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Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article for Prospect Capital Corp.'s (NASDAQ:PSEC) dividend sustainability analysis regarding its investment company net taxable income. PART 1 helps lead to a better understanding of the topics and analysis that will be discussed in PART 2. The link to PART 1's analysis is provided below:

Prospect Capital Corp.'s Dividend Sustainability Analysis - Part 1 (Post Fiscal Q4 2013 Earnings) - Part 1

Focus of PART 2 of Article:

The first part of PSEC's dividend sustainability analysis performed two tests and focused on its investment company net taxable income component. These two tests were termed "TEST 1" and "TEST 2". I will be performing two additional dividend sustainability tests within PART 2 of this publication. These two tests will focus on PSEC's earnings per share ("EPS") and net investment income ('NII') per share components. These two tests will be termed "TEST 3" and "TEST 4". After these two tests are analyzed, a discussion of PSEC's future EPS and NII considerations will be addressed.

At the end of PART 2 of this publication, there will be a conclusion on my opinions about the overall dividend sustainability of PSEC from the results obtained from both parts of the article.

Additional Factors PSEC Considers Regarding its Dividend:

In addition to the required 90% distribution of its investment company net taxable income for RIC compliance per the IRC (discussed within PART 1 of this article), PSEC has stated (within SEC disclosures) its dividend is also based on the following two factors:

First Additional Factor: Pay dividends consistent with its current and future earnings potential

Second Additional Factor (More Important): Intend to cover its dividend payout level with NII

The first factor will focus on PSEC's EPS component and be analyzed via TEST 3. The second factor will focus on PSEC's NII per share component and be analyzed via TEST 4.

Side Note: PSEC's management feels its second factor is more important regarding its current and future dividend payout levels. As such, PSEC's EPS component (TEST 3) is deemed less important when compared to its NII per share component (TEST 4). Readers should remember this distinction as TEST 3 and TEST 4 are presented and analyzed.

Prior to discussing and analyzing PSEC's EPS - basic component (TEST 3), let us briefly describe PSEC's past dividend history. This will ultimately help readers better understand TEST 3 and TEST 4.

Brief History of PSEC's Dividend:

In the past, PSEC paid a quarterly dividend from the fiscal second quarter of 2005 to the fiscal third quarter of 2010. During the fiscal fourth quarter of 2010, PSEC switched from paying a quarterly dividend to a monthly dividend. During this conversion period, PSEC only paid a fiscal fourth quarter of 2010 dividend of $0.10 per share. Prior to this quarter, PSEC paid a fiscal third quarter of 2010 dividend of $0.41 per share. This was a material dividend cut that some investors may have not noticed due to the quarterly to monthly dividend conversion. Even if PSEC's new monthly dividend amount was paid during each month during its fiscal fourth quarter of 2010 (which did not occur), PSEC still would have reduced its quarterly dividend from $0.41 per share to $0.30 per share. As was indicated in PART 1's analysis, this translated to a material dividend cut during the fiscal year of 2010.

Since the material dividend cut in the fiscal fourth quarter of 2010, PSEC fractionally increased its monthly dividend per share amount until the fiscal second quarter of 2013. During the fiscal second quarter of 2013, PSEC moderately increased its monthly dividend from $0.101675 per share in November 2012 to $0.11 per share in December 2012 (instead of just the typical monthly fractional increase). This was mainly attributed to a large increase in its dividend income from one of its portfolio investments (Energy Solutions). These equity distributions occurred during the fiscal fourth quarter of 2012, fiscal first quarter of 2013, and fiscal second quarter of 2013. For these specific fiscal quarters, PSEC recorded a material increase in its quarterly NII per share and a decent quarterly increase in its EPS.

When calculated, PSEC paid an annual fiscal dividend of $1.211, $1.217, and $1.279 per share for the fiscal years of 2011, 2012, and 2013, respectfully. PSEC has continued to declare a fractionally higher monthly dividend per share amount for the first three fiscal quarters of 2014. PSEC's monthly dividends have been declared through March 2014. March 2014's monthly dividend amount of $0.110375 per share continues PSEC's fractionally higher dividend policy from its current dividend of $0.11025 for the month of October 2013.

