- Hercules Technology Growth Capital is the largest BDC in the venture capital space.
- This internally managed BDC currently yields 7.7%.
- Last week's earnings report may provide a buying opportunity.
In an August 4 SA article I said, "The only stock currently on my 'shopping list' is Hercules Technology Growth Capital (NYSE:HTGC). My goal is to obtain a 2.5% position. Along with a 2.5% target allocation for Digital Realty (NYSE:DLR), this would be a 5.0% position in the technology sector."
So, on August 7, I made an initial purchase of internally managed HTGC at $16.54. HTGC currently comprises 1.1% of the portfolio.
A Technology BDC
Hercules is a business development company (BDC) headquartered in Palo Alto, CA, in "Silicon Valley." HTGC is the largest BDC that focuses on venture capital companies. Since the company's founding in 2003, it has deployed over $4.4 billion in financing for 290 companies. HTGC reports $900 million invested in 107 companies and it has $225 million in cash. The company states that in the course of its history, it has lost only 0.9% on its investments (less than 1%), which it considers remarkable.
HTGC seeks to be broadly diversified by industry sectors, by stages of development, by geography, and by sponsors. Over the past decade, HTGC has developed a network of relationships among sponsors in the venture capital community - those who invest in start-up companies. Hercules partners with these sponsors to provide debt financing. HTGC has partnered with 500 venture capital and private equity firms over the last ten years.
While HTGC is "a credit shop," it designs venture capital investments to provide equity warrants as well as debt. About 7% of current assets are represented by these equity warrants, which HTGC considers a healthy equity risk because of the potential gains. Less than 10% of the company's total portfolio is comprised of equity investments.
The company operates in four "verticals," each staffed by special teams in these areas:
- Life Sciences
- Clean Energy
- Lower Middle Market Special Situations.
A Focus on Venture Capital Companies
A presentation, "The Way Forward" on the HTGC website states that Hercules provides "venture debt to entrepreneurial companies at all stages of development to further their growth and help them achieve key milestones."
The presentation highlighted energy technology and life sciences:
The technology companies in our portfolio utilize debt financing for a broad range of activities - hiring the right talent, purchasing equipment, investing in new capabilities, financing working capital, and making strategic acquisitions.
Energy Technology is a fast-growing, rapidly changing sector and our financing solutions in this area have been used for growth, operations, expansion, acquisitions, and deployment of facilities.
Life Science companies leverage Hercules' debt financing solutions to speed time to market, broaden the scope of their clinical development and research, invest in new capabilities to reach important growth milestones, or shore-up their balance sheets ahead of an IPO of negotiations with strategic partners.
Equity Positions through Warrants
The presentation lists the companies in which HTGC holds current positions.
At the Wells Fargo Specialty Finance Conference on May 21, 2014, founder and CEO Manuel Henriquez said HTGC invests $500 million to $700 million annually in new deals. Loans are short-term, typically 36-months, with interest rates ranging from 10% to 14%, plus an "equity kicker." Henriquez said they expect 50% of the warrants to expire worthless, but they typically see a nice boost to HTGC's earnings when one of the VC companies is merged with another company or goes through an initial public offering. Henriquez said generally a merger is preferable to an IPO because during the 18-month lock-up period after an IPO (when HTGC is not permitted to exercise the warrants), it's possible that a new company will have disappointing earnings, which enhances the risk to the warrants. Six of HTGC's companies completed IPOs in the first quarter of 2014.
Henriquez told the conference that technology has many sectors and sub-sectors. HTGC's work is "highly granular" and "stage agnostic." Their investments may be weighted toward early stage development or late stage development depending on many factors, including the overall economic cycle. They may move more into energy or life sciences, for example, depending on market opportunities. Henriquez said when the economy is "turning bad," their focus will be more on later stage life science investments. Because the typical loan duration is 36-months, HTGC can shift the portfolio's focus over a period of 15-18 months.
