After the bell on Tuesday, Prospect Capital (NASDAQ:PSEC) reported a relatively mixed quarter. The company continues to pay an impressive 12% dividend, but the dividend coverage ratio has been a bit disappointing over the past few quarters. While I do not expect the company to cut the distribution anytime in the near future, meaningful increases are unlikely. Prospect Capital continues to make sense from an income perspective, but I do not expect significant capital appreciation in the near term with shares likely to remain within 5-10% of book value.
Prospect is a business development company ("BDC"). Essentially, it lends to mid-size companies to facilitate their growth, and it then distributes the vast majority (over 90%) of its net investment income ("NII") to shareholders. Over the long run, NII must be equal to or greater than the distribution for that distribution to be considered sustainable. Prospect currently pays a roughly $0.11 monthly dividend, so it must earn $0.33 in quarterly NII to cover this distribution. In this quarter, PSEC only generated $0.31 of NII while most analysts were looking for $0.32 or $0.33 (financial and operating data available here). This means that PSEC paid out a bit more than it generated. This is not sustainable forever.
However, it is important to note that over the past decade NII has exceeded distributions by $53.4 million or $0.26. In a sense, PSEC is running through this rainy day fund when its coverage ratio is less than 100%. For the first nine months of this fiscal year, it has paid out $0.04 more than it generated. As a consequence, this rainy day fund should last for quite a while longer; I suspect at least through 2016 under the worst scenario. Still, no one wants to see PSEC exhaust the rainy day fund. It is far more preferable for the company to grow NII and generate cash in excess of the distribution. Perhaps, even grow it enough to raise the distribution at a faster pace.
To this end, Prospect has been aggressively lending. It originated $1.34 billion, but four investments were paid back in full, resulting in net investment origination of $1.15 billion. Now, over 65% of originations closed during the last two days of the quarter. Therefore while these investments showed up on the balance sheet, they did not contribute appreciable investment income. As a consequence, we should see stronger NII in the current quarter when the investments will be on the books for the entire three months. The overall portfolio's yield is 12.5%.
The fair value of the investment portfolio stands at $6.006 billion, compared to $4.886 billion at the end of last quarter. To fund this growth, Prospect mostly borrowed as total liabilities jumped to $2.791 billion from $1.962 billion. This increase was mostly from the revolving credit facility as PSEC drew $729 million during the quarter. Equity increased by roughly $300 million to $3.561 billion. Because Prospect funded new investments mainly with debt, debt to equity increased to 67.9% compared to 48% in the previous quarter. Given low interest rates, it does make sense for Prospect to borrow in the 5 to 30 year range, which it has been doing. This was a dramatic increase in the debt to equity ratio, though some of it was timing with credit facility borrowings to fund end of quarter investments. I would not want to see this ratio go past 75% and expect it to stabilize or fall slightly in this quarter. Over the medium term, a debt to equity ratio of around 55% is an appropriate place for the company to be.
Speaking of interest rates, it is worth noting that Prospect will benefit greatly from rising rates. While around 90% of its long-term debt is at a fixed rate, it lends mostly (over 80% of loans) at a floating rate. If rates rise, its asset will generate more interest income while its liabilities will require the same interest expense. This will lead to significantly higher NII. While interest rates have remained stubbornly low this year, over the next three years I continue to believe the long term trend will be higher.
The one other negative in the quarter was the fall in book value per share to $10.68 in the quarter compared to $10.73 last quarter, due to distributions in excess of income. It is never gratifying to see the book value of a company decline, and with financial firms' valuations so tethered to book value, it makes it harder to see a significant rally in the near term. Shares continue to trade at a mild premium to book value thanks to the strong distribution, but I expect PSEC to remain relatively close to its book value.
Therefore, this quarter had some positives and negatives. Low interest rates continues to drag on NII, which fell short of the distribution. The timing of new investments also put pressure on NII, but that pressure will not be felt this quarter. Over the longer term, PSEC will also be a prime beneficiary of rising interest rates. Investors should also note that PSEC has really increased its lending activities. This is both good news and concerning. On the one hand, new loans should increase income, which is positive. However, we must watch credit quality to ensure PSEC isn't lending more than it should. Thus far, defaults are not a problem, and management has consistently maintained diligence and tough underwriting standards. Investors should watch though for a pick-up in delinquencies, which would be a major warning sign. Finally, book value declined a bit in the quarter.
While NII fell short of the distribution, the $0.11 rate is safe. I would not expect a significant increase in the next twelve months. At this point, PSEC works as an income investment, but investors looking for capital appreciation should invest elsewhere. After an unspectacular quarter, I expect shares to remain in the $10.50-$11.25 range.
Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.