Now that we have discussed PSEC's past, current, and future declared dividends, let us first analyze PSEC's first additional factor it considers when choosing a proper dividend per share amount.

First Additional Factor - Pay Dividends Consistent With its Current and Future Earnings Potential:

Before jumping into PSEC's future earnings potential, I feel it is necessary to analyze and discuss its past/current earnings to see if the company's past/current annual dividends were/are covered by its annual EPS. This will lead to a better understanding of the overall trends regarding this particular component and possible future pitfalls that may arise. Even though not explicitly stated above, I am making the initial assumption PSEC felt its past EPS was capable of covering its past annual dividend per share distributions. Therefore, let us analyze PSEC's past/current annual EPS - basic figures to see if the company covered its past/current annual dividend per share distributions.

Side Note: After a similar analysis is performed on PSEC's past/current annual NII per share figures below (TEST 4), a discussion of future EPS and NII per share considerations will be the topic of conversation.

TEST 3 - Accumulative Undistributed EPS Surplus (Deficit) Analysis:

- See Table 3 Below; Red References "O, P, Q, R" in Table 3 Below Next to the June 30, 2013 Column

Using Table 3 below as a reference, the annual figure in regards to the red references "O" and "P" are derived from PSEC's annual SEC submission via its 10-K. All remaining figures are checked and tied back to various spreadsheets and data from PSEC's supported documentation where applicable.

Table 3 - PSEC Accumulative Undistributed EPS Surplus (Deficit) Analysis


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Using Table 3 as a reference, I first show PSEC's annual "EPS - basic" figure (red reference "O" in Table 3). This is PSEC's annual EPS - basic figure per GAAP and is shown within its income statement. I then show PSEC's annual dividend distributions figure (red reference "P" in Table 3). I then subtract PSEC's annual EPS - basic figure from its annual dividend distributions figure. If PSEC's red reference "O" is greater than its red reference "P", then PSEC technically has enough annual EPS to pay out its annual dividend distributions. If PSEC's red reference "O" is less than its red reference "P", then PSEC has overpaid its annual dividend distributions in regards to EPS.

Regarding TEST 3, I analyze two balances. The first balance (red reference "(O - P) = Q") is PSEC's EPS - basic underpayment (overpayment) for each fiscal year. This particular balance is non-cumulative in nature. The second balance (red reference "R") is PSEC's EPS - basic cumulative running underpayment (overpayment) since its IPO in 2004.

Beginning with the fiscal years 2008, 2009, and 2010, PSEC incurred an enormous annual EPS - basic overpayment/deficit of ($0.421), ($0.505), and ($0.996), respectively. As initially stated in PART 1 of this article, these annual overpayments/deficits were mainly attributed to PSEC's net realized losses of ($16.2), ($39.1), and ($51.5) million for the fiscal years 2009, 2010, and 2011, respectively. From the culmination of three fiscal years of consecutive material EPS - basic overpayments/deficits, PSEC's cumulative running balance went from a $0.673 EPS - basic underpayment/surplus at the end of the fiscal year of 2008 to a ($0.828) EPS - basic overpayment/deficit by the end of the fiscal year of 2010. This was a huge swing in this particular cumulative balance. As was discussed in PART 1 of this article, management correctly reduced its dividend during the fiscal years of 2010 and 2011. However, when looking at TEST 3's analysis on a standalone basis, an argument could be made that the dividend cut that occurred during these two fiscal years were not enough.