Internally Managed, First Lien Senior Secured Positions
Some points emphasized by Henriquez at the conference included:
- HTGC is internally managed, which means management's interests are aligned with shareholders. He and the management team are investors in HTGC and their focus is driving income higher, not focusing on "assets under management" (AUM).
- 98% of loans made to VC companies are senior secured floating rate loans while HTGC's entire liabilities are fixed rate. $70M is due in April, 2015 and the remainder is due from 2016 to 2018.
- HTGC has a national franchise with a national network of offices located close to clients because they depend on their relationships with many sponsors. The VC community is their source of deal flow.
- One of the tools HTGC uses is a "securitization pool," which uses their debt investments as security for a loan. Moody's rated a recent securitization pool A2 and Kroll Bond Rating Agency gives HTGCs rating of BBB+ with a stable outlook.
- HTGC does not take a 2nd lien position. Generally they are the only lender and it is a first lien senior secured position. Henriquez said, "We want to control the capital structure of the companies and we want to control the liquidation preference."
- HTGC anticipates putting the $225M in cash to work by offering "new financial products." Henriquez said, "If we earn 8% on $100M, it means an additional 13 cents in EPS. If we earn 14% on $100M, it means an additional 23 cents in EPS."
At the May 21, 2014 Wells Fargo conference, CFO Jessica Baron reiterated the net asset value of $10.58 NAV, up 7% from year-end 2013. However, the NAV as of June 30 was down to $10.42 on 63.3 million shares outstanding.
At the Wells Fargo Conference, Henriquez said that among BDCs, Main Street Capital (NYSE:MAIN), Triangle Capital (NYSE:TCAP) and Hercules have the highest premiums to net asset value. One thing these BDCs share is an internal management structure. I found this interesting because I am long MAIN and TCAP. (Externally managed BDCs receive a fee based on "assets under management," which provides a temptation to inflate AUM without regard to the safety or profitability of their investments.)
2014 Q4 Earnings
Highlights from last week's earnings release include:
- Increased net investment income, or NII, during the quarter by 5.7% to approximately $18.6 million, as compared to $17.6 million in the second quarter of 2013. NII per share increased 3.4% to $0.30 on approximately 61.1 million basic weighted average shares outstanding for the second quarter of 2014, as compared to NII of $0.29 per share for the second quarter of 2013 based on approximately 60.3 million basic weighted average shares outstanding for the second quarter of 2013.
- Increased distributable net operating income, or DNOI, by 9.4% to approximately $21.0 million compared to $19.2 million in the second quarter of 2013. DNOI per share increased 6.3% to $0.34 per share for the second quarter of 2014, as compared to DNOI of $0.32 per share.
- Received approximately $68.1 million in principal repayments, including approximately $38.7 million of early principal repayments and approximately $29.4 million in scheduled principal payments.
- Announced quarterly dividend of $0.31 per share, payable on August 25, 2014 to shareholders of record as of August 18, 2014; the thirty-sixth consecutive dividend since inception bringing total dividends declared since inception to $9.68 per share.
You can listen a webcast of the Q2 earnings call here.
Some Key Data Points
Some data points from Morningstar as of March 31, 2014:
Long-term debt as a percentage of capital was 43.2% ($497.1 million of $1.15 billion). Outstanding shares were 60.9 million. The 52-week price range was $12.95-$17.25. The high yield for the past three years was 11.3% in 2010, 10.2% in 2011 and 10.0% in 2013. The annual dividend is $1.24. At an August 8 price of $16.04, the yield was 7.73%.
Possible Buy Range
EPS for 2013 was $1.65. If EPS grows at 5% annually, a possible high EPS would be $2.10 in the next five years. The current price/earnings ratio is 9.5. The average PE for the past five years was 21.9, but this was skewed by very high PE ratios in 2010. The average high PE for 2010-2013 was 11.1. The average low PE for 2010-2013 was 7.9. The average PE for 2010-2013 was 9.5 (consistent with the current PE).
