Prospect Capital (PSEC) has been making announcements at a furious clip in recent weeks. The mid-sized Business Development Company ("BDC" has issued at least 6 press releases announcing new business and capital raising developments since its latest earnings release on November 9th. At the BDC Reporter we don’t comment on every new item, but we thought it would be interesting to have a long look at what Prospect has been up to, especially as the stock price has run-up substantially during this time.
By way of background, Prospect is one of the few Business Development Companies (“BDC”) which cut its dividend in 2010, from a quarterly pace in March of 41 cents a share to just over 30 cents. See our commentary of June 22, 2010. The company reduced the ire of its shareholders by switching to a monthly dividend from a quarterly one, which is very popular amongst retail investors, and by pointing to a balance sheet with large amounts of dry powder, susceptible of driving higher earnings in the future. The stock only dropped 7% because a dividend cut was widely expected. Still, even the new reduced dividend level was in excess of Prospect’s earnings, but management indicated actual results would catch up with the payout before long.
As of the last quarter, the company’s Net Investment Income Per Share was at 28 cents, short of the dividend, but materially better than the 25 cents earned in the prior quarter, and still without use of much debt borrowing whatsoever. The implicit promise was that –over time-Prospect might be able to make up some or all of the dividend lost by vigorous growth of the balance sheet: taking Prospect from $830mn in assets to over $1.0bn.
NEW BUSINESS ACTIVITY
Most of Prospect’s press releases have been about this new business activity. Most recently and just before the New Year’s break the company released a press release announcing two new deals:
Prospect Capital Corporation …announced today that Prospect has made a second lien secured debt investment of $15 million to support the acquisition of Jordan Healthcare Holdings, Inc. (“Jordan”) by affiliates of Palladium Equity Partners, LLC (“Palladium”).”
Jordan is the second largest provider of home healthcare services to both Medicare and Medicaid eligible patients in Texas. Based in Mount Vernon, Jordan provides skilled nursing and personal care services to over 13,000 patients in 174 counties throughout Texas.
…Separately, Prospect announced that it has made a senior secured debt investment of $18 million to support the acquisition by a top private equity firm of a leading market share transportation services company. Prospect acted as the facility agent and led a group of club lenders for this transaction.
Prospect reports that in aggregate 7 new originations have closed since the last quarter ended September 30 2010 for a total of $135mn.
CAPITAL STRUCTURE SOUND
From a liquidity standpoint, Prospect has the money for all this new business. As the company reported at the time of the last earnings release, there was $200mn or more in available borrowing capacity and cash available. In the earnings release of November 9th, PSEC indicated:
Since September 30, 2010, we have paid down the credit facility to $14.3 million, and our available liquidity as of today is currently in excess of $200 million for new investments.
Since then, Prospect has also raised $150mn in 5 year Convertible Senior Notes (a relatively unheard of instrument in the BDC space), which has added even more borrowing capacity. The cherry on the sundae was an increase in committed amounts under its Revolver to $285mn (a $25mn increase), announced December 13. Then there’s Prospect’s perpetual equity raising. Just through the period from September 30 to November 3rd, the company sold another 5 million shares to add to the 78 million already outstanding and raised another $50mn. Add all that up and it suggests Prospect has $425mn to spend.
Certainly, the Company’s balance sheet remains very strong. Even if all debt facilities were fully drawn, debt to equity would still be 0:5:1.0 (which is probably as far as Prospect would consider leveraging itself in order to protect its S&P corporate BBB rating.
The market appears to be impressed with all this activity, as the stock price has risen from close to $9.5 a share at the end of the last fiscal quarter to nearly $11 today. Given that the NAV at September 30, 2010 was $10.24, today’s stock price of $10.88 is a 6% premium. Just in October PSEC was still raising capital at a discount to NAV.
OUTLOOK FOR EARNINGS COVERING THE DIVIDEND
But what about earnings? Will they cover or exceed the current dividend level? If we annualize the latest monthly dividend announced, the company will have to earn $1.21 a share a year , or just over 30 cents a quarter. Management has projected Net Investment Income Per Share for the quarter ended December 2010 of 26-30 cents. So it seems that Prospect is in spitting distance of covering its dividend.
Like most things in life it’s not quite that simple. First, there’s the impact of refinancings on the Company’s earnings. We only know that through November 3rd two loans have been repaid for proceeds of $23mn. Why management cannot mention repayments in their press releases announcing new deals is a question we cannot answer, but it means that no one can really know what net assets are likely to look like at quarter end. For all we know, Prospect could have less assets than at September 30th.
Second, the average portfolio yield is on a downtrend and that should continue a while longer. Just a few quarters ago the average yield was 15.7%. Last quarter it was 13.2%, partly impacted by lower dividends from one of its key investment: Gas Solutions. With the natural gas market under-performing, Gas Solutions may not be as large a contributor to earnings as in the past in 2011. For example, a year ago in the quarter ended September 2009, Gas Solutions paid a $6mn dividend. Last quarter it was only $1.75mn. Moreover, PSEC has been booking somewhat safer new loans in recent quarters to improve its credit profile, but that has come at the cost of slightly lower yielding assets.
Third, there are bad debts still to worry about. Prospect is still burdened with 9 non-performing loans out of 57, with a face value of $165mn. Many of the deals date back to the period when Prospect was exclusively a higher risk-return energy lender. There is still the possibility that more loans could go on non-accrual, and recoveries from the existing troubled loans seem unlikely.
Fourth, last quarter’s encouraging earnings were helped by some unusual or exceptional items which might not be repeated in 2011. Here’s an example quoted from the 10-Q:
We also recapitalized our debt investment in Northwestern Management Services, LLC. The $20,000 loan was issued at market terms comparable to other industry transactions. In accordance with ASC 320-20-35 the cost basis of the new loan was recorded at par value, which precipitated the acceleration of $1,612 of original purchase discount from the loan repayment which was recognized as interest income.
Also, Other Income was a major contributor to income in the last quarter: adding $4.1mn versus $0.5mn a year ago. When new business activity slows down (which it might in the current period), Other Income may drop as well.
Then there are the continual equity raises that make estimating what earnings per share will look like very difficult. Plus, there is the relatively high cost of the new Convertible debt. When you add the 6.5% interest rate payable, plus the high management fees and other expenses (which on average amount to 6% of total investment assets at cost), there’s very little incremental earnings left over for shareholders.
ANALYST ESTIMATES: FLAT EARNINGS
All the above factors may account for why the average analyst estimates of earnings for the years ended June 2011 and 2012 are at $1.12 and $1.11 respectively. That’s under 28 cents a share per quarter, and pretty much flat with the last quarter, despite all the new business we’ve been discussing. That’s also below the current dividend level, and implies the investment banks don’t see PSEC covering its dividend with earnings in the next 18 months.
We should point out, though, that GAAP earnings per share are not the same as Taxable Income, and with all the fees being received from new loans and loan repayments Prospect’s Taxable Income Per Share may be sufficient to cover its dividend. What seems less likely is that Prospect will ever be able to build back its earnings and dividends to the pre-cut levels.