Seeking Alpha
Long-term horizon, dividend investing, mREITs, BDCs
Profile| Send Message|
( followers)  

Author's Note: This article is a detailed look at PSEC's dividend sustainability. I perform this detailed analysis for readers who anticipate/want such an analysis performed each quarter. For readers who just want the summarized conclusions/results, I would suggest to just scroll down to the "Conclusions Drawn" section at the bottom of the article.

Focus of Article:

The focus of this article is to provide a detailed analysis with supporting documentation (via two tests) on the dividend sustainability of Prospect Capital Corp. (NASDAQ:PSEC). I am writing this particular article due to the continued high demand that such an analysis be performed. Understanding the tax and dividend payout characteristics of PSEC will provide investors with an overall better understanding of the business development company ('BDC') sector as a whole. Due to the fact PSEC has produced an annual dividend yield between 10% - 13% over the past several years, many investors have chosen this stock (including other stocks within the BDC sector) for income-producing equity investments. From reading this article, investors will better understand how a regulated investment company ('RIC') per the Internal Revenue Code ('IRC') comes up with its current dividend rate and specific signs when an impending dividend raise or cut would be implemented.

I will be performing two dividend sustainability tests within this article. 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 1" and "TEST 2." After these two tests are analyzed, some recent and future trends to consider will also be discussed. These trends will have a direct impact on PSEC's future dividend sustainability and therefore should also be addressed. At the end of this article, there will be a conclusion on my opinions about the overall dividend sustainability of PSEC from the results obtained from the first two tests and future trends considered.

Side Note: In a past PSEC dividend sustainability article, I discussed PSEC's RIC classification per the IRC. This included specific provisions that PSEC must adhere by to remain in RIC compliance. In summary, PSEC is required to distribute annually to shareholders at least 90% of the company's "investment company taxable income" and "net capital gains" in order to be eligible for the tax benefits allowed to a RIC. I feel the specific analysis/discussion should be performed annually (not quarterly) to correspond to an entity's tax calendar. As such, all discussions about PSEC's RIC compliance will be omitted from this particular article.

The following is a link to the past dividend sustainability article where I discussed PSEC's RIC classification per the IRC (including a general business overview of the company) and all related analysis:

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

It should also be noted PSEC's fiscal year-end is June 30th of a given year. Therefore, PSEC's fiscal first quarter ends September 30th of a given year.

Two Factors PSEC Considers Regarding the Company's Dividend:

In addition to the required 90% distribution of its investment company net taxable income for RIC compliance per the IRC (see linked article above for a full discussion), PSEC's management team has stated (within SEC disclosures) the company's dividend is based on the following two factors:

First Factor: Pay dividends consistent with the company's current and future earnings potential

Second Factor (More Important): Intend to cover the company's dividend payout level with NII

The first factor will focus on PSEC's EPS component and be analyzed via TEST 1. The second factor will focus on PSEC's NII per share component and be analyzed via TEST 2. PSEC feels the second factor is more important regarding the company's current and future dividend payout levels. As such, PSEC's EPS component (TEST 1) is deemed less important when compared to the company's NII per share component (TEST 2). Readers should understand this distinction as TEST 1 and TEST 2 are presented and analyzed below.

Prior to discussing and analyzing PSEC's EPS - basic component (TEST 1), let us briefly describe the company's past dividend history. This will ultimately help readers better understand TEST 1 and TEST 2.

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 the new monthly dividend amount was paid in each month of the company's fiscal fourth quarter of 2010 (which did not occur), PSEC still would have reduced the quarterly dividend from $0.41 per share to $0.30 per share. 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 had fractionally increased the company's monthly dividend per share amount until the fiscal second quarter of 2013. During the fiscal second quarter of 2013, PSEC moderately increased the company's 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 PSEC's dividend income from one of the company's 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 the company's NII per share and a decent increase in the company's 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, respectively. PSEC has continued to declare a fractionally higher monthly dividend per share amount through the fiscal year-end of 2014 (through June 2014). When calculated, PSEC will pay an annual fiscal dividend of $1.324 per share for the fiscal year of 2014. June 2014's monthly dividend of $0.110450 per share continues PSEC's fractionally higher dividend policy from the company's most recent dividend of $0.1103 per share for the month of December 2013.