I completed a Stock Selection Guide* on HTGC that indicated a potential high price in the next five years of $27.30. This is based on a projected EPS of $2.10 times a possible PE ratio of 13. I projected a potential low price of $12.40. This was based on the current annual dividend of $1.24 at a 10% yield, providing a potential support level for the stock. This gives a price range of $14.90, with a potential upside of $11.26 and a potential downside of $3.64 from the August 8 closing price of $16.04. This would be a 3-to-1 upside/downside ratio.
By dividing the potential price range into four parts, with the lower part representing a "buy" range, HTGC would be a buy from $12.40 to $16.10. The upper part of the range would be $23.60 to $27.30, making the low end of the "sell" range $23.60.
If an annual price appreciation is 11.2% and the average yield is 6.4%, this gives a possible total annualized return of 17.6%.
* The Stock Selection Guide is a tool developed in the 1950s by the National Association of Investment Clubs, now doing business as BetterInvesting.org.
Initial Purchase Made on August 7
Several weeks ago I placed a limit order in to buy HTGC at $15.65 but the price action after I placed the order moved up and away from my target buy price. On August 7, the day before the Q2 2014 earnings release, I made an initial purchase (a little less than half a position) at $16.54. I was concerned that a positive reaction to earnings might drive the price higher and I wanted to have at least an initial position in HTGC. I reasoned that if the price retreated, I would buy more to complete the position. The earnings release and earnings call were made after the market close on August 7. On August 8, the price drifted lower, but not quite to my original buy price of $15.65.
After the release, Sandler O'Neill cut HTGC to a hold from a buy. This may be one reason the stock was lower the day after the Q2 earnings release.
These comments by CEO Manuel Henriquez as recorded in the earnings call transcript may have dampened some analysts' short-term outlook for the stock. Here are some excerpts:
We remain very committed to addressing the growing needs of many of the innovative and disruptive technology and life sciences companies that we serve. To that end, as previously announced, Hercules has begun to (offer) a comprehensive financial suite of financial solutions that include asset based lending, equipment based financing, acquisition finance, senior stretch financing and our traditional growth term loans to more effectively compete with venture banks and other BDCs attempting to enter the venture capital marketplace or venture capital lending marketplace.
We launched these initiatives mid-second quarter as they have shown great initial promise as evidenced by our recent portfolio growth of our $100 million in new loans and of course our own unfunded commitment of over $230 million. Although much of this effort was realized late in the second quarter, we expect to see the benefits of this translate into earnings growth at the beginning of Q1 2015 and beyond. ...
We expect to continue to deploy our excess liquidity of nearly $300 million, very aggressively in the second half of 2014 and beyond. We intend to leverage our balance sheet ... as we continue to drive new investment asset growth in loans that will translate into earnings and eventually dividend growth for our shareholders. That we expect to see this translate into EPS growth by late 2014 and early 2015.
On the credit side ... you can expect Hercules to proactively continue to work diligently to prune marginal performing companies from our portfolio .... This effort along with some expected M&A events with some of our portfolio companies, will lead to early payoff in Q3 of approximately $60 million to $80 million. This excludes normal amortizations that will take place of approximately $35 million. Because of our proactive investment approach to managing our portfolio and pruning away marginal performing companies or credits, we anticipate that net loan growth for the investment portfolio going into Q3 will be flat to declining $20 million to $30 million.
Henriquez has a long-standing commitment to make the best long-term decisions for the company's portfolio, regardless of those decisions' impact on a particular quarter.
I've been following HTGC for several months. I've been helped, as always, by BDC Buzz' analysis, such as his June 6, 2014 article.
This investment works for me. It may not work for you. We each have different goals. We each have a different risk tolerance, so please do your own study and due diligence. This is presented as a journal of my investing and it is not a recommendation to buy or sell any security. This is offered simply as an idea for a stock to study. Caveat emptor!