Prospect Capital: A Relatively Safe Dividend Yield

• Conservative Fair Value Estimate: $15
• Current Dividend: 17.6% Yield or $1.60/share
• Strategy: Buy stock @ $10.25, and sell June 2009 10 strike Puts for at least .50 for a 5% yield.

Prospect Capital (PSEC) is a private equity, mezzanine debt firm that specializes in investing in the energy/industrial sectors. Occasionally, the firm will also make investments in other industries when the opportunity exists. The company has been beaten down like many other business development and publicly traded private equity firms because of the usual suspects: worries about financing, sustainable dividends, the health of the portfolios, the excess use of leverage to juice returns, the dearth of attractive investment opportunities, etc.

So let's go over these weaknesses that the market likes to point out...

FINANCIAL HEALTH

With $25mil in cash and $138mil in debt, Prospect has about $113 million in net debt vs. $428mil in equity. In the last quarter interest costs totaled approx $2mil against expected distributable cash flows of $50million for the year. I would say financial health is not of any concern at PSEC. Charges-offs have been minimal and the revenue/interest streams have been stable, even in the rough patches of the end of 2008. NAV for the firm is above $14/share. PSEC also has a total credit line of $200mil (all their debt is via their credit line), and are seeking to expand it for opportunistic reasons.

DIVIDEND

Dividend payout is $1.6/share annually, or $48million total. With $50million in cash flows (adjusted to cancel out asset valuations, one time charges, depreciation), these guys make more than they are paying out. A lot of peer companies have a history of paying out more than they earn in constant interest, mostly because firms like to return a portion of the proceeds from capital gains to investors via dividends as well.

However, that is not good fiscal management since it inherently keeps expectations of dividends higher than what can be sustained in a market where asset values are declining.

PORTFOLIO HEALTH

The health of the portfolio is arguably up for debate since we don't have access to information on every company in the portfolio. However, energy and energy related businesses comprise for a large portion of Prospect's investment portfolio. In 2Q (for Prospect that October-December 2008), oil prices reached their low in the $30s per barrel, MLP/pipeline investments and all other energy-related businesses also reached their lows in that quarter.

With oil now at $55+, a lot of those investments have regained ground from their lows last year (or from beginning 2009). More on this will be available in their 3Q report. In fact for this reason, selling options may be the best way to start this investment if your wondering about portfolio health and would like to wait a bit.

INVESTMENT OPPORTUNITY

With lower valuations and a tightened credit market, Prospect's services in providing financing are high in demand. Prospect's low debt structure, solid cash flows, and sound dividend policy, Prospect should be able to increase their credit line and make attractive investments for at least the next year or so as their peers hoard cash and fix-up their balance sheets.

All in all, all of these factors have led this stock fall only about 30% in the last year, many other companies in this space (business development, MLP, private equity) did not fare nearly as well, with many dropping 50%+. Take comfort in the fact that management bought in at prices around $8-9/share recently as well - that is why selling the June 2009 strike 10 puts look especially attractive since they will make your buy price be $9.50 should the market get volatile and these shares fall again.

At the end of 5 years, I can see Prospect averaging at minimum $25mil in net investments per year. Earn a little less than 10%, and the total additional distributable income looks to be about $12.5 million, for a total of about $62million. Conservatively, that will make the company worth at least $15 per share and about a 50% nominal gain.

However you will also be making 17%/year on your dividends, which can give you another 120% in returns. Total net returns can total 170% in 5 years, conservatively.

Should oil prices rebound further or more opportunistic investments are made, these return calculations will can prove to be very conservative.

Disclosure: Planning to go long PSEC by buying stock or selling put options.

Comments

[epeon:]

Sure sounds like ALD and ACAS. Look where investors of those stocks ended up.

May 12 08:48 AM

[Violent Cap...:]

psec is not as levered, not as dependent on capital gains

it sounds like it, but they arent the same and thats why these guys have only lost about 30% of their value-

May 12 08:58 AM

[MILESCFA:]

I also like to sell calls against the long position, BUT in this case, the options have no volume and you could drive a Mack truck thru the bid/ask spreads in the options, so I would avoid this play.

May 12 09:45 AM

[sticktoitiv...:]

I hold shares of a similar company, ares capital arcc. It's a bit more conservative but its not listed on the options exchange. It kind of takes away half the fun.

May 12 02:17 PM

[Violent Cap...:]

just an fyi 4Q earnings expected to come in at .30-.40/share

that sucks, but its not terrible - there will probably be some weakness in the shares for the rest of 2009. Nice to sell puts to lock in a lower price (risk reduction). $7.50 will be way too low of a share price for these guys and I'll look to that end to open another short puts position during the rest of 2009.

stickto - ARCC is not of the same level, their capital structure is not more conservative - I dont' like the fact that their leverage is 80+% of net assets, forced to reduce their dividend, and a history of paying higher dividends than net interest income - i just can't fathom why that's a good long-term policy!

May 13 09:27 AM

[sticktoitiv...:]

Its a good policy because its selling below book. You buy a dollar for 70 cents and get some of the profit from that instantly paid out to you. As far as their dividend reduction they told shareholders that might happen over a year ago and its priced in.

May 13 08:05 PM

[Violent Cap...:]

yea but when slip ups happen you get killed then - i plan on holding for 4-5 years at min, would rather have a company cover dividends from interest and reinvest capital gains to earn higher interest/dividend income in the future, and for asset valuations i dont know if this is the bottom or not so I rather stick to a more conservative management style.

btw, book values on all these guys' balance sheets are probably overstated currently..

May 14 09:23 AM

[sticktoitiv...:]

Well if "slip ups happen" and there are defaults you do get killed. I have confidence in their lending abilities. Most of the companies they invest in are secular (to witch my view of their conservatism is based). I cannot relate to your time frame, I hold my stocks until my thesis for owning it is realized or disappears unrealized. However, I completely understand why you would want prospect instead. I only mentioned it because acas and ald are such bad comparisons. They operate much lower on the capital structure.

May 15 01:07 PM

[buyforeclos...:]

NOW that they diluted it by 15% ( maybe more ) and if the yKEEP paying thay high divy they will burn through a lot of cash. My guess is the ycut the divy to a yield of no more than 10% ..maybe 7%

May 18 05:42 PM

[Violent Cap...:]

this is a shocker, i wasn't expecting it to be priced in that low - $9/share I thought was more appropriate, a 10% discount to market.

The dividend may get cut - but not by 50%, just doesnt make sense, they may pare it back 20% (to reflect the resulting dilution), they'll have enough cash to cover dividends, and with debt at $138 mil + their claim to potentially increasing their credit lines, I'm sort of confused about what exactly is going on here at this present moment.

this may have been a deal in the making since early in the year, and PSEC may have thought it still better to raise cash if possible?

Still by selling puts at a 10 strike, I can watch this unfold on the sidelines...

May 20 11:23 AM