLT has an 8% dividend yield.

Not only that, but PFLT also pays its dividend each month. This allows investors to compound their wealth even faster than a stock that pays a quarterly or semi-annual dividend.

But, as is so often the case with nearly double-digit dividend yields, PFLT’s attractive dividend yield may be too good to be true.

This article will discuss PFLT’s business model, and why the company needs its fundamentals to improve in order for the dividend to be sustainable over the long-term.

Business Overview

PFLT is a business development company, or BDC. It provides mostly debt financing, typically first line secured debt, senior notes, second lien debt, mezzanine loans, or private high-yield debt.

It specializes in making debt investments to middle market companies. To a lesser extent, it also makes preferred and common equity investments.

As of March 31st, PFLT had a total investment portfolio of $731.5 million, consisting of 96 separate investments.

The company’s portfolio breakdown is as follows:

• First-lien, senior secured debt (93% of portfolio)
• Second-lien, secured debt (5% of portfolio)
• Subordinated debt, Common and Preferred equity (2% of portfolio)

PFLT has a highly diversified portfolio in terms if industry groupings.

Source: 2017 Investor Presentation, page 9

PFLT went public in April 2011. Since the IPO, it has invested approximately $1.7 billion. PFLT’s investments are generally in a range between $2 million- $20 million.

The investment strategy follows a disciplined approach, which is to seek out target companies with positive and stable cash flow, experienced management teams, and durable competitive advantages.

Growth Prospects

PFLT has positive growth prospects. It has demonstrated a track record of successful investments.

For example, it is off to a good start to 2017. Through the first six months of the year, total investment income rose 29%.

This growth was due to the company’s debt investments, which are performing well. Interest income increased 36% over the first half of the year.

On a per-share basis, interest income increased 15% over the first half, to $0.53.

Continued growth in interest income is a potential catalyst.

As the company’s name suggests, PFLT primarily makes floating-rate loans. In fact, approximately 98% of its investment portfolio is comprised of floating-rate debt.

Over the past several years, PFLT’s overall portfolio has grown, but its portfolio yield has stagnated, due mostly to persistently low interest rates.

Source: 2017 Investor Presentation, page 7

PFLT’s concentration on floating-rate investments could serve the company well moving forward, especially in a rising-rate environment. The Federal Reserve has begun raising interest rates, with more rate increases likely over the next year.

As rates rise, floating rate investments should perform well. This could increase PFLT’s net investment income, which would be a positive for the dividend as well.

Valuation & Expected Total Returns

PFLT trades for a price-to-net-investment-income ratio of approximately 13.8.

PFLT ended the second fiscal quarter with a net asset value of $14.05 per share. The August 8th closing share price was $14.25, meaning PFLT trades at a slight premium to NAV.

It seems the stock is fairly valued, given its earnings trajectory. The company missed analyst expectations on net investment income, for both the first and second quarter of fiscal 2017.

Going forward, shareholder returns will be comprised of investment income growth, and dividends. Investors should not expect the double-digit growth from the first half of 2017 to continue.

Looking further back, PFLT’s net-investment-income-per-share declined by 5.5% in 2016, and fell by 3.6% in 2015. The last year of growth was 2014, and that was just a 1.8% increase.

As a result, expectations for net investment growth should be modest. Erring on the side of caution is prudent, given the company’s inconsistent growth pattern.

Therefore, a potential breakdown of future returns is as follows:

• 2%-4% net investment income growth
• 8% dividend yield

If this assumption holds true, PFLT could generate 10%-12% annualized returns. Not surprisingly, the dividend would be the largest source of returns.

Dividend Analysis

PFLT pays a monthly distribution of $0.095 per share. The company recently declared its next distribution, payable on September 1st, to shareholders of record on August 18th, 2017.

PFLT has a very attractive annualized dividend yield of 8%. Even better, it makes monthly dividend payments, so investors receive their dividends more frequently than they would on a quarterly schedule.

However, it is also important to assess whether the dividend is sustainable. Stocks with high dividend yields could be an indication that the dividend is in danger.

PFLT did not earn enough to cover its dividend payments in fiscal 2016. Net investment income of $1.02 per share fell below distributions declared of $1.14 per share.

As a result, PFLT had a coverage ratio of less than 90% last fiscal year.

Coverage has not improved much to start 2017. Over the first half, PFLT’s six monthly dividends totaled $0.57 per share. In the same period, the company earned net investment income of $0.53 per share.

Dividend coverage was slightly better to start this year, at 92% over the first six months. But it still remains below 100%.

This is a red flag for investors, and it means that PFLT needs to grow net investment income in order to sustain the dividend over the long-term.

Final Thoughts

The old saying “high-risk, high-reward” seems to apply to PFLT. It certainly has an attractive dividend yield on paper, but there is more to PFLT’s payout than meets the eye.

If everything goes according to plan, PFLT could generate double-digit total returns on an annual basis. There is a high possibility PFLT’s net investment income will continue to grow. Higher interest rates would be a big step in that direction.

However, there is also an elevated level of risk here. If PFLT does not grow investment income, it could decide to reduce the dividend at some point in the future.

As a result, investors should tread carefully. Only investors with a higher risk tolerance should consider buying PFLT.