On 2/8/2017, Prospect Capital Corp. (NASDAQ:PSEC) reported quarterly net investment income ("NII") of $0.235 per share, earnings per share ("EPS") (also known as "net assets resulting from operations") of $0.281 per share, net investment company taxable income ("ICTI") of $0.205 per share, and a net asset value ("NAV") as of 12/31/2016 of $9.62 per share. In comparison, I projected PSEC would report quarterly NII of $0.225 per share, EPS of $0.261 per share, net ICTI of $0.218 per share, and an NAV as of 12/31/2016 of $9.60 per share in the following article:
As such, PSEC's NII, EPS, and NAV figures were a minor "outperformance" when compared to my expectations while the company's net ICTI was a minor "underperformance." However, I would point out these figures were very close to actual results. When calculated, my NII, EPS, net ICTI, and NAV projections had a variance of ($0.01), ($0.02), $0.013, and ($0.02) per share, respectively.
I will now summarize my prior article's account projections and compare each account to PSEC's actual results. I will discuss PSEC's accounts in the same order as provided in my NII and NAV projection article (link provided above).
PSEC's Projected Versus Actual Results (Overview):
To begin this analysis, Table 1 is provided below. Table 1 shows my prior account projections and compares these figures to PSEC's actual results for the fiscal second quarter of 2017.
Table 1 - PSEC NII and EPS for the Fiscal Second Quarter of 2017 (Actual Versus Projected)
(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database)
PSEC's Income and Expense Accounts:
In my prior PSEC NII and NAV projection article (link provided above), I projected the company would report a notably higher quarterly loan originations/add-on investments figure for the fiscal second quarter of 2017 when compared to the prior quarter. As previously projected in prior PSEC/business development company ("BDC") articles, I anticipated loan originations would continue to "pick up" heading into the second half of calendar year 2016. I also anticipated PSEC experienced a high level of portfolio sales/repayments/restructurings as companies classified within certain types of credit markets rushed to refinance existing debt at more attractive interest rates (which has led to the recent tightening of spreads).
These two assumptions/projections came to fruition as PSEC reported loan originations/add-on investments of $470 million during the company's fiscal second quarter of 2017 while reporting portfolio sales/repayments/restructurings (prior to all quarterly "fair market value" ("FMV") fluctuations and scheduled principal payments) of ($645) million. When calculated, PSEC's total investment portfolio decreased ($175) million for the fiscal second quarter of 2017 (prior to all quarterly FMV fluctuations and scheduled principal payments). When compared to my projected loan originations/add-on investments less portfolio sales/repayments/restructurings of ($225) million, PSEC's actual decrease in its investment portfolio was $50 million less severe.
Using Table 1 above as a reference, I projected PSEC would report "total interest income" of $168.2 million for the fiscal second quarter of 2017. In comparison, PSEC reported total interest income of $174.8 million. When calculated, this was a minor variance of $6.6 million. While I basically matched what PSEC reported within the company's "collateralized loan obligation" ("CLO") portfolio, I slightly under projected the accrued interest within its non-CLO portfolio. As stated above, this mainly stemmed from my assumption that PSEC's investment portfolio would net decrease by approximately ($225) million during the fiscal second quarter of 2017 while, in actuality, the company only experienced a net decrease of ($175) million. Simply put, this impacted the quarterly accrued interest within PSEC's non-CLO portfolio. As such, I believe this slight outperformance was a positive trend.
Moving down Table 1, I was somewhat disappointed when it came to PSEC's dividend and structuring/fee income. Both PSEC's dividend and structuring/fee income was slightly lower than I anticipated. I projected PSEC would report quarterly dividend and structuring/fee income of $3.8 and $9.8 million, respectively. When compared to several recent quarters, this was not an overly "ambitious" projection in my opinion. In comparison, PSEC reported quarterly dividend and structuring/fee income of $1.4 and $7.3 million, respectively.
I anticipated one of PSEC's stronger control investments would provide some dividend income; for instance Echelon Aviation LLC (Echelon) or National Property REIT Corp. ("NPH"). However, neither company provided any dividend income this quarter. The only two control investments to provide PSEC with a meaningful amount of quarterly dividend income was MITY, Inc. ("MITY") and Nationwide Acceptance LLC (Nationwide). As stated last quarter, I wanted to see more dividend income being reported by PSEC in regards to the company's profiting control investments, thus offsetting the income lost from one-time monetization events such as the Harbortouch Payments LLC (Harbortouch) sale two quarters ago. Simply put, this did not occur during the fiscal second quarter of 2017.
