Prospect Capital: Dividend Safety And Valuation Attractive, But Weaker Fundamentals Concerning

seekingalpha05-25

Prospect Capital's share price has declined double-digits over the past year due to weaker fundamentals and portfolio quality.The company's declining financials and NAV erosion are concerning, but it ...

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But while many of its peers have enjoyed strong price appreciation over the past year, the BDC has seen its share price decline double-digits over the same period, a result of its portfolio quality and weaker fundamentals. BDCs with superior underwriting quality share prices have risen while those with weaker fundamentals have lagged, some trading at a discount to their NAV prices. In this article we take a look at the company's dividend safety, latest earnings, and fundamentals to see if PSEC is worth investing in at the current price. Previous Thesis I last covered Prospect Capital this past January in an article where I rated the BDC a hold titled: Prospect Capital: Quantity Over Quality. As a dividend investor, I always buy holdings with a long-term outlook and just because they pay an attractive dividend or a higher yield doesn't make them a good investment in my opinion. I discussed the BDC's stagnant dividend growth, which has not grown the past 7 years and was cut back in 2017. I also touched on their Q1 earnings, which surprisingly saw both net investment and total investment income rise quarter-over-quarter. But since then, PSEC has went on to report its Q2 & Q3 earnings but their share price has declined roughly 16% to $5.71 where it currently trades. This is likely a result of their weaker fundamentals and portfolio quality. And although their dividend profile and valuation is currently attractive, I continue to rate the stock a hold. Earnings Update Prospect Capital reported their Q3 earnings on May 9th with a beat on net investment income by $0.03. This came in at $0.23 for the quarter, down a penny from the prior quarter and flat from Q1. Additionally, on an annualized basis, NII declined to $94.4 million from roughly $102.2 million. A likely reason for this is the company's decline in portfolio investments. During the quarter, portfolio companies stood at 122, down from 124 in the prior quarter and 128 in the first. PSEC also made originations during the latest quarter to middle-market companies and 29% in real estate. 5.6% of these were in middle-market lending and buyouts. Currently, real estate accounts for 18.4% of their total portfolio. To be fair however, PSEC is targeting what I think is solid real estate with most of their investments in triple net leases (all financial responsibilities fall on the tenants), multifamily, student housing, self-storage, and senior living facilities. And with the higher for longer environment, management is specifically targeting preferred equity investments which I think is a smart move on their part. But over the past year or so the commercial real estate market has seen weakness, so this is something investors should continue to watch out for when investing in the BDC. PSEC's management also stated during earnings that they were specifically targeting distressed sellers as there was an opportunity to take advantage of those needing capital to address other issues within the business. And while this can provide short-term gains, this speaks to their portfolio quality and will likely lead to problems if the economy experiences further uncertainty like a recession. Investing in businesses that have struggled as a result of the high interest rate environment means willingness to lend to lower-quality ones, which erodes a BDC's portfolio quality over time. This in turn, could lead to higher non-accruals, PIK income and ultimately could lead to lower financials in the foreseeable future. So, while lenders can negotiate better deals on the front end, this is a a long-term issue for a temporary gain. Total investment income also declined 6% year-over-year from $215.1 million to $202.2 million. This was $210.94 million in the prior quarter. So, from a financial standpoint, PSEC hasn't been performing as well as many of its peers, which is likely the reason for the share price decline over the last 4 months. Data by YChartsOver the past year, PSEC has underperformed, down roughly 10%. This is in comparison to their monthly paying peer PennantPark Floating Rate Capital (PFLT), who is up nearly 3.5% over the same period. So, while many BDCs have rewarded their shareholders with special and supplemental dividends on top of strong share price appreciation, PSEC has done neither, which makes them an unattractive investment in my opinion. Data by YChartsConcerning NAV Decline Another concerning metric aside from their declining financials year-over-year is their continued NAV erosion. During their Q3, PSEC's NAV continued to erode with a price of $8.99. This is a 2.7% decline from $9.24 in the first quarter. However, this did rise from $8.92 in the prior quarter but still something shareholders should be concerned with when investing.   