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

First Factor - Pay Dividends Consistent With the Company's Current and Future Earnings Potential:

First, I feel it is necessary to analyze and discuss PSEC's past quarterly EPS to see if the company's quarterly dividends were 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 management felt PSEC's past quarterly EPS was capable of covering the company's past quarterly dividend per share distributions. After a similar analysis is performed on PSEC's past annual NII per share figures (see TEST 2 below), future EPS and NII per share considerations will be discussed.

TEST 1 - Cumulative Undistributed EPS Surplus (Deficit) Analysis:

- See Red References "O, P, Q, R, S" in Table 1 Below Next to the September 30, 2013 Column

Using Table 1 below as a reference, the quarterly figures in regards to the red references "O" and "P" are derived from PSEC's quarterly SEC submissions. All remaining figures are checked and tied back to various spreadsheets and data from PSEC's supported documentation where applicable.

Table 1 - PSEC Cumulative Undistributed EPS Surplus (Deficit) Analysis

(click to enlarge)

Using Table 1 above as a reference, I first show PSEC's quarterly "EPS - basic" figure (see red reference "O" in Table 1). This is PSEC's quarterly EPS - basic figure per GAAP and is shown within the company's income statement. I then show PSEC's quarterly dividend distributions figure (see red reference "P" in Table 1). I then subtract PSEC's quarterly EPS - basic figure from the company's quarterly dividend distributions figure. If PSEC's red reference "O" is greater than the company's red reference "P," then PSEC technically had enough quarterly EPS to pay out the company's quarterly dividend distributions. If PSEC's red reference "O" is less than the company's red reference "P," then PSEC had overpaid the company's quarterly dividend distributions in regards to EPS.

Regarding TEST 1, I analyze three balances. The first balance (see red reference "(O - P) = Q" in Table 1) is PSEC's EPS - basic underpayment (overpayment) for each fiscal quarter. This particular balance is non-cumulative in nature. The second balance (see red reference "R" in Table 1) is PSEC's EPS - basic cumulative running underpayment (overpayment) since the company's last material dividend increase in the second fiscal quarter of 2013. The third balance (see red reference "S" in Table 1) is PSEC's EPS - basic cumulative running underpayment (overpayment) since the company's initial public offering ('IPO') in 2004.

PSEC had quarterly EPS - basic underpayments (overpayments) of ($0.014), ($0.076), ($0.134), and $0.008 per share for the company's first, second, third, and fourth fiscal quarters of 2013, respectively. When combined, this calculated to an annual fiscal year of 2013 overpayment of ($0.216) per share. This annual overpayment was mainly attributed to net realized losses of ($26.2) million on PSEC's sold/exited investments and the company's net unrealized depreciation of ($77.8) million regarding active investments. When calculated, PSEC's cumulative running balance went from a ($0.211) EPS - basic overpayment at the end of the fiscal year of 2012 to a sizable ($0.427) EPS - basic overpayment by the end of the fiscal year of 2013. When looking at TEST 1's analysis on a standalone basis, a strong argument could be made that the dividend raise during the fiscal year of 2013 caused an increase to this particular balance.

For the fiscal first quarter of 2014, PSEC reported EPS - basic of $0.31 per share while distributing ($0.331) per share. When calculated, this was a quarterly overpayment of ($0.021) per share. As such, PSEC's cumulative running overpayment, regarding the company's EPS - basic figure since the last material dividend increase, had risen to ($0.223) per share. PSEC's cumulative running overpayment, regarding the company's EPS - basic figure since its IPO, had risen to ($0.448) per share. This cumulative running balance continued to be a material overpayment at the end of the fiscal first quarter of 2014. However, when compared to PSEC's BDC peers that I research, the EPS - basic cumulative running overpayment of ($0.448) per share was still towards the lower end of the range within the sector.

Therefore, it seems PSEC's cumulative running overpayment regarding the company's EPS - basic figure at the end of the fiscal first quarter of 2014 shows some signs the current dividend could be vulnerable if this was the only factor the company looked at. As stated in an earlier side note, even though PSEC considers EPS as a factor when considering the company's dividend declarations, management has stated NII is a more important factor. This statement should be kept in the back of a reader's mind when TEST 1 and TEST 2 are analyzed and discussed. As such, I make the assumption that TEST 1's results should be considered less important when compared to TEST 2's results.

