Prospect Capital (PSEC) recently reported financial results and surprised analysts with EPS of $0.38 for the quarter, 27% above expectations and adequately covering dividends while maintaining net asset value ("NAV") per share. PSEC also improved its risk profile compared to the other 25 BDCs that I follow due to lower amounts of non-performing loans, decreased portfolio yield from increased investments in senior secured loans, increased skin in the game from management, and improved profitability. I believe analyst recommendations will be upgraded along with target pricing as well as projected EPS in the coming weeks. Given the recent financial improvements and direction of the company I believe PSEC is underpriced and a buying opportunity for investors seeking high yield and potential capital gains. In this article I will highlight the changes from the previous quarter, identify my concerns, and update my personal price targets.
Full Disclosure: I am now long PSEC.
These are the five general criteria I use to evaluate BDCs:
- Profitability (EPS to cover dividends, NAV and EPS growth)
- Risk (diversification, portfolio quality, volatility, leverage)
- Payout (sustainable, consistent, growing)
- Analyst Opinions
- Valuation (NAV, P/E, PEG)
For my most recent overall BDC rankings table see "BDC Rankings For Q2 2013: Part 3" or for more information about BDCs and how I evaluate them, please see "BDC Investment Philosophy And 4 Portfolios". The changes described below have moved PSEC up in my rankings and I will provide an updated chart showing all BDCs early next week or on Sunday if you receive my newsletter. Here are the updated category rankings for PSEC after taking into account the results (10 being the highest) and I would expect the analysts category to improve:
During the calendar year 2012 PSEC looked very profitable with an average quarterly EPS of $0.50 and then analysts projected a decrease of quarterly EPS around $0.30 for the upcoming quarters. This is due to the profits from the Gas Solutions sale on January 4, 2012, taken as income rather than capital gains which were a temporary four quarter bump in net investment income ("NII").
For the quarter ended June 30, 2013, PSEC beat projected EPS estimates by $0.08 per share or 27% and sufficiently covered dividends as well as increase its undistributed net investment income by an additional $11 million.
PSEC seems to have unlimited access to cheap credit at fixed rates as well as a substantial credit line with plenty of potential growth capital as shown in the table below:
PSEC estimates that its net investment income for the current September 2013 quarter will be $0.30 to $0.35 per share and current analyst EPS projection are $0.32 per share but I believe this will be increased to at least $0.34 after digesting the results. In the latest announcement it stated "our originations in the June 2013 quarter were again weighted toward the last month of the quarter, resulting in only a partial quarter positive income impact from such originations. We expect such originations to generate full-quarter positive impact in the current September 2013 quarter." As discussed in "TICC Capital: High Dividends And Low Price" there is a lag between the time capital is deployed and the actual recognition of income from those investments especially with collateralized loan obligation ("CLO") types of investments. For BDCs such as PSEC this can cause a temporary lack of dividend coverage if the company is growing faster than the time it takes to benefit from its investments.
Impacts from rising rates
Recently the CFO announced "Prospect has locked in a ladder of fixed rate liabilities extending 30 years into the future, while most of Prospect's loans float with LIBOR, providing upside to shareholders as interest rates rise". Currently 89% of assets are floating rate and 93% of liabilities are fixed rate and an increase in interest rates by 5.00% would increase net investment income by $0.26 per share or $67.8 million in FYE 2014.
The table below is from the previous quarter and shows the impacts to annual NII and EPS with associated rate increases.
In a recent series of articles I discussed the risk profiles of 25 BDCs, giving PSEC a relative risk ranking of 5.1 (10.0 being the least amount of risk) which has been increased to 5.9 for a few reasons including:
- Improved average portfolio asset classes
- Decreased average portfolio yield
- Decreased non accruals
- Increased use of leverage
- Well positioned for interest rate sensitivity
- Better than average insider and institutional ownership
- Better than average industry diversification
- Better than average volatility ratios
PSEC has clearly stated "Our origination efforts are focused primarily on secured lending, to reduce the risk in the portfolio", investing primarily in first lien loans and subordinated notes in CLOs. At June 30, 2013, its investment portfolio of $4.2 billion (at fair value) consisted of 124 portfolio companies and was invested 53% in senior debt, 27% in subordinated debt, 16% in CLO type investments, and 4% in equity securities. Its CLO investments are derived from portfolios of corporate debt securities which are generally risk rated from BB to B (non-investment grade) depending on the tranche and currently yielding approximately 20%. As discussed in previous articles, CLOs potentially have the following issues: 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.
