Hercules Technology (HTGC) surprised us last week by announcing results below the prior quarter, and below our expectations (see conference call transcript here). Worse, the company cut its dividend by one-third from $0.30 to $0.20. Of course the stock price swooned, dropping over 15% at one point but ended 9% down.
We’ve been a big fan of Hercules in recent quarters, impressed by its deft de-leveraging when Citibank (C) and Deutsche Bank (DB) cut and ran in the middle of the credit crunch, and by its ability to minimize bad debts in a sector which seems primed for regular disasters. Just a few weeks ago the company paid an extra dividend of 4 cents for 2009, after the regular $0.30 quarterly dividend for the period. Last year HTGC paid out a not-so shabby $1.26 in distributions.
Recently the company has been preparing its shareholders for growth by releasing announcements of the hire of a new COO, a new position at HTGC. As late as the last quarter’s earnings report, HTGC was announcing its intention to significantly expand its staff in anticipation of an increase in deal origination thanks to ample liquidity from cash on the balance sheet, unused SBIC capability and an under-utilized Revolver with Wells Fargo (WFC), as well as from fast re-circulating loan repayments.
So what happened? In the fourth quarter of 2009, assets at cost dropped to $380mn, or 13%. Total Investment Income dropped 6%, Net Investment Income 9% and Net Investment Income Per Share 10% to $0.27 from $0.30. Moreover, HTGC recognized material Realized Losses on two companies, writing off ($11.3mn), and was still left with $25mn in 5 non-accruing loans, up from 4 in the prior quarter. Even the very wide net interest margin which HTGC has benefited from narrowed from 13.68% to 12.82%. All of this is at variance with the high hopes we had for the company. Nonetheless, we remain bullish about the company.
Truth be told HTGC did warn in the IIIQ 2009 earnings report that they were still being cautious about spending their growing firepower of cash and borrowing capacity. Moreover, CEO Henriquez warned that the company was continuing "to focus our attention on resolving a handful of outstanding credit issues."
After dodging the bad debt bullet all through 2008, HTGC has racked up over ($30mn) in Realized Losses in 2009. That’s about 7.5% of paid-in capital-a metric we like to look at across the BDC space. Compared to other BDCs that’s not so bad, and $25mn in non-accruing loans is a still OK 7.7% of its debt assets.
HTGC is being cautious and we’d argue that’s a good thing in this environment. Even this quarter the CEO , on the conference call, sounded ambivalent about the current year, even while providing statistics about the the huge backlog of prospective deals being reviewed by HTGC’s growing staff. We’d rather postpone some earnings for a few quarters than walk into a double dip recession, and this seems to be HTGC’s position too.
This conservatism applies to the dividend as well. We don’t want to talk out of both sides of our mouth. We tend to look suspiciously at BDCs which pay out a dividend way in excess of its earnings. HTGC, to its credit, is being very strict on this score and only paying out in distributions what it earns in Taxable Income. Sadly, Taxable Income this quarter was 6 cents a share behind Net Investment Income Per Share. (According to the conference call, OID income which is recognized as earnings in GAAP accounting is treated as a Realized Gain for tax purposes. That tax income was lost in the big Realized Losses for the quarter.) Another BDC might have maintained the dividend at the IIIQ 2009 level of $0.30 and assumed they’d make up the difference the next time round. Certainly HTGC has the cash to fund a dividend shortfall, but they chose to live within their current means. We believe that’s commendable from a shareholder’s perspective but will make the stock more volatile than others.
The key question now, though, is whether HTGC can bounce back, and if so, when? On the conference call the CEO indicated that the company already has $50mn in signed Term Sheets for new deals (a few months ago HTGC was doing no new deals), and $160mn under “active negotiation”. Then there is always the funding of existing companies, offset by the heavy repayments which are common for this company.
Nonetheless, we were being guided by management on the conference call to recognize that assets might not grow until the second quarter of 2010. The company both sees good opportunities in the early stage and middle market segments, and speaks of hedge fund competitors dropping away or liquidating. At the same time, spreads on good loans are narrowing as some lenders stay price competitive on the best credits. If the economy, and especially the life sciences segment, recovers as expected we can expect to see HTGC grows its assets back up.
How much? We’d guess that total assets could get to $500mn at cost, a 31% increase in a few quarters. That’s $120mn in net new assets.
That will probably be partly funded by already committed SBIC long term debt and the cash on the balance sheet. Our back of the envelope calculation suggests that if HTGC uses $100mn of its $125mn in cash, and borrows the rest, $13mn or more could drop to the Net Investment Income line on an annual basis or $3.25mn a quarter. That’s over 9 cents a share a quarter and would get HTGC close to the recent $0.30 level in earnings per share and dividend without straining leverage (debt to equity as of 12/31/2009 would be only 0.4:1.0), and with plenty of room to grow further with $75mn in extra SBIC monies on their way, and $70mn in Revolver debt and $25mn in cash. Then there are the equity gains to be harvested from portfolio companies.
The wild card here is bad debt. We don’t really know if HTGC’s debt troubles have peaked or are on their way up. Does anyone? If non accruals continue to climb, the benefit from higher asset formation will be mitigated. Worse: if HTGC holds back on adding new loans because of a concern about the fundamental health of the economy, we’ll see more Net Investment Income Per Share erosion and we could see the distribution drop again.
To quantify all that: if non-accruals double HTGC could forseably see its dividend drop another 2 cents, or 10%. Obviously the company could cut expenses if things go awry and offset some of the increased losses. The CEO has already suggested as much on the conference call, notwithstanding all the talk about growing the staff.
HTGC is at an inflection point. Success is not guaranteed, nor is failure and the environment is very uncertain. We are betting that bad debts have peaked, Realized Losses will be non-material and that assets and earnings will grow substantially over the next 4-6 quarters. If we’re right, HTGC will meet or exceed the Investment Income of $0.30 a share achieved in the third quarter of 2009. An annual dividend of $1.20 will give a yield of 13.0% on today’s price of $9.22. That’s a reasonable return in our minds for a bDC.
We’re also reassured that should the economy sour HTGC has the protection of a slimmed down balance sheet, no net debt (borrowings less cash), access to SBIC monies (as much as $95mn in incremental monies) and an activist approach to working out whatever troubled loans comes its way.
In a worst case we can foresee lower earnings, but no disaster. All of us are grappling with what we learned from the Great Recession. One of the main lessons we felt we’ve learned is that avoiding disasters such as American Capital (ACAS) is more important than any other factor, and the key is having adequate liquidity under all possible market conditions. This is known as the “live to fight another day” approach.
We feel HTGC, with its conservative, even skeptical approach to the market, is one of the safer bets in this industry despite this week’s dividend cut.
Disclosure: Author holds a long position in HTGC