Introduction/Recap: On 8/25/2014, Prospect Capital Corp. (NASDAQ:PSEC) reported net investment income ('NII') of $0.25 per share and net assets resulting from operations (also known as EPS) of $0.21 per share. In my prior PSEC fiscal Q4 2014 net asset value ('NAV') projection article, I projected NII of $0.279 per share and EPS of $0.208 per share. Even though I correctly projected PSEC's NAV as of 6/30/2014 at $10.56 per share, I was disappointed with PSEC's NII results. A PSEC article written by BDC Buzz was recently provided to S.A. where the "consensus average" of 11 analysts covering PSEC had even more bullish expectations regarding the company's NII for the fiscal fourth quarter of 2014. The median projection of the 11 analysts covering PSEC had the company's NII per share for the fiscal fourth quarter of 2014 at $0.32 per share which seemed "overly aggressive" in my opinion. When compared to my projection, these analysts are probably even more disappointed with PSEC's quarterly results. With that being said, let me highlight a few key points to take from the quarter.
In my prior PSEC article (linked above), I stated the company's investment portfolio growth would be "suppressed" during the fiscal fourth quarter of 2014 (see prior article for further details). I also stated this reduced level of investment portfolio growth would hinder structuring and fee income during the fiscal fourth quarter of 2014. In addition, this general trend would continue until PSEC "re-activates" the company's Internotes/equity programs. I projected PSEC would have quarterly gross loan originations of approximately $550 million while having quarterly portfolio sales/repayments of ($150) million. As such, I was projecting net loan originations of $400 million. However, PSEC reported gross loan originations of only $444 million while having portfolio sales/repayments of ($170) million. When calculated, PSEC had net loan originations of only $274 million for the fiscal fourth quarter of 2014. I correctly anticipated PSEC having a weak quarter regarding net loan originations, but actual results were near the lower-end of my projected range. This directly led to a quarterly increase (decrease) in structuring fees of ($19) million which ultimately hurt NII. Furthermore, PSEC disclosed the company so far has quarterly loan originations of $239 million during the fiscal first quarter of 2015 (through 8/25/2014). However, PSEC also disclosed the company has quarterly sales/repayments of ($322) million during the same timeframe. This calculates to a net loan origination of ($83) million during the fiscal first quarter of 2015. This is the first time I have witnessed a net decrease to PSEC's investment portfolio even if it is only half way through the quarter. With that being said, PSEC's quarterly unrealized appreciation (depreciation) and realized gain (loss) accounts experienced slightly less depreciation than I expected which is good news. This even considers the fact PSEC recorded a total "write-off" of the company's investment in New Century Transportation, Inc. This write-off alone amounted to an unrealized appreciation (depreciation) of ($33.6) million during the quarter.
In my opinion, one of the most important aspects to take from the quarter is the material restructuring/amendment to most of PSEC's control investments. Per PSEC's filed 10-K for the fiscal year-ended 2014, the company removed each control investment's "net revenue interest" feature (where applicable) and either increased the company's debt or equity investment cost basis and fair market value ('FMV'). Even though this factor partially caused PSEC's control investment portfolio to record an unrealized appreciation (depreciation) of $17.4 million during the quarter, many debt investments were also restructured/amended to lower the "cash" interest income feature while materially increasing the payment-in-kind ('PIK') interest accrual. PIK interest income is accrued for and recorded as revenue over the life of the loan. However, PSEC generally does not receive PIK interest income until the loan matures, is sold, or is repaid. In my experience, the material increase in proportion of PIK interest income should be seen as a "yellow flag." If a specific investment has PIK interest income and begins to materially depreciate, PSEC will have the added pressure of eventually putting this investment on "PIK non-accrual" status. When this occurs, a reversing entry needs to be made to reduce the FMV of the loan by the cumulative PIK interest income accrued for throughout the life of the loan. This would directly lower NII in a given quarter. Another important topic to highlight is PSEC made a prior period adjustment to the company's "accumulated realized gains (losses) on investments" account within the equity section of the balance sheet. Prior to PSEC's quarterly press release, the account mentioned above had balance of ($77.8) million at 6/30/2013. Per PSEC's filed 10-K for the fiscal year-ended 2014, the company reported an accumulated realized gains (losses) on investments balance of ($115.1) million at 6/30/2013. This is a retroactive additional loss of ($37.4) million. I believe this retroactive adjustment should be brought up in PSEC's earnings call today.
Conclusions Drawn: I believe this was a disappointing quarter for PSEC. In my opinion, the following negative factors should cause heightened awareness for existing and potential PSEC shareholders: 1) potential of continued slow portfolio growth; 2) hindered structuring and fee income; 3) lower NII and net investment company taxable income (net ICTI); 4) continued modest to material depreciation on several control and non-control/non-affiliate investments; and 5) accounting changes that affect the company's control investments. With that being said, there are still several positive factors regarding PSEC as well. These factors were covered in my prior article. Due to the disappointing quarterly results, I have now revised my recommendation for PSEC. I currently rate PSEC as a HOLD when trading at a minor (under 5%) discount to NAV as of 6/30/2014 and a BUY when trading at a modest (at or over 5% but under 10%) discount to NAV as of 6/30/2014. In a future article, I will provide my quarterly dividend sustainability series incorporating PSEC's fiscal fourth quarter of 2014 results. Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation may not fit each investor's current investing strategy.
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.
Additional disclosure: I will look to exit my already reduced position in PSEC when an attractive premium to NAV occurs.