Prospect Capital: Upcoming Credit Issues And 11%+ Yielding Replacement

About: Prospect Capital Corporation (PSEC), Includes: CGBD, MRCC
by: BDC Buzz

This article discusses some of PSEC's recent credit issues, including one that announced Chapter 11 earlier this week that will drive at least $100 million of upcoming realized losses.

Investors should be prepared for additional book value/NAV declines.

Also discussed is an excellent replacement for selling PSEC shareholders while maintaining an 11%+ dividend yield.

Prospect Capital's (PSEC) net asset value ("NAV") per share has declined by 15% over the last 5 years and heading lower for the reasons discussed in this article. Also discussed is an excellent replacement for selling PSEC shareholders, while maintaining an 11% dividend yield.

As mentioned in my BDC Market Update blog, PSEC's portfolio company United Sporting Companies (“USC”) filed for bankruptcy earlier this week:

United Sporting Companies (“USC”) filed for bankruptcy today due to falling gun sales and tightening credit lines. The company plans to liquidate, hurt by falling sales after President Donald Trump was elected and as Dick’s Sporting Goods began moving away from firearms. In a court filing, Chief Executive Officer Bradley Johnson said USC boosted inventory before the 2016 White House race, expecting the higher sales that historically follow a Democrat’s election."

Other reasons for its Chapter 11 filing were excessive debt (including PSEC with $127 million at cost) and discounting caused by excess inventory. In its petition filed with the U.S. bankruptcy court in Wilmington, Delaware, USC said it had between $100 million and $500 million of liabilities. It plans to keep operating during the wind-down. I will discuss later in the article.

I have warned investors about USC in many previous articles, including the ones shown in the chart below like "United Sporting Companies Driving Lower NAV And Dividend Coverage".

I downgraded PSEC in early May 2017 for many reasons, including dividend coverage issues due to declining operating performance within certain investments including USC. Subsequently, PSEC cut its dividend by 28% on August 28, 2017.

As you can see in the chart below, the previous meaningful drop in stock price came after reporting March 31, 2017, results, and investors who were still long PSEC had plenty of time to get out at higher prices.

PSEC Risk Profile Update

As mentioned in previous reports, USC was already on non-accrual status and has not been contributing to income and dividend coverage but had a fair value of around $35.7 million. Worst case scenario would be a complete write-off impacting net asset value ("NAV") per share by around $0.10, and of course, at least $100 million in upcoming realized losses.

Source: SEC Filings

Also, there are accusations that its majority owner, Wellspring Capital Management, misused funds intended to support the company, that instead went to shareholders. PSEC owns about 21% of SportCo Holding, USC's parent company, and is alleging that the $160 million in financing to provided Ellett Brothers in 2012 and 2013 was "never invested in the business", according to the complaint it filed May 23, 2019.

During the three months ended March 31, 2019, the amount of investments that PSEC had on non-accrual status declined from seven to six due to Ark-La-Tex Wireline Services written off during the quarter. Non-accruals remain around 8.2% of the portfolio at cost and declined to around 3.4% at fair value (previously 3.7%) mostly due to markdowns (discussed next) in calendar Q1 2019.

For the quarter ended March 31, 2019, net asset value ("NAV") per share increased by 0.7% or $0.06 (from $9.02 to $9.08) due to overearning the dividend by $0.03 per share and net realized/unrealized gains of $14.9 million or $0.04 per share partially offset by $3.0 million of realized losses on extinguishment of debt. Similar to the previous quarter, many of the investments on non-accrual status were marked down, including Pacific World, Universal Turbine Parts, LLC and United Sporting Companies. Other meaningful markdowns include its CLOs, National Property REIT Corp (“NPRC”) and CCPI Inc. However, these were offset by large markups in Valley Electric Company (similar to the previous quarter) and First Tower Finance:

Source: SEC Filings

During calendar Q4 2018, PSEC added two of its loans to InterDent, Inc. and another one of its loans to Pacific World to non-accrual status. As mentioned in the previous report, some of my primary concerns include portfolio concentration issues, including its “top 10 investments accounting for over 40% of the portfolio” and the amount of equity investments that continues to increase “accounting for over 16% of the portfolio”. Also mentioned was that “InterDent remains one of its largest investment and needs to be watched.” Previously, PSEC extended its loans to InterDent, which were past due as well as being marked down “but still marked near cost and likely overvalued”. During calendar Q2 2018, PSEC assumed control of InterDent and marked it down an additional $11 million and during Q3 2018 made additional investments.

As shown below, PSEC has only placed around $41 million of the $244 million loans with InterDent on non-accrual. There is a chance that the other loans could be placed on non-accrual that would have a meaningful impact upcoming to dividend coverage. Also, InterDent still accounts for around $0.61 per share or 6.7% of NAV.

Source: SEC Filings

In October 2018, a $96 million loan to Pacific World was added to non-accrual status but is still marked up above cost as shown below and this investment accounts for around $0.36 per share or 3.9% of NAV.

Source: SEC Filings

PSEC Summary and Recommendations

Investors should be prepared for upcoming NAV per share declines, including United Sporting Companies, InterDent, Inc. and Pacific World that currently account for almost 12% of NAV. There will likely be additional markdowns of NPRC as discussed in previous articles.

Also, I consider PSEC to have a higher risk portfolio due to the previous rotation into higher yield assets during a period of potentially higher defaults and later stage credit cycle concerns, CLO exposure of 16% combined with real-estate 14%, online consumer loans of 3%, consumer finance of 11% and energy, oil & gas exposure of 3%. Moody’s and S&P Global Ratings also considers the CLO, real-estate and online lending to be riskier allocations that currently account for over 33% of the portfolio.

As mentioned in "Yield-Starved Investors Still Accumulating BDCs Paying More Than 10% Annually," business development companies ("BDCs") have been outperforming the S&P 500 in 2019 but are still paying above-average yields of more than 10%, including TCG BDC (CGBD) and Monroe Capital (MRCC) for the reasons discussed in recent articles.

I believe that CGBD would be an excellent replacement for investors looking to avoid the next meaningful price decline in PSEC. Please read "Time To Buy 11.3% Yielding CGBD With Upcoming Special Dividend Announcement And Share Repurchases" for a detailed discussion.

Recent Insider Purchases & Ownership:

It should be pointed out that PSEC’s CEO John Barry purchased almost $1.1 million of additional shares at prices from $6.29 to $6.34 earlier this month:

Source: GuruFocus

Disclosure: I am/we are long CGBD. 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.