Side Note: Table 1 omits showing PSEC's quarterly EPS - diluted figures. These figures are slightly different when compared to PSEC's quarterly EPS - basic figures because these figures take 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 quarterly EPS - diluted figures are slightly worse (profit wise) when compared to the company's quarterly EPS - basic figures. All references and methodologies performed in TEST 1 in relation to PSEC's quarterly EPS - basic figures are also performed on PSEC's quarterly EPS - diluted figures. However, I do not see the need to show or discuss PSEC's quarterly EPS - diluted figures due to the similar results obtained.

Now let us analyze and discuss the second factor PSEC considers when choosing a proper dividend per share amount.

Second Factor - Intend to Cover the Company's Dividend Payout Level with NII:

As was the case with the first factor, I feel it is necessary to analyze and discuss PSEC's past quarterly NII per share to see if the company's quarterly dividends were 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 management felt PSEC's past quarterly NII per share was capable of covering the company's past quarterly dividend per share distributions. After TEST 2 is analyzed and discussed, future EPS and NII per share considerations will be discussed.

TEST 2 - Cumulative Undistributed NII Per Share Surplus (Deficit) Analysis:

- See Red References "P, T, U, V, W" in Table 2 Below Next to the September 30, 2013 Column

Using Table 2 below as a reference, the quarterly figures in regards to the red references "T" and "P" are derived from PSEC's quarterly SEC submissions. All remaining figures are checked and tied back to various spreadsheets and data from PSEC's supported documentation where applicable.

Table 2 - PSEC Cumulative Undistributed NII Per Share Surplus (Deficit) Analysis

(click to enlarge)

Using Table 2 above as a reference, I first show PSEC's quarterly "NII per share - basic" figure (see red reference "T" in Table 2). This is PSEC's quarterly NII per share - basic figure per GAAP and is shown within the company's income statement. I then show PSEC's quarterly dividend distributions figure (see red reference "P" in Table 2). I then subtract PSEC's quarterly NII per share - basic figure from the company's quarterly dividend distributions figure. If PSEC's red reference "T" is greater than the company's red reference "P," then PSEC technically had enough quarterly NII per share to pay out the company's quarterly dividend distributions. If PSEC's red reference "T" is less than the company's red reference "P," then PSEC had overpaid the company's quarterly dividend distributions in regards to NII per share.

Regarding TEST 2, I analyze three balances. The first balance (see red reference "(T - P) = U" in Table 2) is PSEC's NII per share - basic underpayment (overpayment) for each fiscal quarter. This particular balance is non-cumulative in nature. The second balance (see red reference "V" in Table 2) is PSEC's NII per share - basic cumulative running underpayment (overpayment) since the company's last material dividend increase in the second fiscal quarter of 2013. The third balance (red reference "W" in Table 2) is PSEC's NII per share - basic cumulative running underpayment (overpayment) since the company's IPO in 2004.

PSEC had quarterly NII per share - basic underpayments (overpayments) of $0.151, $0.194, ($0.067), and $0.046 per share for the company's first, second, third, and fourth fiscal quarters of 2013, respectively. When combined, this calculated to an annual fiscal year of 2013 underpayment of $0.324 per share. This annual underpayment was mainly attributed to material increases in PSEC's interest, dividend, and other income as the company's 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 the company's annual "total investment advisory fees" and "total operating expenses" for the fiscal year of 2013. When calculated, PSEC's cumulative running balance went from a $0.67 NII per share - basic underpayment at the end of the fiscal year of 2012 to a materially larger $0.994 NII per share - basic underpayment by the end of the fiscal year of 2013. This was an extremely positive sign. When looking at TEST 2's analysis on a standalone basis, a very strong argument could be made that the dividend increase during the fiscal year of 2013 could have been raised even higher.

For the fiscal first quarter of 2014, PSEC reported NII per share - basic of $0.319 per share while distributing ($0.331) per share. When calculated, this was a quarterly overpayment of ($0.012) per share. As such, PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure since the last material dividend increase, had slightly been reduced to $0.162 per share. PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure since its IPO, had been slightly reduced to $0.982 per share. This cumulative running balance continued to be a material underpayment at the end of the fiscal first quarter of 2014. When compared to PSEC's BDC peers that I research, the NII per share - basic underpayment of $0.982 per share continued to be near the top of the range within the sector, even with the slight reduction in the fiscal first quarter of 2014.