For the fiscal years of 2011 and 2012, PSEC was able to achieve an annual EPS - basic underpayment/surplus of $0.164 and $0.453, respectively. These annual underpayments/surpluses were mainly attributed to PSEC's net realized gain of $16.5 and $36.6 million for the fiscal years of 2011 and 2012, respectfully. These gains were on PSEC's sold/exited investments within its portfolio. Also, a portion of the annual underpayments/surpluses were attributed to a smaller net unrealized depreciation figure on its active investment portfolio. From the culmination of two fiscal years of consecutive material EPS - basic underpayments/surpluses, PSEC's cumulative running balance went from a ($0.828) EPS - basic overpayment/deficit at the end of the fiscal year of 2010 to only a ($0.211) EPS - basic overpayment/deficit by the end of the fiscal year of 2012. This was a material positive swing for this particular cumulative balance. As was discussed in PART 1 of this article, management began to increase its dividend during the fiscal years of 2011 and 2012. When looking at TEST 3's analysis on a standalone basis, an argument could be made that the dividend raise during these two fiscal years still caused a minor cumulative running deficit per share balance by the end of the fiscal year of 2012. However, I feel the better argument is the material reduction in PSEC's cumulative running overpayment/deficit per share balance between the fiscal years of 2010 and 2012.

For the fiscal year of 2013, PSEC had an annual EPS - basic overpayment/deficit of ($0.217) per share. This annual overpayment/deficit was mainly attributed to PSEC's net realized losses of ($26.2) million on its sold/exited investments and net unrealized depreciation of ($77.8) million on its active investments. This was a moderate overpayment/deficit regarding annual dividend distributions. As such, PSEC's cumulative running balance went from a ($0.211) EPS - basic overpayment/deficit at the end of the fiscal year of 2012 to a more moderate ($0.428) EPS - basic overpayment/deficit by the end of the fiscal year of 2013. When looking at TEST 3's analysis on a standalone basis, an argument could be made that the dividend raise during the fiscal year of 2013 caused an increase to this particular balance.

Therefore, it seems PSEC's cumulative running overpayment/deficit regarding its EPS - basic figure at the end of the fiscal year 2013 shows some signs the current dividend could be vulnerable. This leads me to conclude that PSEC's first additional factor, regarding past performance, is currently in jeopardy under the current annual dividend rate of $1.324 per share (or a monthly dividend of approximately $0.11 per share).

TEST 3's results drew a different conclusion than TEST 1 and TEST 2 in PART 1 of the analysis. As such, I feel TEST 4 becomes extremely important. TEST 4's results will dictate whether PSEC's current/future dividend has a higher probability of being sustainable thus solidifying TEST 1 and TEST 2's results or whether TEST 3's analysis has shed some light on possible vulnerabilities of the current/future dividend.

Side Note: As stated in an earlier side note, even though PSEC considers its EPS as an additional factor when considering its dividend declarations, management has stated its NII component is a more important factor. This statement should be kept in the back of a reader's mind when TEST 3 and TEST 4 are analyzed and discussed. As such, I make the assumption that TEST 3's results should be considered less important when compared to TEST 4's results. Also, PSEC's ($0.428) EPS - basic overpayment/deficit by the end of the fiscal year of 2013 is rather modest when compared to other companies within the BDC sector (ones that I cover).

Additional Side Note: Table 3 omits showing PSEC's annual EPS - diluted figure. This figure is slightly different when compared to PSEC's annual EPS - basic figure because this figure takes into consideration the dilutive nature of PSEC's convertible senior notes. Holders may convert these convertible senior notes at any time prior to maturity. As such, PSEC's annual EPS - diluted figure is slightly worse (profit wise) when compared to its annual EPS - basic figure. All references and methodologies performed in TEST 3 in relation to PSEC's annual EPS - basic figure are also performed on PSEC's annual EPS - diluted figure. However, I do not see the need to show or discuss PSEC's annual EPS - diluted results because both figures basically have the same results. Therefore, the conclusions drawn on the overall dividend sustainability of PSEC via its annual EPS - basic and annual EPS - diluted figures are the same.

Now let us analyze and discuss PSEC's second additional factor it considers when choosing a proper dividend per share amount.

