Shares of Prospect Capital (NASDAQ:PSEC) have had a tough week with shares falling 9% over the past five sessions. The company's recent quarterly results can be best described as mediocre (more on that here). The company reported net investment income (NII) of $0.31, which is less than the $0.33 it spends on dividends per quarter (financial and operating data available here). This is in part because of unfavorable timing of new loans. As a consequence, I expect stronger NII in the quarter. While this quarterly report provided little that would push shares higher, it is not the reason for shares to fall so much.
Instead, possible SEC action is a major overhang for the stock. Prospect has not been consolidating its controlling interest in holding companies, and the SEC wants them to start consolidating these companies. Prospect has appealed the finding and does not want to consolidate these investments. In last week's conference call (transcript available here), COO Grier Eliasek put it this way:
Had we not used the HoldCo, but had simply put all the debt at the operating company -- my understanding is that there would not be an issue. So, in other words, because we used the holding company there is an issue that would not exist without a holding company. The economics of the transaction are exactly the same.
Prospect in a sense is facing scrutiny because it is putting its investment in a holding company, which then invests in the operating company.
While Prospect is appealing the SEC ruling, there is simply no way of knowing whether or not they will win. As a general rule when there is a dispute between a company and the SEC, it is probably wise to assume the SEC will win. For the purpose of this article, I will assume the SEC forces a change. If the SEC were to lose, I expect PSEC shares would snap back to where they were trading prior to the disclosure, around $10.50-$10.75. If the SEC wins, I expect shares to remain at a lower price, probably around $9.50-$10.00, but I would not sell shares. Instead, I would be a buyer as shares should trade above $10.50 anyway.
Prospect is mainly owned as an income vehicle and it currently yields over 13%. The question is whether the SEC's ruling will threaten its ability to pay the distribution or whether it merely will result in some accounting changes. I do not expect consolidation to threaten the distribution as it will not impact the cash flow PSEC is receiving from its investments, both controlled and not controlled. On Tuesday, Prospect released a press release (available here) that was very important for dividend considerations. The company stated:
The [SEC] staff is not seeking consolidation of the operating companies underneath these holding companies. If these wholly-owned holding companies were to be consolidated for financial statement purposes, there would be no significant change in the leverage ratio of Prospect because there is no third party debt at any of these holding companies. Because the tax basis of these entities would not change, we expect there would be no negative effects on our taxable income from consolidation. At least 90% of taxable income is required to be distributed to shareholders to maintain our Federal income tax status as a regulated investment company. As a result, we expect no negative change in our dividend paying capacity or change in our dividend policy through consolidation.
First, taxable income, which is a determining factor in the dividend policy, will not be impacted. This means that PSEC's dividend policy should not be impacted by SEC action. As PSEC will only consolidate holding not operating companies, this event will not be too dramatic. It is also critical that Prospect's leverage ratio does not get impacted. Prospect receives favorable tax treatment because it is a business development company (BDC), which is a firm that mainly lends to mid-size businesses. A BDC cannot have a debt to equity ratio greater than 1.0x. PSEC currently has a ratio of 67.9%. If consolidation significantly increased leverage, that would threaten PSEC's tax status, which would threaten the dividend.
It is now clear that while the SEC may require an accounting change this change will not impact PSEC's dividend policy, which is the main reason to own the stock. Importantly, in yesterday's press release, PSEC also disclosed a $45 million increase in its credit facility to $837.5 million. PSEC hopes to eventually increase this facility to $1 billion. Even with the SEC controversy, lenders are staying with PSEC, which is an important vote of confidence.
Now irrespective of the outcome, this SEC action is definitely having two negative impacts on Prospect. First, PSEC has indefinitely postponed its acquisition of Nicholas Financial (NASDAQ:NICK), which would have been accretive to the dividend. Hopefully, this acquisition is merely delayed and not cancelled. Second, Prospect's shares have fallen well below book value. While book value is $10.68, shares are trading at $9.81. Prospect funds loan originations with debt and equity. Given the discount to book, Prospect cannot economically issue new equity and has postponed its at the market secondary program. This does hamstring Prospect's ability to originate new investments, and it will have to rely on debt issuance. Given its preference to keep the debt to equity ratio below 75%, there is limited room for maneuvering. The SEC action will temporarily slow Prospect's origination activity.
Overall, Prospect shares have clearly been hit by the SEC news, but this news should not change your investment thesis. Even if resolved unfavorably, cash flow, taxable income, and leverage will not be impacted. This means that Prospect's dividend is safe, and its policy will not be altered. It is also does not face the risk of losing its BDC status. On the plus side, investors can now buy PSEC at an 8% discount to book value. Tuesday's press release was positive for shares, and they irrationally fell 2% in the session. For an income-oriented investor, now is the perfect time to add or initiate a long in PSEC, which is paying a handsome and sustainable 13.5%.
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.