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Summary

  • PSEC had an underpayment (overpayment) of net investment income (‘NII’) of ($16.8) million for the fiscal first three quarters of 2014 (based on GAAP methodologies).
  • PSEC had an underpayment (overpayment) of net investment company taxable income (‘ICTI’) of ($1.7) million for the fiscal first three quarters of 2014 (based on IRC methodologies).
  • Starting with PSEC’s fiscal first quarter of 2015, understanding the differences between NII and net ICTI will be heightened in regards to providing accurate future dividend projections.
  • Summarized results from Test 1 and Test 2, in regards to PSEC’s dividend sustainability, are stated within the “conclusions drawn” section of the article.
  • Part 2 of this analysis will discuss some additional topics/trends that will impact PSEC’s future dividend and net asset value ('NAV') sustainability.

Author's Note: Due to the length of the material covered in this article, I believe it is necessary to break Prospect Capital Corp.'s (NASDAQ:PSEC) dividend and NAV sustainability analysis into two parts. This two-part article is a very detailed look at PSEC's dividend and net asset value ('NAV') 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 scroll down to the "Conclusions Drawn" section at the bottom of each part of the article.

Focus of Article:

The focus of PART 1 of this article is to provide a detailed analysis with supporting documentation (via two tests) on the dividend and NAV sustainability of PSEC. This analysis will be provided after a brief overview of the following three topics: 1) PSEC's regulated investment company ('RIC') classification per the Internal Revenue Code ('IRC'); 2) brief overview and update regarding the SEC's determination that certain wholly-owned holding companies should be consolidated within PSEC's financial statements (impacting future classifications); and 3) a comparison between the company's net investment income ('NII') and net investment company taxable income ('ICTI').

After the discussion of these three topics, I will be performing two dividend sustainability tests within PART 1 of this article. These two tests will focus on PSEC's earnings per share ('EPS') and NII per share figures. These two tests will be termed "TEST 1" and "TEST 2." At the end of PART 1 of this article, there will be a conclusion based on the results obtained from TEST 1 and TEST 2 about the dividend sustainability of PSEC for several upcoming quarters.

The focus of PART 2 of this article will discuss some additional topics/trends regarding PSEC's future dividend and NAV sustainability. These trends will have a direct impact on PSEC's future dividend and NAV sustainability and therefore should also be addressed. The conclusions derived from PART 2 of this analysis will either help solidify or contradict the results obtained in PART 1 regarding PSEC's dividend sustainability. At the end of this article, there will be a conclusion on my personal opinion about the overall dividend and NAV sustainability of PSEC for several upcoming quarters.

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 an RIC per the IRC comes up with the company's current dividend rate and specific signs when an impending dividend increase or decrease would be implemented.

Side Note: It should also be noted PSEC's fiscal year-end is June 30th of a given year. Therefore, PSEC's fiscal third quarter ends on March 31st of a given year.

Discussion of RIC Classification per the IRC:

In a past PSEC dividend sustainability article, I discussed the company'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 to shareholders at least 90% of the company's "ICTI" and "net capital gains" (in excess of its "capital loss carryforward" balance; if applicable) in any given calendar tax year in order to be eligible for the tax benefits allowed to a RIC (dividends paid deduction at the corporate level). When these two figures are combined, this comprises an entity's net ICTI / annual distribution requirement ('ADR').

The following is a link to the past dividend sustainability article I wrote where this topic was covered at length:

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

As such, a further discussion of this topic is redundant and unwarranted for this article.

Brief Overview and Update Regarding the SEC's Determination that Certain Wholly-Owned Holding Companies Should be Consolidated Within PSEC's Financial Statements (Impacting Future Classifications):

As stated in PSEC's 10-Q for the fiscal third quarter of 2014, the company disclosed that the Securities and Exchange Commission's ('SEC') staff had determined certain "wholly-owned holding companies" within PSEC's control investment portfolio are deemed "wholly-owned subsidiaries" per "Generally Accepted Accounting Principles" ('GAAP'). As such, these entities are also considered investment companies per GAAP and should be consolidated at the parent level. This determination was based on the SEC staff's interpretation of "Accounting Standards Codification 946 - Investment Companies ('ASC 946')." Specifically, the SEC staff's interpretation was based on "Accounting Standards Update 2013-08: Amendment to the Scope, Measurement, and Disclosure Requirements ('ASC 2013-08')." This specific piece of accounting literature was partially an amendment to the original rules within ASC 946 so there is more conformity between the Financial Accounting Standards Board ('FASB') and the International Accounting Standards Board ('IASB') regarding investment companies. This update was compiled through certain expert panels and discussions throughout the accounting community.