Second Additional Factor - Intend to Cover its Dividend Payout Level with NII:

As mentioned within the first additional factor above, I feel it is necessary to analyze and discuss PSEC's past/current NII per share to see if the company's past/current annual dividends were/are covered. This will lead to a better understanding of the overall trends regarding this particular component and possible future pitfalls that may arise. Even though not explicitly stated above, I am making the initial assumption PSEC felt its past NII per share was capable of covering its past annual dividend per share distributions. Therefore, let us analyze PSEC's past/current annual NII per share - basic figures to see if the company covered its past/current annual dividend per share distributions.

Side Note: After TEST 4 is analyzed and discussed, a discussion of future EPS and NII per share considerations will be the topic of conversation.

TEST 4 - Accumulative Undistributed NII Per Share Surplus (Deficit) Analysis:

- See Table 4 Below; Red References "P, S, T, U" in Table 4 Below Next to the June 30, 2013 Column

Using Table 4 below as a reference, the annual figure in regards to the red references "S" and "P" are derived from PSEC's annual SEC submission via its 10-K. All remaining figures are checked and tied back to various spreadsheets and data from PSEC's supported documentation where applicable.

Table 4 - PSEC Accumulative Undistributed NII Per Share Surplus (Deficit) Analysis


(Click to enlarge)

Using Table 4 as a reference, I first show PSEC's annual "NII per share - basic" figure (red reference "S" in Table 4). This is PSEC's annual NII per share - basic figure per GAAP and is shown within its income statement. I then show PSEC's annual dividend distributions figure (red reference "P" in Table 4). I then subtract PSEC's annual NII per share - basic figure from its annual dividend distributions figure. If PSEC's red reference "S" is greater than its red reference "P", then PSEC technically has enough annual NII to pay out its annual dividend distributions. If PSEC's red reference "S" is less than its red reference "P", then PSEC has overpaid its annual dividend distributions in regards to NII.

Regarding TEST 4, I analyze two balances. The first balance (red reference "(S - P) = T") is PSEC's NII per share - basic underpayment (overpayment) for each fiscal year. This particular balance is non-cumulative in nature. The second balance (red reference "U") is PSEC's NII per share - basic underpayment (overpayment) since its IPO in 2004.

Beginning with the fiscal years of 2010 and 2011, PSEC incurred a moderate annual NII overpayment/deficit of ($0.196) and ($0.115) per share, respectively. This was mainly attributed to PSEC's rapid expansion of its investment portfolio. As such, a material amount of outstanding common shares were raised to fuel PSEC's rapid growth. This caused a "dilution" of PSEC's NII for the fiscal years of 2010 and 2011 prior to the full deployment of its newly raised capital. PSEC's annual weighted average common shares outstanding were 31.6, 59.4, and 86.0 million in the fiscal years of 2009, 2010, and 2011, respectfully. From the culmination of two fiscal years of consecutive NII per share - basic overpayments/deficits, PSEC's cumulative running balance went from a $0.566 NII per - basic underpayment/surplus at the end of the fiscal year of 2009 to only a $0.255 NII per share - basic underpayment/surplus by the end of the fiscal year of 2011. This was a modest decrease in this particular cumulative balance. As was discussed in PART 1 of this article, management correctly reduced its dividend during the fiscal years of 2010 and 2011. Even though PSEC's cumulative running balance decreased during these two fiscal years, the ending balance was still positive.

For the fiscal years of 2012 and 2013, PSEC was able to achieve an annual NII per share - basic underpayment/surplus of $0.415 and $0.323, respectively. These annual underpayments/surpluses were mainly attributed to material increases in PSEC's interest, dividend, and other income as its investment portfolio rapidly expanded and capital was fully deployed. This also included a lower portion of PSEC's investment portfolio being put on "non-accrual" status. PSEC's annual "total investment income" outpaced the modest increases in its annual "total investment advisory fees" and "total operating expenses" for the fiscal year of 2012 and 2013. From the culmination of two fiscal years of consecutive material NII per share - basic underpayments/surpluses, PSEC's cumulative running balance went from a $0.255 NII per share - basic underpayment/surplus at the end of the fiscal year of 2011 to a materially larger $0.993 NII per share - basic underpayment/surplus by the end of the fiscal year of 2013. This was an extremely positive swing for this particular cumulative balance. As was discussed in PART 1 of this article, management continued to increase its dividend during the fiscal years of 2012 and 2013. When looking at TEST 3's analysis on a standalone basis, an argument could be made that the dividend increases during these two fiscal years could have been raised even further.

