Whitehorse Finance Stock: Dividend is well covered, but NAV growth is lacking (NASDAQ:WHF)

overview

Business development companies have been a great hedge against the high interest rate environment we've found ourselves in over the past two years. This is because BDCs typically invest in debt capital. Look out for variable interest rates. This means that as interest rates rise, so will the interest you earn on your loaned capital. Whitehorse Finance (NASDAQ:WHF) is an externally managed business development firm focused on investing in lower middle market companies. WHF follows a disciplined underwriting approach to help us find quality investments that generate the highest returns.

WhiteHorse is managed by HIG WhiteHorse Advisors and went public in 2012. As a BDC, our primary objective is to calculate and use senior secured loans to generate risk-adjusted returns through all market conditions. to middle-market companies across a broad range of industries. However, WHF’s total return performance underperforms some of its peer BDCs. To WHF’s credit, they are much smaller than these peers, with a market cap of only nearly $300 million.

One of the main attractions of business development companies like WHF is their high dividend yield. The current dividend yield is 11.7%, which means it packs enough punch to provide a significant source of compounding income over the long term. As a result, I aim to take a deep dive into their portfolio quality, dividend sustainability, and valuation composition.

portfolio

Whitehorse's fixed income investment portfolio is highly diversified across a variety of industries. This is always great, as a highly diversified portfolio eliminates concentration risks and vulnerabilities in certain sectors. It can be seen that the largest industry is Broadline Retail, accounting for 6.2%. This is closely followed by application software at 5.6% and commodity chemicals at 5.2%.

While the diversity of the industry is great, we're also pleased to see a major focus on first lien loans. WHF's portfolio currently consists of more than 80% first lien senior secured debt securities. First lien senior secured bonds sit at the top of a company's capital structure, meaning this portfolio reduces repayment risk. First Lien Senior Secured Debt is at the top of the capital structure, meaning that this form of debt has the highest priority in terms of repayment.

If a portfolio company has problems with its performance or debt service, it may need to go through bankruptcy or liquidation proceedings to meet these obligations. Loans provided by WHF are prioritized in terms of repayment, so you won't lose all your invested capital. This gives me a little more confidence on my part as an investor.

Finally, the portfolio is also made up of 98.9% floating rate investments, with the remaining 1.1% in fixed rate investments. This has allowed WHF to take advantage of this high interest rate environment by effectively earning more income from the loans it provides. With inflation remaining high and the labor market remaining strong, WHF expects this high interest rate environment to continue.

Finance

WHF recently released its first quarter earnings report, with NII (net investment income) per share totaling $0.465. NII was able to grow gradually even in this high interest rate environment. This means that WHF has been able to grow its portfolio and earning power efficiently. This can be seen by looking at its earnings history over the past few years. For reference, interest rates started rising rapidly around the beginning of his second quarter of 2022. This was no coincidence as this was the same time that his NII at WHF started to rise and he eventually crossed the $0.40 per share mark.

This increase in net investment income can also be attributed to WHF's active efforts to continue to grow its portfolio. NAV decreased last year due to fewer investments at fair value. Total fair value investments increased to approximately $698 million. This growth was accompanied by additional investments totaling $44.7 million in five new portfolio companies. During the quarter, he made eight additional investments in existing portfolio companies, bringing his total to $10.3 million. These new investments could contribute to his NII per share growth going forward and help offset the decline in NAV.

Total leverage level increased slightly compared to the previous quarter to 1.26x. His cash on hand remained modest at $20.9 million at the end of the quarter. This is down from the first quarter of 2023, when his total cash and cash equivalents were $22.2 million. However, the amount of other assets has increased from $9.6 million the previous year to $16.2 million.

dividend

The most recently declared quarterly dividend was $0.385 per share, with a current dividend yield of 11.7%. As mentioned earlier, NII's stock price was $0.465 per share. This means that NII is comfortably covering its dividend at 120.8%. WHF's portfolio is strong enough to generate ample profits, which can be attributed to the high interest rate environment. As interest rates remain elevated, so will the amount of interest earned on the debt you own.