Therefore, it seems PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure at the end of the fiscal first quarter of 2014, still shows no signs the dividend will be cut. In fact, TEST 2 shows there still is strong evidence fractionally higher dividend raises will continue to occur. This determination has already been partially validated as PSEC recently declared fractionally higher monthly dividend distributions through the fiscal year of 2014 (June 2014). This leads me to conclude that PSEC's second factor 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 2 concludes a dividend cut is a fairly low probability going into the fiscal year of 2015. TEST 2's results also show TEST 1's conclusion should be less alarming regarding possible vulnerabilities of PSEC's current dividend sustainability.

Side Note: Table 2 omits showing PSEC's quarterly NII per share - diluted figures. These figures are slightly different when compared to PSEC's quarterly NII per share - basic figures because these figures take 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 quarterly NII per share - diluted figures are slightly worse (income wise) when compared to the company's quarterly NII per share - basic figures. All references and methodologies performed in TEST 2 in relation to PSEC's quarterly NII per share - basic figures are also performed on PSEC's quarterly NII per share - diluted figures. However, I do not see the need to show or discuss PSEC's quarterly NII per share - diluted figures due to the similar results obtained.

Since TEST 1 and TEST 2 covered PSEC's past performance, let us now discuss PSEC's future expectations regarding the company's EPS and NII. PSEC's future EPS and NII considerations will be discussed to see if the conclusions above currently remain accurate and valid.

Future EPS and NII Considerations:

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

For instance, if a portfolio company starts to see slowing operations and/or net losses, a fair market value ('FMV') "write-down" (also known as capital depreciation) could occur on PSEC's debt investment. As such, the value of PSEC's investment portfolio would be reduced causing an immediate drop to EPS. This occurs even if the write-down is still "unrealized." Through generally accepted accounting principles ('GAAP'), quarterly FMV write-downs or "write-ups" occur (also known as "mark-to-market" adjustments). If a portfolio company begins to show signs of the inability to pay its loan obligations, this would cause PSEC's debt investment within that company to be put on "non-accrual" status. When this occurs, interest income would not be recognized. As such, this would cause an immediate drop in PSEC's NII.

The same general risks would occur on PSEC's equity investments. Generally speaking, if a portfolio company (which PSEC has an equity investment in) starts to see slowing operations and/or net losses, PSEC's equity investment would ultimately be deemed less valuable. As such, a FMV equity write-down/capital depreciation would occur. In a worst case scenario, a total write-off would be necessary leaving PSEC's equity investment worthless. Similar to the debt investment example above, this would cause a direct drop to EPS. If a portfolio company (which PSEC has an equity investment in) begins to show signs of an inability to pay its loan obligations (whether it has a loan arrangement with PSEC or elsewhere), PSEC's equity investment in that company would most likely see a reduction in dividend income. This would occur because the portfolio company's dividend distributions would be reduced or suspended. As such, this would cause an immediate drop to NII.

Now that some examples have been provided showing the potential risks to PSEC's investment portfolio when management deems a higher yield is appropriate, let us look at the annualized weighted average yield regarding the company's debt investments.

Table 3 - PSEC Annualized Weighted Average Yield Analysis

(click to enlarge)

Using Table 3 above as a reference, PSEC had an annualized weighted average yield on the company's debt investments of 13.3% at the end of the fiscal first quarter of 2013. In comparison, PSEC had an annualized weighted average yield on the company's debt investments of 16.2%, 12.8%, and 13.9% for the fiscal years ended 2010, 2011, and 2012, respectively. When combined, PSEC's annualized weighted average yield on the company's debt investments was an average of 14.3% for the fiscal years of 2010, 2011, and 2012. As such, PSEC's annualized weighted average yield at the end of the fiscal first quarter of 2013 was slightly lower when compared to the average yield for the past three years. PSEC had slight variations in the company's annualized weighted average yield on the company's debt investments through the rest of the fiscal year of 2013.

It should be noted PSEC recognized net realized losses of ($26.2) million and net unrealized capital depreciation of ($77.8) million for the fiscal year of 2013. Even though NII per share had continued to remain relatively strong during the fiscal year of 2013, PSEC's EPS per share had suffered due to the material capital depreciation that was recognized. As such, readers should pay attention to future realized gains (losses) 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 eventually have an impact on the dividend per share rate considerations (as TEST 1 and TEST 2 showed earlier).