In regards to PSEC's structuring/fee income, as stated above the company actually reported an attractive loan originations figure for the quarter which positively impacted this account when compared to the prior quarter. With that being said, the amount of structuring/fee income actually reported was a bit of a disappointment when compared to my projections, especially when it came to PSEC's non-control/non-affiliate investment portfolio.
When PSEC's total interest, dividend, and structuring/fee income are combined, I projected the company would report "total investment income" of $181.7 million for the fiscal second quarter of 2017. In comparison, PSEC reported total investment income of $183.5 million which was a slight outperformance in my opinion. When calculated, this was a variance of only ($1.8) million which was well within my stated range.
Still using Table 1 above as a reference, I projected PSEC would report "total operating expenses" of $101.0 million for the fiscal second quarter of 2017. In comparison, PSEC reported total operating expenses of $99.1 million. When calculated, this comes out to be a variance of only $1.9 million. Again, this was well within my stated range. When taking a look at all the accounts that make up this figure, since PSEC reported total investment income that was slightly above my projected figure, the company also reported an "investment advisory fee" above my projection ($20.2 million projected versus $21.1 million actual; a negative strictly from an expense perspective). PSEC's reported "base management fee" was very close to my projection ($30.8 million projected versus $30.9 million actual). This slight variance was due to the slightly lower net decrease of PSEC's investment portfolio when compared to my projection for the fiscal second quarter of 2017 (discussed earlier). PSEC's reported "interest and credit facility" expenses were also very close to my projection ($41.5 million projected versus $40.8 million actual). PSEC's "audit, compliance, and tax related fees," "allocation of overhead from Prospect Admin.," and "other general and administrative expenses" were slightly lower when compared to my projection which should be seen as a minor positive trend.
Continuing to move down Table 1, when all the amounts above are combined, I projected PSEC would report NII of $80.7 million for the fiscal second quarter of 2017. In comparison, PSEC reported NII of $84.4 million. Simply put, PSEC's reported NII was a minor outperformance of ($3.7) million or ($0.01) per share. This variance was within my stated NII range. Let us now discuss PSEC's three valuation accounts.
PSEC's Valuation Accounts:
I believe PSEC's investment portfolio, as a whole, slightly outperformed my expectations which ultimately led to the company reporting EPS of $0.281 per share when compared to my projected EPS of $0.261 per share. This directly led to PSEC reporting an NAV as of 12/31/2016 of $9.62 per share versus my projection of $9.60 per share. Still, this minor variance was well within my projected range and should be seen as almost an exact match due to the complexities of valuing such illiquid types of assets.
As stated in my PSEC NII and NAV projection article (link provided above), I correctly anticipated continued stress on certain oil & gas investments and several struggling portfolio companies while correctly projecting modest net appreciation within the rest of the company's investment portfolio. I was also encouraged by the performance (including overall valuation fluctuations) within PSEC's CLO portfolio which I correctly anticipated. These three factors will be further discussed within PSEC's "unrealized appreciation (depreciation) on investments" account later in the article.
First, continuing to move down Table 1, I projected PSEC would report a "gain (loss) on the extinguishment of debt" of ($0.1) million (rounded) for the fiscal second quarter of 2017 which is what the company reported. As such, further discussion of this account is unwarranted.
Next, I projected PSEC would report a "net realized gain (loss) on investments" of $1.8 million during the fiscal second quarter of 2017. As stated within my prior projection article (see link above), I anticipated several minor gains within the company's investment portfolio during the quarter. However, in addition to the events I correctly anticipated, the company also recorded several undisclosed minor realized losses during the quarter which ultimately led to a total net realized loss of ($0.1) million. This still led to a minor variance of only ($1.9) million which was well within my stated range.
This leads us to one last projection with PSEC's income statement, the company's unrealized appreciation (depreciation) on investments account. I projected PSEC would report net unrealized appreciation of $11.0 million in regards to the company's entire investment portfolio for the fiscal second quarter of 2017. In comparison, PSEC reported net unrealized appreciation of $16.7 million for the fiscal second quarter of 2017. Due to the sheer size of PSEC's investment portfolio (FMV of $5.94 billion as of 12/31/2016), including backing out the minor realized gain (loss) variance of ($1.9) million which directly impacts valuations within the unrealized appreciation (depreciation) on investments account, I believe a net variance of only $3.8 million regarding the company's entire investment portfolio was an extremely accurate projection and should be considered as a very minor outperformance (some could argue basically matching my expectations).