Author creationSome BDCs do experience a slight decline in their NAV or NII as a result of dividend payments or timing of loan repayments. But a constant decline is something that should start to worry investors. This usually speaks to the BDC's underwriting ability and portfolio quality. Peer, PennantPark's NAV grew quarter-over-quarter and on an annualized basis from $11.15 to $11.40. Higher-quality BDCs like Ares Capital (ARCC), Blackstone Secured Lending (BXSL), and Main Street Capital (MAIN) have all seen their NAV grow on an annualized basis. Moreover, if management can turn things around and continue growing their portfolio at a healthy rate, and see some healthy NAV growth in the next two quarters, then I would consider upgrading the stock a buy. There's Some Good Investing In PSEC Although the BDC's declining financials and NAV erosion concerns me, there are some positives when investing in PSEC. First, you get a monthly dividend that's covered by net investment income. During the quarter NII was $0.23 or $94.4 million. This covers the quarterly payout of $0.18, giving PSEC dividend coverage of 127%, which is very comfortable. This is actually higher than its peers PennantPark, who brought in net investment income of $0.31 during its latest Q2 earnings. Using their monthly dividend of $.1025, this would give them quarterly coverage of roughly 101%. PSEC also paid roughly $74.7 million in dividends giving them a safe payout ratio of 79.1% for the quarter. Through 3 quarters PSEC has earned roughly $317 million in NII and paid nearly $222 million in distributions, giving them an even lower payout ratio. As seen by their conservative payout ratio, I think it would behoove management to repurchase shares while the company trades at a significant discount to its NAV. This would not only likely increase shareholder confidence, but further strengthen their dividend payout ratio as well. Furthermore, management declared dividend payments for the months of June through September, which speaks to their confidence in their ability to reward shareholders. So, from a dividend standpoint, PSEC is an attractive investment as their dividend safety remain intact despite their NAV erosion and declining financials year-over-year. Author creationLow Leverage PSEC's leverage level at quarter's end was also low at just 0.46x, putting them in a strong position financially. This is in comparison to PennantPark's 1.2x at the end of their Q2. Their debt maturities are also well-laddered with none maturing until 2025. They are also investment-grade rated by S&P and Moody's, which gives them cheaper access to capital than its non-rated peers. PSEC investor presentationUndervalued Another reason PSEC may be attractive is their current share price. At a P/NAV ratio of roughly 0.63x, the BDC is well-below its 3-year average discount of 27.66%. Most BDC peers trade at premiums well above their NAV prices. But seeing by the company's NAV erosion and unimpressive financials, you can understand why the market is pricing them at a discount to its NAV price. But as previously mentioned, the stock from a dividend standpoint is attractive as it's hard to find many BDCs trading at a discount as a result of the high interest rate environment. Additionally, their discount of roughly 37% is higher than their 3-year average discount as previously mentioned. So, from a valuation standpoint, the BDC also appears attractive. However, Wall Street rates the stock a sell, likely a result of the constant NAV decline and headwinds PSEC has faced in the high interest rate environment. Although I'm not ready to give them a sell rating just yet due to their solid balance sheet and well-covered dividend, if NAV continues to erode, then I think the stock would warrant a sell rating from my viewpoint. But with interest rates likely at their peak and financial conditions likely to become more favorable in the next 4-6 months, I'm willing to give PSEC a shot at redemption, hence the hold rating for now.   Seeking AlphaRisks The high interest rate environment has placed downward pressure on BDCs, especially those considered to be lower quality. As a result, their share prices have lagged. Aside from lower-quality borrowers feeling the effects of high for longer interest rates, PSEC's exposure to real estate should also be of concern. That being said, management has been increasing their exposure to first-lien loans, putting the portfolio in a more defensive position. At quarter's end, first-lien exposure was 59%, up from 54.4% year-over-year. Another risk the company faces is a continued decline in its NAV, which will likely negatively impact their share price moving forward. Bottom Line PSEC has underperformed the broader market and several of its peers, likely a result of their declining financials, real estate exposure, and NAV erosion. But as a result of this, their share price now trades at a steeper discount than their 3-year average, making them attractive.  Furthermore, their monthly dividend remains safe with a 70% payout ratio through the first 9 months of the fiscal year. Moreover, if interest rates remain higher for longer, PSEC will likely continue to face headwinds due to its real estate exposure and preference to lend to distressed sellers. Although the valuation and dividend is attractive, I continue to rate Prospect Capital a hold for now.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.0","shortVersion":"4.24.0","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2438078264"}