Also, getting back to the risk versus reward metric discussed earlier, notice what occurred when PSEC's annualized weighted average yield on the company's debt investments climbed to a fiscal year of 2013 high of 14.7% during the fiscal second quarter of 2013. During that quarter, PSEC recognized the company's highest amount of unrealized capital depreciation for the fiscal year of 2013 of ($44.6) million. Because of this material unrealized capital depreciation, I feel management reduced PSEC's risk tolerance and thus lowered the company's annualized weighted average yield on debt investments to only 12.5% at the end of the fiscal first quarter of 2014. In other words, PSEC had lowered the company's NII potential (via the lower annualized weighted average yield percentage) for the sake of EPS and net asset value ('NAV') preservation. This should help regarding lower valuation losses going forward. Since PSEC had such a large cumulative running underpayment regarding the company's NII per share - basic figure at the end of the fiscal first quarter of 2014, I'm not too concerned by the recent drop in annualized weighted average yield. However, one will need to continue to pay attention to PSEC's annualized weighted average yield to ensure this percentage stays within a relatively attractive range. I feel an attractive range is currently 12% - 14%.

When PSEC reported earnings in regards to the company's fiscal first quarter of 2014, several portfolio companies caught my attention regarding material unrealized valuation gains (losses).

Table 4 - PSEC Fiscal First Quarter of 2014 Material Unrealized Valuation Gains (Losses)

(click to enlarge)

Using Table 4 above as a reference, various portfolio companies had material unrealized valuation gains (losses) for the fiscal first quarter of 2014. One particular portfolio company, which I highlighted and "flagged" in my previous dividend sustainability analysis, 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 largest principal balances, this is not considered a smaller balance either. Up until the fiscal fourth quarter of 2013, the FMV of this investment was basically the same as the remaining principal balance owed (positive sign). However, a ($9.2) million unrealized FMV write-down occurred in the fiscal fourth quarter of 2013. As such, this particular loan was only valued at $32.0 million as of 6/30/2013. This was somewhat troubling because the investment was still under a year old. I stated it would be wise to monitor the FMV of this company in future quarters.

During the fiscal first quarter of 2014 PSEC had accrued an additional ($19.0) million unrealized FMV write-down on Gulf Coast Machine & Supply Company. As of 9/30/2013, this company had a principle remaining balance of $41.2 million with a FMV of only $13.0 million. Personally, I feel PSEC should have put this investment on non-accrual status due to the fact the loan is currently valued at approximately 32% of the loan's 9/30/2013 cost basis. When calculated, PSEC accrues approximately $1.0 million of interest income each fiscal quarter for this debt investment. If the FMV of this debt investment continues to remain materially lower than the principle balance, this company will go on non-accrual status.

Still using Table 4 above as a reference, there were several additional material FMV increases (decreases) worth paying attention to in the fiscal first quarter of 2014. Several material FMV increases were in relation to the following PSEC investments: 1) First Tower Holdings of Delaware, LLC; and 2) several collateralized loan obligations ('CMO'). Several material FMV decreases were in relation to the following PSEC investments: 1) Ajax Rolled Ring and Machine, Incorporated; 2) Valley Electric Company of Mt. Vernon, Incorporated; and 3) National Bankruptcy Services, LLC. For future quarters, the companies displayed in Table 4 will be the first companies I pay attention to regarding FMV changes.

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 6.5% - 8.5%. As mentioned earlier, PSEC can also achieve equity appreciation (depreciation) regarding certain portfolio investments/sponsors. PSEC also obtains certain annual dividend or "one-time" dividend payouts, which are treated as a partial return of the company's capital. These additional sources of capital gains/income increase PSEC's annualized weighted average yield by an additional 1% - 2% under a "best case scenario." PSEC also receives various structuring, servicing, and prepayment/exit fees regarding the company's 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 an annualized dividend yield between 10% - 13% over the past several years.

In order to maintain or slightly increase PSEC's dividend in the future, management needs to carefully balance the company's risk versus reward metric. Under current market conditions, an annualized weighted average debt yield between 12% - 14% should help solidify this balance. An annualized weighted average debt yield below 12% will cause an immediate reduction in NII per share and eventually cause some stress on the future dividend being maintained or fractionally increasing. An annualized 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 annualized weighted average debt yield would raise the probability of material portfolio company write-offs regarding both debt and equity investments. As such, a material decrease in EPS would likely occur causing a material reduction in NAV and a heightened level of stress regarding the future dividend. This was the case in the fiscal year of 2010 as the annualized weighted average debt yield rose to 16.2%. When this occurred, material realized valuation losses occurred and a dividend cut ensued.