To further understand this topic, the following is a link to a past PSEC article I wrote where this topic was discussed at length:

Prospect Capital's Potential Financial Restatements: Explaining The Current Situation And Its Impacts - Part 1

PSEC disagreed with the SEC staff's interpretation of ASC 946 and appealed to the SEC's Office of the Chief Accountant ('OCA'). PSEC stated the SEC staff's interpretation to consolidate these particular holding companies was not supported by any written guidance within existing GAAP. PSEC strongly believed these wholly-owned holding companies did not meet the definition of an investment company under GAAP. Furthermore, management believed GAAP permitted, but did not require, investment companies to consolidate other investment companies.

As stated in PSEC's 10-Q for the fiscal third quarter of 2014 (referenced earlier), management stated one of the following three outcomes would occur on this pending issue: 1) no changes to the company's accountant treatment regarding its wholly-owned holding companies; 2) a consolidation of its wholly-owned holding companies on a "prospective" basis (consolidation at a future "point-in-time"); or 3) a "prior period" consolidation of its wholly-owned holding companies (restatement of prior period financial statements). Out of the three possible outcomes, the third scenario would have had the greatest impacts regarding "the look" and "amounts reported" within PSEC's financial statements. If the third outcome came to fruition, accounting figures going back several years would have been altered to incorporate the SEC staff's interpretation of ASC 946.

On 6/10/2014, PSEC announced the company would not be required to. However, under the guidance of the newly amended ASC 946 (through ASU 2013-08), PSEC will need to consolidate the company's wholly-owned or "substantially wholly-owned" holding companies (deemed wholly-owned or substantially wholly-owned subsidiaries) starting with the company's fiscal year of 2015. The following is a direct quote from ASU 2013-08:

"…The amendments in this Update are effective for an entity's interim and annual reporting periods in fiscal years that begin after December 15, 2013…"

Since PSEC's fiscal year ends on June 30th of a given year, adoption of this amendment will begin on 7/1/2014. In other words, this change in accounting treatment will begin with PSEC's fiscal year of 2015.

As stated in PSEC's 10-Q for the fiscal third quarter of 2014 (referenced earlier), management stated if a prior period restatement is deemed necessary, the company's NII and net ICTI would "significantly decouple." This would have occurred because PSEC's NII needed to be adjusted. Specifically, all interest, structuring, and fee income associated with certain portfolio companies where PSEC funded the company's investments through the wholly-owned subsidiaries (the holding companies of certain control investments) would have been adjusted. PSEC would have only been able to record dividend income up to the underlying profits of the subsidiaries. The portion of interest, structuring, and fee income in excess of the underlying profits of the subsidiaries would have been classified as a "distribution / return of capital" to PSEC. This would be a reduction of PSEC's cost basis in these investments and would have been recognized below NII within the unrealized / realized gain (loss) accounts within the company's "consolidated statement of operations." All intercompany loan activity would also be eliminated upon consolidated.

To further understand this topic, the following is a link to a past PSEC article I wrote where this topic was discussed at length:

Prospect Capital's Potential Financial Restatements: Explaining The Current Situation And Its Impacts - Part 2

Side Note: It should be noted the link above was PRIOR to PSEC announcing on 6/10/2014 a restatement of the company's prior period financial statements was NOT required by the SEC (just a prospective consolidation). At the time of the linked article above, a prior period restatement was still a possibility and was "hypothetically" being shown. With that being said, the same impacts to PSEC's accounts will still occur going forward under the OCA's finalized ruling. Instead of BOTH prior period and prospective consolidations, the OCA is ONLY requiring a consolidation starting with PSEC's fiscal year of 2015. A prior period financial restatement would have caused material changes within PSEC's past income and expense accounts on a "line-by-line" mentality. While a prospective consolidation will also affect the same accounts mentioned above (when comparing a future consolidation versus no consolidation), the impact will be less material at the beginning of the change in accounting treatment. This occurs because a restatement of PSEC's prior period financial statements would have had a "cumulative" effect within the company's consolidated statement of operations and equity section of its "consolidated statement of assets and liabilities."