Therefore, it seems PSEC's cumulative running underpayment/surplus regarding its NII per share - basic figure at the end of the fiscal year 2013 shows no signs the dividend will be cut. In fact, TEST 4 shows there is strong evidence dividend raises will continue to occur. This determination has already been partially validated as PSEC has declared a slight fractional monthly increase on its dividend distributions for the first three fiscal quarters of 2014. This leads me to conclude that PSEC's second additional factor, regarding past performance, is currently passing under the annual dividend rate of $1.324 per share (or a monthly dividend of approximately $0.11 per share) with room to spare. As such, TEST 4 concludes a dividend cut is a fairly low probability. As such, TEST 4's results solidify the results obtained in PART 1 of this analysis (TEST 1 and TEST 2). TEST 4's results also show TEST 3's conclusion should be less alarming regarding possible vulnerabilities of PSEC's current dividend sustainability.

Side Note: As stated earlier in the article, even though PSEC considers its EPS as an additional factor to considering regarding its dividend declarations, management has stated its NII is a more important factor. This statement should be kept in the back of a reader's mind when TEST 3 and TEST 4 are analyzed and discussed. As such, I make the assumption that TEST 3's results should be considered less important when compared to TEST 4's results.

Additional Side Note: Table 4 omits showing PSEC's annual NII per share - diluted figure. This figure is slightly different when compared to PSEC's annual NII per share - basic figure because this figure takes into consideration the dilutive nature of PSEC's convertible senior notes. Holders may convert these convertible senior notes at any time prior to maturity. As such, PSEC's annual NII per share - diluted figure is slightly worse (income wise) when compared to its annual NII per share - basic figure. All references and methodologies performed in TEST 4 in relation to PSEC's annual NII per share - basic figure are also performed on PSEC's annual NII per share - diluted figure. However, I do not see the need to show or discuss PSEC's annual NII per share - diluted results because both figures basically have the same results. Therefore, the conclusions drawn on the overall dividend sustainability of PSEC via its annual NII per share - basic and annual NII per share - diluted figures are the same.

Since TEST 3 and TEST 4 covered PSEC's past and current performance, let us now discuss PSEC's future expectations regarding its EPS and NII. PSEC's future EPS and NII considerations will be discussed to see if TEST 3 and TEST 4's conclusions remain accurate and valid.

Future EPS and NII Considerations:

When compared to other companies within the BDC sector, PSEC has historically had an annual dividend yield more towards the higher end of the spectrum. PSEC is able to support this higher annual dividend yield by maintaining an above average weighted average yield on its debt investments when compared to its sector participants. Typically, a higher weighted average yield (return) comes with added potential volatility/risk. This basically gets back to the risk versus reward metric. PSEC's higher overall weighted average yield on its debt investments comes with a greater risk of losing investment principle if a particular company has the inability to repay its loan obligations or declares bankruptcy. This risk has direct EPS and NII implications.

A portfolio company's inability to pay its loan obligations would cause its debt investments to be put on "non-accrual" status. As such, interest income is not accrued for which in turn causes a direct and immediate drop in a company's NII. If a portfolio company continues to have the inability to repay its loan obligations, a fair market value ('FMV') "write-down" (also known as capital depreciation) occurs. As such, the value of PSEC's investment portfolio is reduced thus causing a direct and immediate drop to EPS.

