Why 9.2%-Yielding Hercules Capital Is Still A Strong Buy

Summary

• Hercules Capital remains a compelling income vehicle for high-yield investors.
• The business development company covers its dividend, on average, with NII and DNOI. Hercules Capital further has interest rate upside.
• Hercules Capital has a moderate degree of dividend safety.
• Hercules Capital's income stream sells for a premium to NAV, which is justified, in my opinion.
• An investment in HTGC yields 9.2 percent.

Hercules Capital, Inc. (NYSE:HTGC) remains a "Strong Buy" after the business development company released earnings for the second quarter yesterday. Hercules Capital has covered its dividend payout with net investment income and distributable net operating income, on average, in the last three years, and the BDC has considerable net interest income upside in a rising rate environment. Shares change hands for a justified premium to net asset value. An investment in Hercules Capital at today's price point yields 9.2 percent.

Hercules Capital - Overview

Hercules Capital is a tech-focused business development company with an equity value of ~$1.3 billion and a ~$1.6 billion debt investment portfolio. The business development company largely invests in innovative venture growth-stage companies in the technology, life sciences and sustainable and renewable technology industries.

Here's a company and portfolio snapshot.

Source: Hercules Capital Investor Presentation

Hercules Capital has seen strong asset and income growth in recent years, partly because banks have pulled back from high-risk lending after the financial crisis a decade ago.

Business development companies such as Hercules Capital have captured significant market share since, which has been reflected in a steady increase in portfolio assets and associated portfolio income.

Source: Hercules Capital

Importantly, Hercules Capital has produced strong returns for shareholders. The business development company outperformed its BDC peer group in terms of returns on equity in four out of the last five years.

Source: Hercules Capital

Interest Rate Upside

One of the most attractive features of an investment in HTGC is that the BDC has interest rate upside in a rising rate environment.

Management expects that a 25 basis point increase will benefit Hercules Capital's net interest income by $0.04/share annually. Since the Fed has become increasingly aggressive in terms of raising interest rates in 2018, Hercules Capital is a preferred income vehicle to hold during the current rate hiking cycle.

Source: Hercules Capital

Balance Sheet And NAV

Given the growth trajectory outlined above, Hercules Capital has seen a steady increase in balance sheet assets over the last couple of years. Importantly, the BDC's net asset value also has increased over time, allowing the company to raise equity at a premium valuation.

Source: Hercules Capital

The Dividend Has A Moderate Degree Of Safety

Just as importantly, Hercules Capital covered its dividend payout (on average) with both net investment income and distributable net operating income. In the last 12 quarters, the business development company pulled in $0.31/share in NII and $0.33/share in DNOI, on average, which compares to a stable quarterly dividend rate of $0.31/share.

Hercules Capital earned $0.26/share in NII and $0.29/share in DNOI in the second quarter, slightly under-earning its going dividend. However, one-time expenses of $2.4 million ($0.03/share) associated with Hercules Capital's 2024 notes redemption negatively affected those key stats. Correcting for said expenses leads to adjusted NII of $0.29/share and adjusted DNOI of $0.32/share.

Source: Achilles Research

Valuation

Hercules Capital's dividend stream sells for a ~11.7x Q2-2018 run-rate adjusted NII and ~10.7x Q2-2018 run-rate adjusted DNOI.

Hercules Capital has consistently sold for a premium to NAV in the last several years as investors value the BDC's solid performance results and stable dividend distribution.

Hercules Capital P/NAV-ratio has consistently exceeded the peer group average in the last five years.

Source: Hercules Capital

Your Takeaway

Hercules Capital is a higher-quality business development company and a promising income vehicle to hold during the current rate hiking cycle. The BDC, on average, covered its dividend payout with both net investment income and distributable net operating income in the last three years. The single most attractive feature of an investment in HTGC relates to the company's positive interest rate sensitivity: The higher rates climb, the bigger the NII benefits for Hercules Capital. Shares sell for a premium, but still have an attractive risk-reward in my opinion. Buy for income and capital appreciation.

If you like to read more of my articles, and like to be kept up to date with the companies I cover, I kindly ask you that you scroll to the top of this page and click "follow." I am largely investing in dividend paying stocks, but also venture out occasionally and cover special situations that offer appealing reward-to-risk ratios and have potential for significant capital appreciation. Above all, my immediate investment goal is to achieve financial independence.

Analyst’s Disclosure: I am/we are long HTGC. 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.