Furthermore, as I previously stated in a prior article (see link above; which was then confirmed by management), the tax structure/basis of PSEC's investment portfolio will remain the same. This is an important concept to understand for this article's next topic.

Understanding Certain Distinctions Between PSEC's NII and Net ICTI:

From the discussion above, it is now even more important to understand the differences between PSEC's NII and net ICTI. In the past, some could argue there was a generalized correlation regarding the two sets of figures (whenever a net capital loss carryforward position existed). However, beginning with the fiscal first quarter of 2015, the beginning of a decoupling effect between PSEC's NII and net ICTI accounts will likely occur. This assumes there will not be a change in the legal/organizational structure/hierarchy of certain established control investments where PSEC created wholly-owned or substantially wholly-owned holding companies to serve as a "conduit" per se to the underlying operating companies. People who have used NII to assess PSEC's future dividend sustainability will begin to realize this was technically incorrect the whole time (as I have always stated; see past BDC articles I have written on the subject). If one still bases PSEC's dividend sustainability off NII past the fiscal first quarter of 2015, there is an extremely high likelihood this methodology will lead to inaccurate results over time.

To properly understand and accurately predict a BDC's future dividend sustainability, one must understand the subtle distinctions between a company's NII and net ICTI and its "undistributed NII" and "undistributed net ICTI." Undistributed NII is a GAAP figure, which is based on the accrual method of accounting. Undistributed NII is NOT the same as a company's undistributed net ICTI, which is generally based on the cash method of accounting (some exceptions but I am keeping it simple for this discussion).

In order for PSEC to come up with a proper ICTI figure, there are specific GAAP to IRC adjustments (reversals) that need to be performed each quarter. Income and expense recognition of certain accounting transactions differ between GAAP and the IRC (book versus tax accounting treatments). A majority of PSEC's book to tax differences (either temporary or permanent) consist of the following: 1) deferred financing fees on loans and deferred offering costs in relation to equity raises; 2) amortization (accretion) of loan/investment premiums (discounts); and 3) timing recognition of interest income on certain loans. There are several additional book to tax adjustments that PSEC recognizes. However, for purposes of this article, further discussion of these additional adjustments is unwarranted.

Once PSEC's ICTI is known, one adds all net capital gains to this figure (if a capital loss carryforward does not exist). PSEC had a capital loss carryforward balance as of 12/31/2013 to offset any net capital gains that might arise in the future. As such, this balance will continue to remain $0 for at least the next several quarters even if PSEC realizes a material amount of net capital gains on the company's debt/equity investments or warrants.

To understand the subtle differences between NII and net ICTI, Tables 1 and 2 are provided below. Table 1 shows PSEC's past NII and undistributed NII while Table 2 shows the company's past net ICTI and undistributed net ICTI.

Table 1 - PSEC NII and Undistributed NII Analysis (Per GAAP)

(click to enlarge)

Table 2 - PSEC Net ICTI and Undistributed Net ICTI Analysis (Per IRC)

(click to enlarge)

(Source: Tables created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database)

Readers should look at the subtle differences between PSEC's NII and undistributed NII (via Table 1) and net ICTI and undistributed net ICTI (via Table 2) when comparing similar time frames. As an example, let us look at the differences in NII and net ICTI for the first three fiscal quarters of 2014.

Using Table 1 above as a reference, PSEC had an underpayment (overpayment) of NII of ($4.3), ($4.4), and ($8.0) million for the fiscal first, second, and third quarters of 2014, respectively (see red reference "(C - D) = E"). This translated to a dividend distributions payout ratio of 105%, 105%, and 108% for the fiscal first, second, and third quarters of 2014, respectively (see red reference "(D / C)"). As such, PSEC's cumulative undistributed NII balance decreased from $77.1 million as of 6/30/2013 to $60.3 million as of 3/31/2014 (see red reference "F"). Again, these figures are based on GAAP methodologies.