The same general risks would occur on PSEC's equity investments. If a portfolio company (which PSEC has an equity investment in) begins to show signs of its inability to pay its loan obligations (whether it has a loan arrangement with PSEC or elsewhere), PSEC's equity investment in that company will most likely see a reduction in dividend income. This would occur because the portfolio company's dividend distributions would be reduced. As such, this would cause a direct and immediate drop to NII. A particular equity investment could also have a faltering business operation thus making PSEC's equity investments less valuable. As such, a FMV equity write-down/capital depreciation would occur. In extreme cases, a total write-off may come to fruition leaving PSEC's equity investment worthless. Similar to the debt investment example above, this would cause a direct and immediate drop to EPS.

Now that we have a basic understanding of the potential risks that could occur when a particular BDC has an overall higher level of risk regarding its investment portfolio (hence higher appetite for yield), let us look at PSEC's weighted average yield regarding its debt investments.

Table 5 - PSEC Weighted Average Yield Analysis:


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Using Table 5 above as a reference, by the end of the fiscal year of 2010, PSEC had an increase in its weighted average yield on debt investments from 14.6% to 16.2% on a "year-over-year" basis. This weighted average yield increase of 1.6% is a direct result of PSEC increasing its potential yield on its debt investments through an increase in risk tolerance. However, as Table 5 points out, PSEC's NII only slightly increased while incurring material realized losses on its sold or written-off investments. For the fiscal year 2010, PSEC had a realized loss of ($51.5) million. Even though PSEC's weighted average yield on its debt investment increased, its NII did not increase accordingly due to the various debt and equity write-offs that occurred (including the non-deployment of its recently raised capital as was discussed earlier). As such, the dividend for the fiscal year 2010 dramatically decreased.

By the end of the fiscal year of 2011, PSEC had a material decrease in its weighted average yield on debt investments from 16.2% to 12.8% on a year-over-year basis. This weighted average yield decrease of 3.4% is a result of PSEC decreasing its potential yield on its debt investments through a decrease in risk tolerance. Another reason for the dramatic decrease in yield was due to the continued low interest rate environment. As such, most new investments had lower yields as a result of overall market conditions. As Table 5 highlights, during the fiscal year of 2011 PSEC's NII materially increased due to both realized and unrealized capital appreciation regarding its sold and unsold investments (including a rapidly expanding investment portfolio). As such, even though PSEC had a material decrease it its weighted average yield for the fiscal year of 2011, its investment portfolio actually performed better as a whole when compared to the fiscal year of 2010. Even though PSEC's NII per share decreased $0.03 per share, its EPS increased a substantial $1.04 per share. These results led to the new dividend "base" of $1.211 per share that was mentioned earlier in the article.

By the end of the fiscal year of 2012, PSEC had a modest increase in its weighted average yield on debt investments from 12.8% to 13.9% on a year-over-year basis. By the end of the fiscal year of 2013, PSEC had a slight decrease in its weighted average yield on debt investments from 13.9% to 13.6% on a year-over-year basis. Even though the company had a year-over-year decrease of 0.3% regarding the change in its weighted average yield, it should be noted PSEC recognized both realized and unrealized capital depreciation of ($26.2) and ($77.8) million for the fiscal years of 2012 and 2013, respectfully. Even though NII per share has continued to remain very strong, PSEC's EPS per share has suffered due to the material capital depreciation that has occurred during the fiscal year of 2013. As such, readers should pay attention to future realized and unrealized capital appreciation (depreciation) figures accordingly. These two figures provide potential signs that determine whether PSEC's investment portfolio will be suffering current or future valuation losses. These two accounts have an impact on the dividend per share rate considerations (as TEST 3 showed earlier).

When PSEC recently reported its fiscal fourth quarter of 2013 results, several portfolio companies caught my attention regarding material unrealized valuation losses.

