Hercules Technology Growth Capital: Make High-Growth Tech Stocks Pay Dividends

| About: Hercules Capital, (HTGC)

Remember what a dividend is? It’s an old-fashioned way of creating shareholder value by giving shareholders money.

Dividends have gone out of fashion with the focus on high-tech growth stocks. Investors are looking for capital gains on their investment, not dividend yield. But there is a way to make high-growth tech stocks pay dividends right away – with an investment in Hercules Technology Growth Capital, Inc. (Nasdaq: HTGC).

Hercules has a current dividend yield of 9.9%, one of the highest among Nasdaq stocks. The specialty finance company has carved out a niche in “venture debt” – it makes loans of $1 million to $30 million to private technology and life sciences companies that are backed by venture capital or private equity firms.

Hercules has paid a dividend every quarter since it went public in June 2005 – it just declared its eighth consecutive quarterly dividend, $0.30, for the second quarter, ended June 30. The reason: it has to pay dividends, because it is organized as a business development company [BDC], making it a registered investment company under the Investment Company Act of 1940, the same act that governs mutual funds. To maintain this status, which exempts it from paying corporate income tax, the company must distribute 90% of its net taxable income as dividends.

Of course, you have to have income to pay dividends. Though its track record is still short, Hercules has made its high-risk loans with minimal losses – of the $700 million loan commitments made since its founding in 2003, the gross loss has been $5 million and the net loss, after bankruptcy workouts, has been $1 million. One of the reasons for this strong record is that Hercules has forged relationships with more than a hundred top venture capital and private equity firms to provide it with a high-quality deal flow.

The flip side is that Hercules can charge high interest rates for these loans, which are virtually impossible to obtain through traditional banks. The average yield-to-maturity on its loan portfolio in the second quarter was 12.75%, a figure that has been creeping up over the past few quarters even as loan volume has expanded. Compare this to its financing costs – LIBOR, currently at 5.40, plus 1.20, or about 6.6% on an annual basis.

Plus, there’s an equity kicker. Most of Hercules’ loans take the form of structured mezzanine debt so that the company also receives warrants or options to acquire the stock of the companies it loans to. This stock can end up being a multiple of the price on the warrant – five to 10 times if the loan comes in the early stages of a company’s growth, three to seven times if it’s in its expansion stage, and two to four times if a company is ready to go public.

Many of the tech and biotech companies, of course, have no income in the development stage, and they pay off their loans from Hercules with the next round of equity financing. The average term of a Hercules loan is three years. So why do the tech companies seek debt? Several reasons: it stretches out the time between equity financing, it is less dilutive than equity financing, it leverages the returns of equity investors, and it gives the company negotiating leverage for higher valuations.

All of this has analysts excited – the stock currently has two “strong buys” and two “buys” on it, with a median price target of $17. The stock was recently trading at $12.33, giving it a market cap of nearly $400 million, compared with its 52-week high-low of $14.71-$11.32.

The figures from the most recent quarter, ended June 30, reflect the company’s strong growth. Net investment income rose to $7.2 million, or $0.29 a share, from $2.5 million, or $0.19 a share, in the year-ago period. Total investment income was $13.3 million, compared with $6.8 million. Total debt and equity commitments reached $149 million in the 2007 quarter (only $750,000 was equity commitment), compared with $40.8 million the second quarter of 2006.

The fair value of the company’s investment portfolio at the end of the second quarter was $416.7 million, compared with $193.6 million a year earlier. The company had 70 companies in its warrant portfolio, compared with 41 a year ago.

Going into the third quarter, Hercules had $111 million in unfunded debt commitments and another $48 million in unsigned term sheets – an “order backlog” that gives a picture of what will happen in the third quarter, traditionally the weakest in terms of new commitments.

Hercules just completed its own new round of capital-raising, selling new shares for a total $124 million in June. Deutsche Bank joined Citicorp in providing Hercules’ credit line, raising it to $250 million from $150 million. As a regulated BDC, Hercules is limited to 1:1 on its own leverage – it must have $1 of equity for every $1 of credit. However, the company has also set up a small business investment company [SBIC] affiliate, which can draw $127 million in 10-year credit from the Small Business Administration and has an SEC exemption for that line of credit from the 1:1 ratio. The company believes it has enough funding now to see it through at least another four or five quarters of growth.

The $0.29 earnings per share in the second quarter beat estimates of $0.24. For the current quarter, ending September 30, analysts have raised their expectations in the past month to $0.28, vs. $0.23 in the year-ago period, and for the year to $1.08, vs. $0.86 a year ago.

It may seem counterintuitive to plunge into a finance company stock when credit markets are in such turmoil. But Hercules, which has its own financing in place for a year or so, operates in the separate sphere of venture capital, where activity in terms of new commitments and “liquidity events” remains robust. And then there’s those dividends.

Disclosure: none