In comparison, using Table 2 above as a reference, PSEC had an underpayment (overpayment) of net ICTI of $0.4, $2.0, and ($4.1) million for the fiscal first, second, and third quarters of 2014, respectively (see red reference "(K - D) = L"). This translated to a dividend distributions payout ratio of 100%, 98%, and 104% for the fiscal first, second, and third quarters of 2014, respectively (see red reference "(D / K)"). As such, PSEC's cumulative undistributed net ICTI balance only decreased from $28.9 million as of 6/30/2013 to $27.2 million as of 3/31/2014 (see red reference "M"). Again, these figures are based on IRC methodologies. Also, one should understand this figure continues to be near the highest cumulative undistributed net ICTI balance PSEC has had since the company's IPO in 2004 (as partially seen in Table 2 above).

Therefore, PSEC's cumulative undistributed NII (based on GAAP) had modestly decreased during the first three fiscal quarters of 2014. However, it also should be noted PSEC's cumulative undistributed net ICTI (based on the IRC) had only slightly decreased during the same time frame. Since PSEC's dividend is ultimately based on the company's net ICTI figure, readers should understand the distinction between NII and net ICTI. If not, under certain circumstances one could come to a less accurate conclusion about the sustainability of PSEC's dividend. This inaccuracy will only cumulatively increase starting with PSEC's fiscal first quarter of 2015 (as highlighted in an earlier discussion).

Side Note: If one were to look at Table 2's red reference "(D / K)," some fiscal years show PSEC distributed less than the 90% ADR per the IRC. For instance, fiscal year 2012 shows a total net ICTI dividend distributions payout ratio of 84%. However, as mentioned in a side note earlier, PSEC's fiscal year-end is June 30th of a given year. For taxation purposes, PSEC's year-end is December 31st of a given year. Tables 1 and 2 show PSEC's fiscal year-end (as opposed to the calendar tax year-end) to highlight the company's net ICTI when compared to its fiscal quarterly dividend distributions to spot patterns and trends within SEC filings. Under any given calendar tax year, PSEC did not fail the required 90% distribution of an entity's annual net ICTI for RIC compliance per the IRC (even excluding the "spillback provision" allowed for RIC entities). If Tables 1 and 2 were based on figures representing a calendar tax year (versus a fiscal year), the results would dictate as such. Using Table 2 above as a reference, PSEC's overpayment for the fiscal third and fourth quarters of 2011 were offset by the company's underpayment for the fiscal first and second quarters of 2012. To reiterate, Table 2 shows PSEC's net ICTI based on the company's fiscal year-end of June 30th of a given year versus the calendar tax year-end of December 31st of a given year for analysis purposes.

Two Additional Factors PSEC Considers Regarding the Company's Dividend:

In ADDITION to the required 90% distribution of an entity's annual net ICTI for RIC compliance per the IRC (see linked article above for a full discussion of this provision), PSEC's management team has stated the company's dividend is inherently 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 figures and be analyzed via TEST 1. The second factor will focus on PSEC's NII per share figures and be analyzed via TEST 2. PSEC believes the second factor is more important regarding the company's current and future dividend distribution per share amounts. As such, PSEC's EPS figures (TEST 1) are deemed less important when compared to the company's NII per share figures (TEST 2). Readers should understand this distinction as TEST 1 and TEST 2 are presented and analyzed below.

Side Note: Even though the two tests about to be per performed below are based on GAAP methodologies (EPS and NII), readers should understand the dividend is ULTIMATELY based on PSEC's net ICTI. Management states these two additional factors are based on GAAP methodologies because EPS and NII are mandatory figures to disclose in quarterly SEC filings while net ICTI is a "non-GAAP" metric, which is not a required disclosure. Some BDC sector peers voluntarily provide net ICTI or a company's equivalent to net ICTI. Through this article's earlier discussion, TEST 2 will be changing next quarter as management will not be able to compare NII versus net ICTI as an effective metric for the dividend per share amount (as the prospective consolidation will have a decoupling effect). However, since the new accounting treatment will not occur until PSEC's fiscal year of 2015, I believe TEST 2 can remain unchanged for one more quarter.

Prior to discussing and analyzing PSEC's EPS - basic figures (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:

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. 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) during the fiscal fourth quarter of 2012, fiscal first quarter of 2013, and fiscal second quarter of 2013.

When calculated, PSEC paid an annual 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 second quarter of 2015 (through December 2014). When calculated, PSEC will pay an annual dividend of $1.324 per share for the fiscal year of 2014. PSEC's monthly dividend declaration of $0.1106 per share for the month of December 2014 continues the company's fractionally higher dividend policy.

