This article focuses on Prospect Capital (PSEC) and compares it to the 24 BDCs covered in previous articles, including American Capital (ACAS). PSEC is a BDC that people either love or hate (in a financial sense) and I will try to give a fair and balanced view as a starting point for investor due diligence. In this article I am not going to get into all the nuances of a large and complex BDC, but rather hit some of the highlights and key factors in ranking PSEC.
Please visit bdcbuzz.blogspot.com for updated rankings and info or see the list of previous BDCs covered at the end.
Business Development Companies (BDCS) lend to small and mid-sized businesses, with limited financial leverage, paying out most of their income to investors and paying little to no corporate tax.
These are the five general criteria I use to evaluate BDCs:
- Profitability (EPS to cover dividends, growth)
- Risk (diversification, volatility, leverage)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (P/E, PEG, NAV)
For more information about BDCs, how I evaluate them, and my BDC investment philosophy, please see this article.
Below is an oversimplified table ranking the 25 BDCs I have reviewed giving them a relative score between 0 and 10 (10 being the best). In reality I use different weightings for almost 100 data points on each company and my personal rankings (based on my risk/return comfort) are close to these but far from exact. In future articles, I will add the new companies to this table as well as update info.
- Market Cap: $2.4 billion
- Div Yield: 12.3%
- Div/EPS: 110% (using proj. EPS of $0.30)
- P/E: 8.9 (using annualized proj. EPS of $0.30)
- Price/NAV: 0.99
- Debt/Equity: 0.48
At first glance, PSEC looks very profitable for the last four quarters with an average quarterly EPS of $0.50 and then analysts projected a decrease of quarterly EPS to $0.30 for the upcoming quarter. This is due to the profits from the Gas Solutions sale on January 4 2012, taken as income rather than capital gains which was a temporary four quarter bump in net investment income ("NII"). Its stabilized NII run rate is around $0.30 per share but expected to grow to $0.34 over the coming quarters. The analysts for PSEC have their work cut out for them when putting together these projections because of all the moving parts including constant equity and debt offerings coupled with announcements of record quarterly originations and expansion into new markets and investment vehicles.
When looking at profitability, I look for the ability to cover dividends as well as growth. Currently, PSEC is paying 110% of its March 2013 projected quarterly EPS, but it is expected to catch up to the $0.33 in dividends at some point.
PSEC has a $3 billion portfolio at fair value with a less than average industry diversification mostly because of a larger concentration in consumer discretionary (see chart below). It invests in collateralized loan obligations ("CLO") which are debt and equity positions in a form of securitization where the cash flows of a portfolio of loans are pooled and passed on to different classes of owners in various tranches; generally risk rated from BB to B depending on the tranche. In a previous article, I discussed some potential issues with these types of investments including potentially riskier and less transparent than direct investments in portfolio companies, repayment priority of more senior debt holders, thinly traded, not listed on traditional exchanges, making them less liquid, difficult to value and more volatile. CLO investments account for 14% of the portfolio. Other BDCs that invest in CLO-type vehicles are KCAP Financial (KCAP) with 24% of its portfolio, TICC Capital (TICC) at 32% and ACAS at 5%.
As of December 31, 2012, 50% of the portfolio was senior secured debt, 25% subordinated secured debt, 6% subordinated unsecured debt, 14% CLO, and 5% in equity. When interest and/or principal payments on a loan become past due, or if the borrower is not expected to be able to service its debt and other obligations, loans are placed on non-accrual status. PSEC had nine investments on non-accrual status at a fair value of $39 million representing approximately 1.3% of the portfolio which is about average and much lower than ACAS at 9.0%.
PSEC has better than average volatility ratios and has recovered from the recession significantly better than others such as Apollo Investment (AINV), Gladstone Capital (GLAD), MCG Capital (MCGC) and ACAS.
