Rebuttal To Prospect Capital Corp. Unsafe At Any Price

Summary

• No, a 60% discount to NAV is not justified.
• A simple example to illustrate a crucial point on why losses in NAV must be treated at cost and not at face value.
• PSEC loss rates have never reached 3%.

This article is a rebuttal of this article, which seeks to claim that Prospect Capital Corporation (NASDAQ:PSEC) deserves a 60% discount to NAV. I dispute several facts and methods presented in this article and revise them to get a better estimate for PSEC's valuation.

Accounting For Losses In NAV

The author counts an NAV decline as a face value loss when we have acquired the NAV at a steep discount.

I have provided the calculations he used below. In his model, we have a NAV of $1000, which was acquired for $700. The problem here is that the author then counts the projected decline in NAV as a loss to the shareholder at face value. As you can see in the image below, the author treats the projected $51 decline in NAV as if the shareholder has lost $51. This is a crucial mistake that greatly impacts the end result.

Let me illustrate why this is wrong with an example:

Suppose you bought 100 $1000 par value bonds at a 30% discount, in other words $700 each. Now let's suppose a year later, 5 of these bonds completely default and are now worth $0 and the rest remain the same.

How much have you lost?

The author would have you believe that you have lost $5000, but in reality, you have lost what you paid on those 5 bonds, which is $3500.

Still not convinced?

Let me give you an extreme example. Suppose all 100 bonds default and are now worth nothing. Did you lose $100,000 or $70,000? Clearly, you lost only $70,000 because that's what you paid.

Now, to correct this, we need to discount the NAV decline in his model by the discount to NAV or the rate at which we acquired it. In his model, that means we need to discount his 5.1% loss by 30% and so the actual value should be 3.57%. This fact alone means, if we take everything else the author said to be true, PSEC at current valuations represents just under 8% shareholder return.

Loss Rate != NAV Decline

I'm going to borrow a figure from one of my previous articles here

As we can see, the annualized NAV decline since inception has been roughly 3.19%. But wait, this is NAV decline not loss rate. You see, NAV decline is the loss rate after we account for leverage. The reality is, PSEC's annualized loss rate is probably going to be closer to 2%. Now if we do some simple arithmetic, the NAV decline in this model will be roughly 3.4% and applying the discount factor yields 2.38%. Now if we factor this in, we see that shareholders are getting a ~9.6% return based on this model.

Time Value Of Money

A dollar today is worth more than a dollar tomorrow. You get dividend today, losses don't impact you until later. Considering we are factoring an expected return nearing 10% on PSEC, this actually makes a difference in valuations. This is a good reason why a dividend discount model is perhaps more accurate when trying to value PSEC.

Origination Fees?

These were notably missing from the model.

Conclusion

If we accept everything else the author has written, then this actually makes a pretty good case to go LONG PSEC as the valuation is decently attractive.

Analyst’s 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.