With that being said, let us discuss the three main factors stated earlier in relation to PSEC's investment portfolio which I believe should be examined to compare projected versus actual results within this account.
1) PSEC's CLO Portfolio:
First, I was encouraged with the overall valuation fluctuations within PSEC's CLO portfolio. As initially discussed in my PSEC NII and NAV projection article (see link above), PSEC refinanced several of the company's CLO investments during the fiscal second quarter of 2017. Simply put, this positively impacted valuations within the portfolio which was correctly anticipated.
However, market participants also need to consider there was a notable increase to the forward LIBOR curve during the calendar fourth quarter of 2016. This factor partially offset the CLO price increases and valuations gains from refinancing/resets during the quarter. Due to the fact most of a CLO's liabilities are "floating-rate" in nature which are directly tied to current/spot LIBOR, including the fact that most investments currently have cash LIBOR floors of say 1% (typically higher floors with more vintage securitizations), an increase in current/spot LIBOR up to 1% actually negatively impacts current and projected near-term discounted cash flows.
I projected PSEC's CLO portfolio would record net investment appreciation of $30 million for the fiscal second quarter of 2017. In comparison, PSEC recorded net investment appreciation of $40 million. Due to the size of PSEC's CLO portfolio (FMV of $1.09 billion as of 12/31/2016), I believe a $10 million variance was very close to my projection.
It should also be noted PSEC's CLO portfolio witnessed a minor decrease in its trailing twelve-month default rate during the fiscal second quarter of 2017. As of 9/30/2016, PSEC's CLO portfolio experienced a default rate of 1.39%. As of 12/31/2016, this default rate decreased to 1.16%. This was one reason why PSEC's CLO portfolio recorded a relatively unchanged accrued interest income during the fiscal second quarter of 2017 when compared to the prior quarter.
So, in other words, this quarter PSEC's CLO portfolio had relatively unchanged quarterly accrued interest income (current cash flows per se; shown within the income statement) but had an increase in the actual valuation of the portfolio itself (projected future discounted cash flows per se; shown within the balance sheet).
Now, with that being said, it should also be noted PSEC's CLO residual interests are in the "lowest tranche/bottom basket" when it comes to income distributions. If, in the future, there is a noticeable uptick in underperforming/non-performing loans (defaults), the residual interest (equity) tranche of a CLO bears first risk loss of this income. This methodology is also known as a CLO's "waterfall" calculation which I have discussed at length in prior PSEC articles. This is why this particular tranche of the CLO can have highly attractive yields under certain positive environments (say north of 25%) yet also have very poor yields under certain negative environments (say single digit or even negative yields). This all gets back to an investment's "risk versus reward" metric. Within a CLO's residual interest/equity tranche, there's heightened risk for investment depreciation but also a heightened reward if the security is performing above expectations.
This is an analysis that constantly needs to be "tweaked." As is the case with all my mortgage real estate investment trust (mREIT) and BDC research, I constantly evaluate all applicable factors/variables that go in a modeled projection. In this instance, this includes a non-simulated future discounted cash flow projection, various modeled forecasts through a privately accessed intranet valuation software (includes "Monte Carlo" modeling), and comparable research tools/models from outside resources (including Intex).
With that being said, I continue to stress to readers valuing a CLO portfolio is not an "exact science." This is dealing with various imputed factors/variables and providing certain "judgments." That is why these types of investments are classified as level 3 assets per Accounting Standards Codification 820 (ASC 820) which I have continued to reiterate since I began covering PSEC several years ago. In the end, if a company were to engage three independent valuation firms, I believe each firm will likely derive three different valuation ranges for a particular portfolio (though a partial overlap of these three ranges would likely occur). Currently, that's just the "grim reality" that investors/market participants have to deal with regarding these types of more illiquid investments/securitizations. Let us now move on to the next factor.
2) PSEC's Oil and Gas Investments:
Second, I correctly anticipated PSEC would continue to see net investment depreciation within the company's oil and gas portfolio companies. In particular, the following oil and gas portfolio companies had notable net depreciation (proportionately speaking) during PSEC's fiscal second quarter of 2017: 1) Arctic Energy Services, LLC (Arctic Energy); and 2) CP Energy Services Inc. (CP Energy). It should be noted this net depreciation occurred even as crude oil prices net increased during the calendar fourth quarter of 2016. This is because crude oil prices are still materially below levels from several years ago. As such, these two recently restructured portfolio companies continue to struggle.