Table 6 - PSEC Fourth Quarter of 2013 Material Unrealized Valuation Losses


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Using Table 6 as a reference, several portfolio companies had material unrealized valuation losses for the fiscal fourth quarter of 2013. One particular write-down which was rather large was Gulf Coast Machine & Supply Company. This particular investment was only added to PSEC's investment portfolio in the fiscal second quarter of 2013. As such, this is a relatively new investment with a loan maturity of 10/12/2017. The total principal balance on this senior secured term loan was originally $41.7 million. While not one of PSEC's larger principal balances, this is not considered a smaller balance either. Up until the fourth fiscal quarter of 2013, the FMV of this investment was basically the same as the remaining principal balance owed (positive sign). However, as Table 6 shows, a ($9.2) million unrealized FMV write-down occurred. As such, this particular loan is currently only valued at $32.0 million as of 6/30/2013. This is somewhat troubling because the investment is under a year old. Regarding all the companies in Table 6 above, it may be wise to monitor the valuations of these companies in future quarters.

Currently, a majority of PSEC's weighted average debt is between an annual rate of 4%-6%. This includes PSEC's credit facility, senior convertible notes, "InterNotes©", and senior unsecured notes. Therefore, the net interest "spread" on PSEC's main source of income is between 7%-9%. As mentioned earlier, PSEC can also achieve equity appreciation (depreciation) regarding certain portfolio investments/sponsors. PSEC only obtains certain annual dividend or "one-time" dividend payouts which are treated as a partial return of its capital. These additional sources of gains/income would increase PSEC's weighted average yield by an additional 1%-2% at most under a "best case scenario". PSEC also receives various structuring, servicing, and prepayment/exit fees regarding its investment portfolio (if applicable). When all these percentages and figures are combined, it helps identify why PSEC has been able to continue to pay out a dividend yield between 10%-13% over the past several years.

In order to maintain or slightly increase its dividend in the future, PSEC needs to carefully balance its risk verses reward metrics. Under current market conditions, a weighted average debt yield between 12.5%-14% should help solidify this potential. A weighted average debt yield below 12.5% will cause an immediate reduction in NII per share and cause some stress on the future dividend being maintained or fractionally increasing. A weighted average debt yield above 14% could cause PSEC's NII per share to increase accordingly. However, the increase in risk associated with an increase in PSEC's weighted average debt yield would raise the probability of portfolio company write-offs regarding both debt and equity investments. As such, a material decrease in EPS would likely occur causing a heightened level of stress regarding the future dividend. As evident in Table 5 above, this was the case in the fiscal year of 2010 as the weighted average debt yield rose to 16.2%. When this occurred, material realized valuation losses occurred.

I feel PSEC's management understands this general concept and has positioned the company to achieve an attractive rate of return to investors while trying to remain somewhat cautious regarding the risk associated with its current and future investment portfolio.

Conclusions Drawn:

To reiterate what was performed in both parts of the article, four dividend sustainability tests were performed on PSEC. During PART 1 of this article, two tests focused on PSEC's investment company net taxable income component. During PART 2 of this article, a third test focused on PSEC's EPS - basic component and a fourth test focused on PSEC's NII per share - basic component.

Let us first summarize the conclusions drawn from PART 1 of this article. TEST 1 took PSEC's annual investment company net taxable income figure and compared it to its annual dividend distributions figure. TEST 1 showed PSEC (over several years) has distributed an annual dividend extremely close to 100% of its investment company net taxable income. As such (from a taxation standpoint), the probability of a dividend cut being declared is a fairly low probability as evidenced from TEST 1's results. Due to PSEC's investment company net taxable income underpayments for the fiscal years of 2012 and 2013, the current trends indicate the moderately high probability of a continued fractional dividend increase for at least the next several quarters.

TEST 2 took PSEC's accumulative undistributed net investment income (deficit) balance per GAAP and reconciled this balance to PSEC's accumulative undistributed investment company net taxable income (deficit) balance per the IRC. TEST 2 then analyzed both these cumulative running balances. TEST 2 showed PSEC has maintained an adequate annual dividend per share rate. TEST 2 also showed PSEC should continue to increase its accumulative undistributed investment company net taxable income balance if it maintains or fractionally increases its monthly dividend per share rate. As such, I felt TEST 2 helps add evidence to the conclusion stated in TEST 1's results.