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

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

To test management's first additional factor, I believe it is necessary to analyze and discuss PSEC's past quarterly EPS figures 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 figures were capable of covering the company's past quarterly dividend per share distributions.

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

- See Red References "O, P, Q, R, S" in Table 3 Below Next to the March 31, 2014 Column

Using Table 3 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 3 - PSEC Cumulative Undistributed EPS Surplus (Deficit) Analysis

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(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database [link provided below Tables 1 and 2])

Using Table 3 above as a reference, I first show PSEC's quarterly "EPS - basic" figure (see red reference "O"). This is PSEC's quarterly EPS - basic figure per GAAP and is shown within the company's consolidated statement of operations. I then show PSEC's quarterly dividend distributions figure (see red reference "P"). 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") 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") is PSEC's EPS - basic cumulative running underpayment (overpayment) since the company's last material dividend increase in the fiscal second quarter of 2013. The third balance (see red reference "S") is PSEC's EPS - basic cumulative running underpayment (overpayment) since the company's initial public offering ('IPO') in 2004.

For the fiscal first, second, and third quarters of 2014, PSEC reported quarterly EPS - basic of $0.31, $0.297, and $0.259 per share while distributing dividends of ($0.331), ($0.331), and ($0.331) per share, respectively. When calculated, this was a quarterly EPS - basic underpayment (overpayment) of ($0.021), ($0.033), and ($0.072) per share, respectively. As such, by the end of the fiscal third quarter of 2014, PSEC's cumulative running underpayment (overpayment), regarding the company's EPS - basic figure since the last material dividend increase, had risen to ($0.328) per share. PSEC's cumulative running underpayment (overpayment), regarding the company's EPS - basic figure since its IPO, had risen to ($0.519) per share. This cumulative running balance continued to be a material overpayment at the end of the fiscal third quarter of 2014. However, when compared to some of PSEC's BDC peers that I research, the EPS - basic cumulative running underpayment (overpayment) of ($0.519) per share (since each company's IPO) was still lower than most sector participants.

Therefore, it seems PSEC's cumulative running EPS - basic overpayment at the end of the fiscal third quarter of 2014 showed some signs the future dividend could be vulnerable if this were 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 (and beginning in the fiscal first quarter of 2015 net ICTI) is a more important factor. As such, I make the assumption that TEST 1's results should inherently be considered less important when compared to TEST 2's results.

Side Note: Again, the MAIN determinate of PSEC's dividend per share amount is to be in compliance with the required 90% distribution of an entity's annual net ICTI for RIC compliance per the IRC (see linked article earlier for a full discussion of this provision). As such, even though it appears PSEC has materially overpaid its dividend when compared to recent EPS results, the company needs to FIRST factor in net ICTI figures when choosing a proper dividend per share amount.

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

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

To test management's second additional factor, I believe it is necessary to analyze and discuss PSEC's past quarterly NII per share figures 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 figures were capable of covering the company's past quarterly dividend per share distributions.

Side Note: Through this article's earlier discussion, TEST 2 will be changing next quarter as management will not be able to compare NII versus net ICTI as an effective metric for the dividend per share amount (as the prospective consolidation will have a decoupling effect). However, since the new accounting treatment will not occur until PSEC's fiscal year of 2015, I believe TEST 2 can remain unchanged for one more quarter.

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

- See Red References "P, T, U, V, W" in Table 4 Below Next to the March 31, 2014 Column

Using Table 4 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 4 - PSEC Cumulative Undistributed NII Per Share Surplus (Deficit) Analysis

(click to enlarge)

(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database [link provided below Tables 1 and 2])

Using Table 4 above as a reference, I first show PSEC's quarterly "NII per share - basic" figure (see red reference "T"). This is PSEC's quarterly NII per share - basic figure per GAAP and is shown within the company's consolidated statement of operations. I then show PSEC's quarterly dividend distributions figure (see red reference "P"). 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") 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") is PSEC's NII per share - basic cumulative running underpayment (overpayment) since the company's last material dividend increase in the fiscal second quarter of 2013. The third balance (red reference "W") is PSEC's NII per share - basic cumulative running underpayment (overpayment) since the company's IPO in 2004.