Conclusions Drawn:

To reiterate what was performed in this article, two dividend sustainability tests were performed on PSEC. The first test focused on PSEC's EPS - basic component while a second test focused on PSEC's NII per share - basic component.

TEST 1 took PSEC's quarterly EPS - basic figure and compared it to the company's quarterly dividend distributions per share figure. PSEC's cumulative running overpayment, regarding the company's EPS - basic figure since the last material dividend increase, had risen to ($0.223) per share. PSEC's cumulative running overpayment, regarding the company's EPS - basic figure since its IPO, had increased to ($0.448) per share. Therefore, TEST 1 seemed to point out PSEC's cumulative running overpayment regarding the company's EPS - basic figure at the end of the fiscal first quarter of 2014 showed some signs the current dividend could be vulnerable if this was the only factor the company looked at. Even though PSEC considers EPS as a factor when considering the company's dividend declarations, management has stated NII is a more important factor. As such, I make the assumption that TEST 1's results should be considered less important when compared to TEST 2's results.

TEST 2 took PSEC's quarterly NII per share - basic figure and compared it to the company's quarterly dividend distributions per share. PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure since the last material dividend increase, had slightly been reduced to $0.162 per share. PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure since its IPO, had been slightly reduced to $0.982 per share. However, both balances still had a material surplus. Therefore, TEST 2 seemed to point out PSEC's cumulative running underpayment, regarding the company's NII per share - basic figure at the end of the fiscal first quarter of 2014, still shows no signs the dividend will be cut. In fact, TEST 2 shows there still is strong evidence fractionally higher dividend raises will continue to occur. This determination has already been partially validated as PSEC recently declared fractionally higher monthly dividend distributions through the fiscal year of 2014 (June 2014). This leads me to conclude that PSEC's second factor 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 2 concludes a dividend cut is a fairly low probability going into the fiscal year of 2015. TEST 2's results also show TEST 1's conclusion should be less alarming regarding possible vulnerabilities of PSEC's current dividend sustainability.

Regarding PSEC's future EPS and NII considerations, PSEC needs to continue to balance the company's risk versus reward metric. PSEC's annualized weighted average yield on the company's debt investments climbed to a fiscal year of 2013 high of 14.7% during the fiscal second quarter of 2013. During that quarter, PSEC recognized the company's highest amount of unrealized capital depreciation for the fiscal year of 2013 of ($44.6) million. Because of this material unrealized capital depreciation, I feel management reduced PSEC's risk tolerance and thus lowered the company's annualized weighted average yield on debt investments to only 12.5% at the end of the fiscal first quarter of 2014. In other words, PSEC had lowered the company's NII potential (via the lower annualized weighted average yield percentage) for the sake of EPS and net asset value ('NAV') preservation. This should help regarding lower valuation losses going forward. Since PSEC had such a large cumulative running underpayment regarding the company's NII per share - basic figure at the end of the fiscal first quarter of 2014, I'm not too concerned by the recent drop in annualized weighted average yield However, one will need to continue to pay attention to PSEC's annualized weighted average yield to ensure this percentage stays within a relatively attractive range. I feel an attractive range is currently 12% - 14%. I believe management understands this concept and can keep the company's investment portfolio within this range. One should note, as overall interest rates change, this ideal annualized weighted average debt yield range will fluctuate as well.

When the two 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 through at least the first half of the fiscal year of 2015 (through at least December 2014). I anticipate a continued fractionally higher dividend declared through this time frame (no material increases though).

PSEC's future dividend sustainability is currently in better shape when compared to most of the company's peers that I research within the BDC sector. One particular BDC that I currently projected was long due for a dividend cut was Fifth Street Finance (NASDAQ:FSC).

Author's Note: Finally, it should be noted I started an initial position in PSEC when the stock dipped below $11.00 per share in October 2013. I feel the current risk versus reward structure continues to be attractive. I would look to increase my position in PSEC if the stock price decreased near the company's 9/30/2013 NAV of $10.72 per share.

Source: Prospect Capital's Dividend Sustainability Analysis (Post Fiscal Q1 2014 Earnings)