Let us now discuss the conclusions drawn from PART 2 of this article. TEST 3 took PSEC's annual EPS - basic figure and compared it to its annual dividend distributions per share figure. TEST 3 showed PSEC's cumulative running overpayment/deficit regarding its EPS - basic figure at the end of the fiscal year 2013 showed some signs the current dividend could be vulnerable. This led me to conclude that PSEC's first additional factor, regarding past performance, is currently in jeopardy under the current annual dividend rate of $1.324 per share (or a monthly dividend of approximately $0.11 per share) if continued capital depreciation occurs regarding future quarters. Since TEST 3's results drew a different conclusion than TEST 1 and TEST 2, TEST 4 becomes fairly important.

TEST 4 took PSEC's annual NII per share - basic figure and compared it to its annual dividend distributions per share. TEST 4 shows PSEC currently has a material NII per share - basic underpayment/surplus for both the fiscal year 2013 and regarding its cumulative running balance. TEST 4 showed there were no signs the dividend will be cut in the near future. In fact, TEST 4 showed there is strong evidence fractionally higher dividend raises will continue to occur. This determination has already been partially validated as PSEC has declared a slight fractional monthly increase on its dividend distributions for the first three fiscal quarters of 2014. This leads me to conclude that PSEC's second additional factor, regarding past performance, is currently passing under the annual dividend rate of $1.324 per share (or a monthly dividend of approximately $0.11 per share) with room to spare. As such, TEST 4 concludes a dividend cut is a fairly low probability. As such, TEST 4's results solidify the results obtained in PART 1 of this analysis (TEST 1 and TEST 2). TEST 4's results also show TEST 3's conclusion should be less alarming regarding possible vulnerabilities of PSEC's current dividend sustainability.

Regarding its future EPS and NII prospects, PSEC needs to continue to balance its risk versus reward metrics. When PSEC's weighted average debt yield increased to 16.2%, it incurred material investment valuation losses during the fiscal year of 2010. As a direct result, PSEC needed to lower its dividend during the fiscal years 2010 and 2011. When PSEC's weighted average debt yield dropped below 12.8% in the fiscal year of 2011, it incurred a slight decrease to NII per share but had a material increase of $1.04 in its annual EPS. As such, PSEC was able to gradually increase its annual dividend for the fiscal years of 2012 and 2013.

Going forward, PSEC needs to balance having an attractive yielding investment portfolio while limiting the potential risks a higher-yielding portfolio can have. As such, I currently feel a weighted average debt yield between 12.5%-14% can achieve both goals. I believe management understands this concept and can keep the investment portfolio within this range. One should note, as overall interest rates change, this ideal weighted average debt yield range will fluctuate as well.

Final Conclusion:

When all four tests are analyzed and future considerations are taken into account, I feel there is moderate (some could argue strong) evidence PSEC's dividend will not be cut over the next 1-2 years.

Were it not for TEST 3's result (EPS component), I would have stated there was very strong evidence (high probability) a dividend cut will not occur during the next 1-2 years. PSEC is currently in better shape when compared to other companies within the BDC sector regarding the future sustainability of its current dividend.

Author's Note: Finally, it should be noted although I like PSEC as an investment, I do not currently own the stock. I have never owned this particular BDC. From researching PSEC, I like the company's management team and recent financials. I also like the recent rapid growth of its investment portfolio which will help spur additional NII. The current risk vs. reward structure seems attractive. However, I feel any additional risk to PSEC's current investment portfolio would be seen as unnecessary and possibly a negative sign regarding potential future debt and equity write-offs.

I would definitely be looking to initiate a position in PSEC if its stock price decreased near its 6/30/2013 NAV of $10.72 per share. Specifically, I would feel comfortable acquiring an initial position in PSEC at a price of $10.90 per share.

As such, I personally would rate PSEC a BUY at $10.90 per share.

Source: Prospect Capital Corp.'s Dividend Sustainability Analysis (Post Fiscal Q4 2013 Earnings) - Part 2