Prospect Capital: Let It Ride

| About: Prospect Capital (PSEC)
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PSEC is approaching a 52 week high.

I discuss several reasons why the rally can continue.

The distribution is safe and the discount is still compelling.

Prospect Capital (NASDAQ:PSEC) is a name that I was pounding the table on when it fell under $6.00 a share. Fast forward just a few short months and this name is just about at a 52 week high, at $7.93 right now. The 52 week high is $8.09, and I think that is a number that is about to be surpassed. Why? Well first there has been broad strength in the market following the brief sell-off in equities following the so-called BREXIT event. That helped propel the name higher, along with other equities. Yield plays like REITS and BDCs had been hit along with precious metal and oil prices. Strange correlations there, although some BDCs have exposure to these sectors. With the rebound in these commodities, these sectors went along for the ride. I will add of course, that PSEC has been performing well in its own right. There were persistent fears that the company would drastically miss earnings and potentially cut the dividend, but this has not been the case.

The most recent quarter as at worst a "so-so quarter", as it was not strong, nor was it overly weak. A key piece of news is that company maintained its distribution payout the next three months following earnings. Now to the bears credit, total investment income was down 1% year-over-year. The big story, of course, is the net investment income. Net investment income generally mirrors so-called distributable income, the income that is available to be paid out to investors. The company, of course, is required to pay out 90% of taxable income. Well, net investment income came in at $87.6 million or $0.25 per weighted average share for the quarter. This net investment income was a miss against estimates and rose $0.2 million year over year. Keep in mind the company paid $0.25 per share in distributions. When looking at the non-GAAP distributable income figure, we see this came in at $86.6 million $0.24 per share. Thus, the distribution was nearly covered, but not entirely. However, the distribution is in no immediate danger. Why? Well the term "spillback" comes into play. That is, income in excess of distributions. For fiscal 2015 year, which ended June 30, 2015, the company generated $1.31 in distributable income, exceeding the $1.19 paid out. In fiscal Q1 2016, there was another $0.02 in "spillback." In fiscal Q2 2016, there was $0.03. So this one penny shortfall is nothing to be concerned with.

I am opining that there is room to run here. This is because not only is there momentum post-BREXIT, and from a rebounding set of commodities, but there is also a large discount-to-net asset value still present. Although net asset value has trickled lower over the last two years, the bleeding seems to have nearly ceased. As of December 31, 2015, the net asset value stood at $9.65 whereas at the end of March 2016, it was $9.61. It fell a bit due to unrealized depreciation based on volatility in the capital markets rather than fundamental credit issues. Now, again, in the bears' defense the net asset value decline gives some strength arguments such as: "the stock will fall because we expect NAV to spiral downward" or similar. That said, a small discount is perhaps warranted, but based on the price of $7.93, the stock trades at a $1.68 or a 17% discount-to-book. It is still on sale.

Given the power of the distribution, particularly for those who are compounding their investment, I am reluctant to sell at these levels. There is room to run given the trading action in the name, the macroeconomic changes we are seeing for the name as well as the discount still coming in well over 15%. Let it ride.

Christopher F. Davis has been a leading contributor with Seeking Alpha since early 2012. If you like his material and want to see more, scroll to the top of the article and hit "Follow." He also writes a lot of "breaking" articles, which are time-sensitive, actionable investing ideas. If you would like to be among the first to be updated, be sure to check the box for "Real-time alerts on this author" under "Follow."

Disclosure: I am/we are long PSEC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.