PSEC had a NII per share - basic underpayment (overpayment) of $0.324 per share for the fiscal year of 2013. When calculated, PSEC's cumulative running balance went from a NII per share - basic underpayment (overpayment) of $0.67 per share at the end of the fiscal year of 2012 to a sizable NII per share - basic underpayment (overpayment) of $0.994 per share 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 even higher.

For the fiscal first, second, and third quarters of 2014, PSEC reported quarterly NII per share - basic of $0.319, $0.321, and $0.311 per share while distributing dividends of ($0.331), ($0.331), and ($0.331) per share, respectively. When calculated, this was a quarterly NII per share - basic underpayment (overpayment) of ($0.012), ($0.010), and ($0.020) per share, respectively. As such, by the end of the fiscal third quarter of 2014, PSEC's cumulative running underpayment (overpayment), regarding the company's NII per share - basic figure since the last material dividend increase, had slightly been reduced to $0.132 per share. PSEC's cumulative running underpayment (overpayment), regarding the company's NII per share - basic figure since its IPO, had slightly been reduced to $0.953 per share. This cumulative running balance continued to be a material underpayment at the end of the fiscal third quarter of 2014. When compared to PSEC's BDC peers that I research, the NII per share - basic cumulative running underpayment (overpayment) of $0.953 per share continued to be near the top of the range (even with the slight reduction to this balance for the fiscal first, second, and third quarters of 2014).

Therefore, it seems PSEC's cumulative running NII per share - basic underpayment at the end of the fiscal third quarter of 2014 still showed little signs the future dividend will be cut over the next several fiscal quarters. Actually, TEST 2 showed there still is strong evidence fractionally higher dividend increases will continue to occur. This determination has already been partially validated as PSEC recently declared fractionally higher monthly dividend distributions through the fiscal second quarter of 2015 (December 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). As such, TEST 2 concludes a dividend cut continues to be a relatively low probability through the fiscal third quarter of 2015 (through March 2015). TEST 2's results also show TEST 1's results should be less alarming regarding possible vulnerabilities of PSEC's future dividend sustainability.

Continuing with the "non-bias" nature of my articles, let us perform an additional analysis regarding PSEC's NII to account for the growing number of outstanding shares of common stock the company has accumulated due to its rapid expansion of the balance sheet. PSEC's cumulative NII dividend distributions coverage ratio had decreased from a factor of 0.71 as of 12/31/2013 to a factor of 0.57 as of 3/31/2014. Looking back at the history of PSEC's cumulative NII dividend distributions coverage ratio, the current balance is still above the company's historical average. With that being said, this ratio should continue to be monitored going forward and will be converted into a cumulative net ICTI dividend distributions coverage ratio starting with the fiscal first quarter of 2015.

Compared to the prior quarter's analysis, the probability of a possible dividend cut past the fiscal third quarter of 2015 has slightly increased (as shown via PSEC's cumulative NII dividend distributions coverage ratio). Again, this is currently only a SLIGHT increase regarding possible implications past the fiscal third quarter of 2015.

Side Note: Again, the MAIN determinate of PSEC's dividend per share amount is to be in compliance with the required 90% distribution of an entity's annual net ICTI for RIC compliance per the IRC (see linked article earlier for a full discussion of this provision). As such, even though it appears PSEC has slightly overpaid its dividend when compared to recent NII results, the company needs to FIRST factor in net ICTI figures when choosing a proper dividend per share amount. Furthermore, as stated above, the company still had a modest cumulative undistributed net ICTI balance and material cumulative undistributed NII balance as of 3/31/2014.

Conclusions Drawn - PART 1:

To reiterate what was performed in PART 1 of this article, I first discussed three topics, which have a direct impact on the future dividend sustainability of PSEC. First, I provided a brief discussion of PSEC's RIC classification per the IRC. Second, I provided a brief overview and update regarding the SEC's determination that certain wholly-owned holding companies should be consolidated within PSEC's financial statements (including future impacts). PSEC does not have to restate the company's prior year financial statements. However, per an update to ASC 946 via ASU 2013-08, PSEC's wholly-owned or substantially wholly-owned holding companies within the company's control investments are considered to be investment companies and need to be consolidated at the parent level. PSEC's wholly-owned or substantially wholly-owned holding companies are deemed to be wholly-owned subsidiaries under GAAP. This amendment will impact PSEC starting in the fiscal first quarter of 2015.