When combined, I projected PSEC's oil and gas portfolio companies would record net investment depreciation of ($8) million for the fiscal second quarter of 2017. In comparison, PSEC recorded a combined net investment depreciation of ($5) million. I believe this $3 million variance was a minor outperformance when compared to my projection yet was still within my stated range for this sector.
3) Remaining Companies within PSEC's Investment Portfolio:
Third, there were several notable FMV fluctuations when it came to the rest of PSEC's investment portfolio. While some valuation fluctuations were positive in nature, several were negative as well. In particular, notable investment appreciation occurred within the following portfolio companies (excludes all specific CLO investments which were discussed, as a whole, in the first factor above): 1) Echelon; 2) MITY; 3) NMMB, Inc. ("NMMB"); and 4) CURO Group Holdings Corp. ("Speedy"). Due to improving performance metrics, in addition to the notable improvement of MM and UMM loan pricing during the fiscal first and second quarters of 2017, these four portfolio companies witnessed a notable increase in valuations (proportionately speaking). This should be seen as a positive trend/catalyst.
Offsetting these positive FMV fluctuations, notable investment depreciation occurred within the following portfolio companies (excludes all specific CLO and oil and gas investments which were discussed in the first and second factors above): 1) First Tower Finance Co. LLC (First Tower); 2) NPH; 3) Nixon, Inc. (Nixon); 4) Pacific World Corp. (Pacific World); and 5) Venio LLC (Venio). As discussed within last quarter's PSEC assessment article, at the time I stated NPH's $30 million quarterly investment appreciation was fairly"aggressive" in my professional opinion. At the time, I stated NPH should have recorded investment appreciation of only $20 million. When calculated, this was a valuation "difference of opinion" of ($10) million. Well, during PSEC's fiscal second quarter of 2017, the company reported NPH had investment depreciation of ($9.1) million which I believe more appropriately values this particular portfolio company. This includes the notion of considering the positive fundamentals of the rental/multi-family and online lending markets (including refinancing of existing liabilities). Shifting to a different portfolio company, I was most disappointed with investment depreciation of ($13.1) million regarding Pacific World. This will be one of the first portfolio companies I pay attention to regarding future FMV fluctuations as I believe this investment has begun to experience heightened credit risk.
When combined, I projected PSEC's portfolio companies (excluding the company's CLO/oil and gas investments) would record net investment depreciation of ($9) million for the fiscal second quarter of 2017. In comparison, PSEC recorded net investment depreciation of ($18) million. I believe this ($9) million variance was a minor underperformance when compared to my expectations.
Therefore, when analyzing PSEC's entire investment portfolio, I had the following overvaluations (undervaluations) when compared to the company's reported FMV fluctuations during the fiscal second quarter of 2017: 1) net undervaluation of CLO portfolio by $10 million; 2) net undervaluation of oil and gas portfolio companies by $3 million; and 3) net overvaluation of the remainder of the company's investment portfolio by ($9) million. I believe a net variance of only $4 million regarding the company's entire investment portfolio was an extremely accurate projection and should be considered as a very minor outperformance (some could argue basically matching my expectations). With that being said, for added clarity, I wanted to provide readers a "breakout" of this variance.
Readers have continued to request that I provide these types of "update"/"follow-up" articles showing how my quarterly projections "stacked-up" to PSEC's actual results. I believe the analysis above accomplishes this request. Since a company's operating performance (quarterly earnings) is one of the key drivers to stock price valuations, I believe these types of projection/assessment articles are appreciated by most readers. In addition, this article provides my overall thoughts on the quarter which I believe most readers see as beneficial when assessing certain investing strategies.
From the analysis provided above, I believe it was determined PSEC's NII, EPS, and NAV per share figures were a minor outperformance when compared to my projections while the company's net ICTI was a minor underperformance. With that being said, I would point out all four of my projected metrics were very close to actual results.
For readers curious about PSEC's future dividend sustainability, one negative piece of news that was provided by management stated the company had notable prior period net ICTI "true-down" adjustments reflected within the company's taxation figures over the prior several reporting periods. Simply put, these adjustments notably decreased PSEC's cumulative undistributed taxable income ("UTI") balance. Readers should know about this event because it directly impacts PSEC's future dividend sustainability. Since this event was not the focus of this quarterly earnings assessment article, these adjustments will be fully discussed/analyzed in my quarterly PSEC dividend sustainability article.