Overall, PSEC has improved its investment class mix from the previous quarter by increasing the amount of senior debt to 53% of the portfolio from 51% the previous quarter, and reducing its exposure to CLO type investments from 17% to 16%. However this was only due to rounding and the actual difference as a percentage of the portfolio was nominal.
PSEC had an annualized yield of 13.6% as of the end of the year compared to 13.9% in the previous quarter, most likely due to origination efforts focused on secured lending as well as potentially some yield compression in the industry from increased competition.
Non-accruals decreased from 1.3% of assets at fair value to 0.3% and none of the loans originated in nearly six years has gone on non-accrual status. The decrease was mostly due to the sale of Wolf Energy.
The debt to equity ratio increased from 0.55 to 0.63 but after subtracting cash and equivalents it is closer to 0.56 and near the industry average. PSEC has increased its NII for better than average interest expense coverage as shown in the charts below.
Most likely PSEC allowed their debt levels rise by borrowing on the credit facility and will continue to use the ATM program to issue new shares at higher prices, after investors digest the latest results, at a premium to NAV and lower cost of capital which would be accretive and potentially used to reduce leverage. From July 1, 2013 to August 21, 2013, PSEC raised over $57 million in InterNotes and sold 9,818,907 shares of common stock at an average price of $10.97 per share, raising almost $107 million in net proceeds, under the ATM Program.
Continued management skin in the game - senior management has never sold a single share of stock and continues to be significantly invested with more than $35 million of cash equity in the company (including an additional $1.5 million in 2013).
Recently PSEC was given a BBB+ bond rating by Kroll Bond Rating Agency which "reflects the Company's significant position in senior secured debt investments, strong leverage metrics that are well below the BDC regulatory limits, excellent asset quality performance to date, and the quality of its credit originations and monitoring. The rating is also supported by Prospect's proven management expertise in middle market lending. These strengths are balanced by the potential risks related to the Company's rapid growth trajectory during the past 18 months as well as the potentially more volatile performance embedded in equity exposures within its "buyout" portfolio and CLO investments."
The current dividend yield of 12.1% is much higher than the industry average of 9.5%. As of June 30, PSEC had accumulated undistributed net investment income of $77 million (or around $0.30 per share), an increase of $11 million from the previous quarter, and more than enough to comfortably continue to pay the dividends it has declared through March 2014. The CEO stated in a recent announcement: "Given the stable and predictable profitability of our business, our board has declared monthly shareholder dividends through the end of 2013 to enhance visibility and planning for investors who might otherwise be concerned by recent interest rate volatility".
PSEC has declared cumulative distributions to shareholders of approximately $12.27 a share, totaling around $991 million.
Before the earnings release yesterday, most analysts considered PSEC a "Hold" or "Market Perform" with a target price between $11 to $12. Over the next few weeks there will most likely be analyst upgrades and increased price targets. I will cover my price expectations at the end.
PSEC is currently trading at a 2% premium to NAV, which is lower than the average for BDCs as shown in the chart below, along with the standard deviation of current BDC multiples of NAV per share, excluding ACAS which is not an RIC, does not pay a dividend, and is potentially priced differently by investors. The 'standard deviation' statistically measures the variation of pricing compared to the average with 68% of BDCs priced between 0.92 and 1.20 times NAV. Ideally, each BDC would be priced along the curve with investors paying a premium for favorable risk to reward ratios.
PSEC currently has a P/E ratio of 8.6 times using the last 12 months earnings (after adjusting for the Gas Solutions sale discussed earlier) which is much lower than the average of 10.8 times.
PSEC has improved its risk profile and profitability, and is now considered to be above average relative to other BDCs. It has been actively raising capital through debt and equity offerings but still maintains an average amount of leverage. The current NAV per share multiples for PSEC are below average and given its improved risk profile, adequate dividend coverage and maintaining NAV per share values I believe PSEC should be priced slightly above average, between $12 and $13.
My key concerns are its continued investments in CLO type vehicles and portfolio yields. Over the next few quarters I would like to see PSEC issuing fewer shares and allowing time for recent deployments to continue to cover dividends while investing less in CLOs and reducing or maintaining current yields, as well as growing NAV per share. On the earnings call later today I will be looking for the direction of portfolio yields and investments, the appetite for leverage or dilution through continued offerings, and backlog or updated deployment opportunities.
Investors should only use this information as a starting point for due diligence. See the following for more information:
- BDC Investment Philosophy for general BDC information
- List of 25 BDCs that I follow and associated articles
- BDC Risk Profiles