Its debt-to-equity of 0.48 is less than the average of 0.60 but as its recent quarterly earnings news release said, "Our debt-to-equity ratio stood at 47.8% (29.2% after subtraction of cash and cash equivalents) at December 31, 2012." However, this is higher than ACAS currently at 0.14.
The current dividend yield is 12.3%, the highest among BDCs, and has a history of monthly increases since June 2010. This seems like one of the more stable dividends and as the CEO stated on an earnings call last August, "We're being very, very careful to make sure investors are seeing the dividend as a rock solid proposition."
During the four quarters of extra income from Gas Solutions, PSEC did not issue a special dividend most likely to keep dry powder and sustain the current payout, considering the lag time between deploying capital and growing NII. I have no doubt that it will continue its excruciatingly slow monthly dividend growth of $0.000025 as it waits for EPS to catch up or surpass.
Analyst ratings of PSEC change constantly and currently are at a solid "Hold" with a target price between $11 and $12.
This section is covered in the summary below.
I recently wrote an article on ACAS and would like to summarize by comparing and contrasting the two BDCs. First here is a table showing the rankings without the "Payout" category to give ACAS a fair advantage as fellow contributor Stone Fox Capital pointed out in this article. The reason I include a payout category is because the average BDC investor is seeking dividend yield along with the assumed risk of owning companies with higher risk profiles.
Keep in mind that the total score is not accurately weighted to reflect individual investor needs and even using a simple average, the difference is nominal.
Analyst expectations for annual EPS growth is approximately 5% for both. From a risk profile standpoint ACAS has better industry diversification, lower leverage, and less exposure to CLO investments. PSEC has a much healthier overall asset class mix of investments with 75% in secured debt (compared to ACAS with 58% in equity), much lower non-accrual rates, lower volatility ratios and performs better in down markets.
The discount to NAV of 20% gives ACAS investors security especially in replacement of dividend income. PSEC is trading slightly under NAV but better than the average BDC with a 10% premium. Coming up with an accurate P/E using last 12 months would give PSEC an artificially low ratio of 5.4 (because of Gas Solutions income) so I used the next quarters projected EPS of $0.30 annualized to $1.20 to come up with a P/E of 8.9. Using the same methodology for ACAS, the annualized EPS is $1.08 or a P/E of 13.1, and using last 12 months EPS of $1.16, the P/E is 12.2 and much higher than PSEC. PEG for PSEC would accordingly be lower as well.
To answer the loaded question, is PSEC better than ACAS, it is up to the individual investor to compare, taking into account personal investing needs and trading the 12.3% dividend payout for increasing NAV and capital gains. ACAS is similar to a DRIP program where earnings are plugged back into the company for share repurchases and debt pay down.
I will be cautiously waiting to see the next earnings release, looking for signs of decreased dilution rates through its ATM program and the probability of covering its dividend soon, as well as the growth expectations for the CLO program.
- Part 21 - PennantPark Floating Rate Capital (PFLT)
- Part 20 - American Capital
- Part 19 - Full Circle Capital (FULL)
- Part 18 - Solar Senior Capital (SUNS)
- Part 17 - Gladstone Capital
- Part 16 - Fidus Investment (FDUS)
- Part 15 - Horizon Technology Finance (HRZN)
- Part 14 - TICC Capital
- Part 13 - TCP Capital (TCPC)
- Part 12 - Triangle Capital (TCAP)
- Part 11 - New Mountain Finance (NMFC)
- Part 10 - THL Credit (TCRD)
- Part 9 - Golub Capital (GBDC)
- Part 8 - KCAP Financial
- Part 7 - Ares Capital (ARCC)
- Part 6 - Hercules Technology Growth Capital (HTGC)
- Part 5 - Solar Capital (SLRC)
- Part 4 - PennantPark Investment (PNNT)
- Part 3 - Apollo Investment
- Part 2 - Prospect Capital , BlackRock Kelso Capital (BKCC) and Main Street Capital (MAIN)
- Part 1 - Medley Capital (MCC), MCG Capital and Fifth Street Finance (FSC)