For interested readers, the following were the NAV increase (decrease) and economic return (loss) percentages for PSEC and six other BDC peers I currently cover that have either provided preliminary results or have already reported results for the calendar fourth quarter of 2016 (in order of highest to lowest economic return/lowest to highest economic loss):
1) Main Street Capital Corp. (NYSE:MAIN)*: 2.22% increase in NAV; 6.06% economic return
2) PSEC: 0.21% increase in NAV; 2.81% economic return
3) Golub Capital BDC Inc. (NASDAQ:GBDC): (1.38%) decrease in NAV; 2.19% economic return
4) Medley Capital Corp. (NYSE:MCC): (1.05%) decrease in NAV; 1.26% economic return
5) Apollo Investment Corp. (NASDAQ:AINV): (1.29%) decrease in NAV; 0.86% economic return
6) Fifth Street Senior Floating Rate Corp. (NASDAQ:FSFR): (1.81%) decrease in NAV; 0.23% economic return
7) Fifth Street Finance Corp. (NYSE:FSC): (8.29%) decrease in NAV; (6.03%) economic loss
* = MAIN's estimated mean of the company's NAV as of 12/31/2016 (per press release dated 1/19/2017)
My BUY, SELL, or HOLD Recommendation:
In my opinion, the following positive factors/catalysts should be highlighted for existing and potential PSEC shareholders: 1) recent modest price increases within the high yield debt market (positively impacts valuations); 2) quarterly economic returns being generated in most quarters; 3) recent refinancing/resets of some CLO investments (positively impacts projected future discounted cash flows); 4) continued strong cumulative performance regarding several control investments; 5) continued minor exposure to the oil and gas sector; 6) continued high percentage of floating-rate debt investments; 7) continued extremely large percentage of fixed-rate liabilities; and 8) notable insider purchases of common stock by the company's Chief Executive Officer ("CEO") John Barry (since 12/9/2015 has purchased 14.7 million outstanding shares of common stock [excludes all reinvestments] for a total purchase price of $98.0 million).
However, the following cautionary/negative factors should cause heightened awareness for existing and potential PSEC shareholders: 1) continued suppressed dividend and structuring/fee income (excluding the recent one-time fees associated with the Harbortouch sale); 2) recent elevated amount of loan repayments due to refinancing with other market participants (negatively impacts NII); 3) continued modest-material depreciation within several control/non-control investments (including most oil and gas portfolio companies) and increase in non-accruals during 2016; 4) "non-amendment" of the company's Investment Advisory Agreement with Prospect Capital Management L.P. (regarding the "2%/20%" fee structure); 5) continued delays regarding the company's three proposed spin-offs; 6) high weighted average cash LIBOR floor and cost of funds rate when compared to sector peers; 7) recent notable cumulative UTI decrease due to various true-down adjustments in relation to net ICTI regarding the company's CLO portfolio (negatively impacts future dividend sustainability); and 8) lack of share repurchases initiated by PSEC (the company itself; not insider purchases which do not impact the amount of dividend distributions accrued for/paid).
PSEC recently closed at $9.10 per share as of 2/10/2016. This was a ($0.52) per share discount to PSEC's NAV as of 12/31/2016 of $9.62 per share. This calculates to a price to NAV ratio of 0.9457 or a discount of (5.43%).
When combining the analysis above with various other catalysts/factors not discussed within this specific article, I currently rate PSEC as a SELL when the company's stock price is trading at less than a (12.5%) discount to my projected NAV as of 12/31/2016, a HOLD when trading at or greater than a (12.5%) but less than a (20%) discount to my projected NAV as of 12/31/2016, and a BUY when trading at or greater than a (20%) discount to my projected NAV as of 12/31/2016. These percentage ranges are unchanged when compared to my last PSEC article (approximately two weeks ago).
As such, I currently rate PSEC as a SELL. My current price target for PSEC is approximately $8.40 per share. This is currently the price where my SELL recommendation would change to a HOLD. This price target is unchanged when compared to my last PSEC article. My current re-entry price for PSEC is approximately $7.70 per share. This is currently the price where my recommendation would change to a BUY. This re-entry price is also unchanged when compared to my last PSEC article.
Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions. All trades/investments I have performed over the past few years have been disclosed to readers in "real time" (that day at the latest) via the "StockTalks" feature of Seeking Alpha. Through this resource, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered).
Disclosure: I am/we are long GBDC.
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.
Additional disclosure: I currently have no position in PSEC, AINV, FSC, FSFR, MAIN, or MCC.