Third, I then highlighted the subtle differences between PSEC's NII and net ICTI. Using the second topic as direct support, I highlighted it is now even more important to understand the differences between PSEC's NII and net ICTI accounts. Beginning with the fiscal first quarter of 2015, the beginning of a decoupling effect between PSEC's NII and net ICTI accounts will likely occur.

After this distinction was discussed, two dividend sustainability tests were performed on PSEC. The first test focused on PSEC's EPS - basic figures while the second test focused on PSEC's NII per share - basic figures. Even though the two tests performed above were based on GAAP methodologies (EPS and NII), readers should understand the dividend is ultimately based on PSEC's net ICTI. Management states these two additional factors are based on GAAP methodologies because EPS and NII are mandatory figures to disclose in quarterly SEC filings while net ICTI is a "non-GAAP" metric, which is not a required disclosure. While NII is a good metric to base PSEC's future dividend sustainability on, the company's net ICTI continues to be the BEST metric. Beginning in PSEC's fiscal first quarter of 2015, the company's NII will likely become an even less useful metric due to the prospective consolidation.

TEST 1 took PSEC's quarterly EPS - basic figure and compared it to the company's quarterly dividend distributions per share figure. TEST 1 seemed to point out PSEC's cumulative running EPS - basic overpayment at the end of the fiscal third quarter of 2014 showed some signs the future dividend could be vulnerable if this were 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 figure. TEST 2 seemed to point out PSEC's cumulative running NII per share - basic underpayment at the end of the fiscal third quarter of 2014 still showed little signs the future dividend will be cut over the next several fiscal quarters. Actually, TEST 2 showed there still is strong evidence fractionally higher dividend increases will continue to occur. 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).

As such, TEST 2 concluded a dividend cut continued to be a relatively low probability through the fiscal third quarter of 2015 (through March 2015). TEST 2's results also showed TEST 1's results should be less alarming regarding possible vulnerabilities of PSEC's future dividend sustainability.

Continuing with the "non-bias" nature of my articles, I also performed an additional analysis in regards to PSEC's NII. Taking the continued growing number of outstanding shares into consideration, PSEC's cumulative NII dividend distributions coverage ratio had decreased from a factor of 0.71 as of 12/31/2013 to a factor of 0.57 as of 3/31/2014. Looking back at the history of PSEC's cumulative NII dividend distributions coverage ratio, the current balance was still above the company's historical average. With that being said, this ratio should continue to be monitored going forward and will be converted into a cumulative net ICTI dividend distributions coverage ratio starting with the fiscal first quarter of 2015.

As such, when compared to PART 1's analysis from the prior quarter, the probability of a possible dividend cut past the fiscal third quarter of 2015 has slightly increased (as shown via PSEC's cumulative NII dividend distribution coverage ratio). Again, this is currently only a SLIGHT increase regarding possible implications past the fiscal third quarter of 2015.

Final Note: Based on the mixed results shown in TEST 1 and TEST 2 above, I believe it is only prudent to include additional analysis regarding PSEC's future dividend sustainability. As such, PART 1 of this article is only a PARTIAL analysis of PSEC's future dividend sustainability. Therefore, a "full" conclusion regarding PSEC's future dividend and NAV sustainability will not be provided yet. PART 2 of this article will just pick up where PART 1's analysis ends. Since PART 1 of this article mainly covered PSEC's past performance, PART 2 will discuss some additional topics/trends regarding PSEC's future dividend sustainability. The conclusions derived from PART 2 of this analysis will either help solidify or contradict the results obtained in PART 1 regarding PSEC's dividend sustainability. PART 2 will also include an analysis of PSEC's future NAV sustainability. At the end of PART 2 of this article, I will include the following PSEC projections: 1) next set of dividend declarations (dividend amount per share for January, February, and March 2015); and 2) NAV per share ranges for the next four fiscal quarters. PART 2 will also include my personal BUY, SELL, or HOLD recommendation regarding PSEC. PART 2 of this article will be available to readers in the near future.

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.

Source: Prospect Capital Corp.'s Dividend And Net Asset Value Sustainability Analysis (Post Fiscal Q3 2014 Earnings) - Part 1