Additionally, the dividend has been increasing over time, even though the yield is already in the double digits. As you can see below, the base dividend has increased every year since its inception. The dividend has actually grown at a CAGR (compound annual growth rate) of 2% over the past three years. However, NAV has struggled to grow, raising questions such as: Wouldn't WHF be better able to limit dividend growth and take a more conservative approach, freeing up more capital for further portfolio and NAV growth? Typically, BDCs that are not earning more than their distributions on NII, or whose portfolio composition is substandard, will see a downward trend in NAV.

While I am in favor of dividend growth over time, total returns will be limited if NAV continues to trend in this direction. Remember the total return comparison I provided earlier in this article and how all of its peers outperformed WHF? This is likely because all of these peers have managed to grow their NAV and distributions over time, not just distributions like WHF has. NAVs have been trending consistently lower since 2018, despite rising interest rates being ideal conditions to drive growth. This leads me to believe they could improve the quality of the companies they choose to invest in.

risk profile

As mentioned earlier, rising interest rates can definitely drive higher levels of net investment income per share. However, there are caveats to this concept. Rising interest rates can also place stress on these portfolio companies, as these high interest rates for an extended period of time mean that they also have to maintain higher interest payments. This situation could be very difficult for some of these lower-middle market companies to sustain if a large portion of their earnings go toward debt rather than other initiatives that drive growth.

We believe this may be one of the reasons why NAV is not growing. Based on investment costs, WHF's accrual ratio is currently 3%, which is slightly higher than the weighted average of its BDC peers. Accounts receivable represents the percentage of portfolio companies that are no longer contributing to WHF's NII per share because they are no longer making debt payments. These companies are typically more than 120 days past due on their debt payments and are underperforming so much that they can no longer expect full repayment of their investments. For reference, here are some peer BDC non-occurrence rates.

• Ares Capital (ARCC): 1.3%
• Main Street Capital (MAIN): 0.6%
• Golub Capital (GBDC): 1.1%

This is further supported by looking at the deterioration in investment performance ratings within the portfolio. WHF uses an internal rating number system from 1 to 5, with a rating of 1 representing the highest quality portfolio company and a rating of 5 representing the lowest quality.

Q1 2024 will see a decrease in portfolio companies assigned a rating of 1. The proportion of companies given a rating of 1 is now 14.3%, down from 18.3% in the previous quarter. Most of our portfolio companies fall within that 2 rating range, which means that our portfolio companies are meeting expectations in terms of performance and prospects. Thankfully, most of WHF's investments fall into these two rating categories. There was a decrease in three rated companies where the risk of investment loss may have increased compared to originally expected. However, the investment amount with a rating of 2 has increased to 2.9%, and a rating of 2 means there is a risk that the invested principal will not be repaid in full.

Finally, 1.2% of the fair value portfolio is rated 5. A rating of 5 means the investment is in default status and there is a high risk that the investment will not be fully refunded. This is down from last quarter's total of 2.2%, but with the continued high interest rate environment, it wouldn't be surprising to see this rate start to rise again.

evaluation

Despite the decline in NAV over the past few years, price has recovered above pre-pandemic levels. Currently, price is trading at a slight discount of only 3% from NAV. For reference, price traded at an average discount of 6.4% over the past three years. Discounts over the past three years have reached as high as 26% while price has only traded in premium territory of up to 5%. Since price is above the average discount from NAV and NAV per share is not showing any meaningful growth, I choose to stay on the sidelines here.

For reference, Wall Street's average price target is $13.20 per share. This represents a very small upside of less than 1% for him. The highest target is $14 per share, and the lowest target is $12.50 per share. However, NAV has been consistently declining, so we expect the price to drop a bit. Credit quality concerns, NAV declines and accruals do not seem to have been fully factored in yet, potentially overshadowing the rise in NII per share.

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In conclusion, I believe WhiteHorse Finance has a good portfolio structure, so I'm giving it a Hold rating at this point, but I'm a little concerned about the lack of NAV growth. Furthermore, the dividend is covered by a sufficient rate of return to offset the increase in his NII per share. As interest rates have risen, WHF has been able to leverage its assets more efficiently and grow its income, but this has not translated into meaningful growth in terms of the net asset value of its portfolio. This keeps the stock price low compared to many of its peers. As a result, I have decided to stay on the sidelines and see how the outlook improves in the coming quarters.