Buy Prospect Capital After The SEC's All-Clear

| About: Prospect Capital (PSEC)


On Tuesday afternoon, PSEC rallied 3% after the company won its appeal with the SEC.

Prospect will not have to restate any financial statements and will only have to consolidate some investments in new holding companies going forward.

This means PSEC's dividend policy will not change, and it is still an attractive income stock.

Since reporting earnings last month, shares of Prospect Capital (NASDAQ:PSEC) have been under pressure as investors focused on a problem with the SEC. The SEC wanted to make Prospect Capital consolidate wholly-owned holding companies, which it used to make investments. While Prospect did say consolidation would not impact its ability to pay its 13% dividend, investors never like to see a company do battle with the SEC, which is why shares pushed nearly 10% below book value. Prospect had been fighting this change, and we got a resolution of this dispute on Tuesday.

After the bell, Prospect announced it had won its appeal with the SEC (details available here). Prospect will not have to restate any financial statements, which is a major victory. PSEC also does not have to consolidate existing holding companies going forward. However going forward, Prospect will begin to consolidate some wholly-owned holding companies that it makes new investments in. This is a bit of a concession to the SEC. In summary, the way Prospect accounts for its current portfolio does not change, but Prospect may consolidate some new holding companies in the future, based on the nature of the investment.

This news sent shares up over 3% in the after-hours session. I have been in the camp that the SEC overhang was mostly unmerited and I'm glad to see this pop. The decision about consolidation never was going to impact Prospect's cash flow and would not meaningfully impact leverage. In other words, the "fair value" of Prospect is not really impacted by consolidation, which is why I called the sharp sell-off a buying opportunity. With the SEC inquiry in the rear view mirror, I expect shares to recoup much of the recent losses and return to the $10.50 level.

It is also worth noting that future consolidation may not be a big deal. Prospect only drew SEC attention because it sometimes uses holding companies to make investments in operating companies rather than investing directly in operating companies. In a conference call, COO Grier Eliasek said, "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" (transcript available here)

Prospect can lend directly to operating companies as companies like Main Street (NYSE:MAIN) tend to do. Much of Prospect's existing investments are also done without holding companies as they don't change the economics of transactions. As a consequence, I don't expect future consolidation to have a material impact on results. As Prospect returns virtually all of its taxable income to shareholders, PSEC is mainly an income investment. This agreement with the SEC affirms my belief that the dividend policy will not be changed, which means PSEC continues to work as an income investment.

At the end of last quarter (financial and operating data available here), PSEC had a book value of $10.68, and PSEC is a wise investment below that level. Prospect mainly borrows at a fixed rate but lends at a floating rate, which means PSEC will earn appreciably more if interest rates rise. While rates have remained low, I do expect rates to pick up in 2015 when the Federal Reserve is likely to increase short-term rates. This makes investing in PSEC attractive at current levels.

The SEC overhang is now behind PSEC, and the stock can once again trade on its fundamentals. This will help push shares back toward book value. With its 13% yield, Prospect works well as an income investment, and shares should rally a bit in the near term toward book value. If rates rise, PSEC's dividend could be increased, but until then, I expect the payout to remain at $0.11. With this SEC victory, I would continue to own PSEC.

Disclosure: The author is long PSEC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.