Prospect Capital: The Yield Is Not Worth The Risk

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Prospect Capital has consistently failed to generate sufficient cash flow to cover dividends, leading to a significant risk of future dividend cuts.The company's NAV per share has declined ...

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You can become one too! Share your best investment idea by submitting your article for review to our editors. Get published, earn money, and unlock exclusive SA Premium access. Click here to find out more »    peshkov Introduction Prospect Capital (NASDAQ:PSEC) has not been generating sufficient cash flow to cover the dividend for several years. Significant growth in PIK interest and preferred dividends is putting the common shareholder’s dividends at increasing risk of being cut. Additionally, the poor financial management of this BDC has led to a significant erosion of shareholder value, as evidenced by the multi-year decline in NAV per share. Absent any meaningful changes in management of this BDC, shareholders should expect the NAV to continue to decline. The increasing risk of a dividend cut and a reasonable expectation of further declines in shareholder value would lead any rational investor to conclude that buying PSEC stock for its current yield is not worth the risk. Investment Objective PSEC has failed to achieve their own investment objective, which they have stated as follows: Our investment objective is to generate both current income and long-term capital appreciation through debt and equity investments. PSEC Form 10K filed 8/24/2024 for the Period Ending 6/30/2024 (Unless otherwise noted, all data used to generate the charts in this article was obtained from the company's 10k's - 6/30/2015 through 6/30/2024. All of the public filings used can be accessed directly from Seeking Alpha under \"SEC Filings\" on the PSEC Summary page.) Capital Appreciation Prospect has clearly failed at the second part of their investment objective – long term capital appreciation. Author created from public filings NAV per share declined by 13% from 2015 to 2019 and by 16.7% from 2022 to 2024. The sharp rise in value from 2020 to 2024 was due, in great part to unrealized gains, post-COVID. The declines in NAV per share resulted from realized and unrealized losses, dividends exceeding NII and an increasing number of shares outstanding. The BDC had realized losses of over $400MM in 2024 alone, a roughly $1/share impact on NAV before a positive offset from unrealized gains. Additionally, beginning in 2021, PSEC began issuing preferred stock. The claim of the preferred shares is senior to the common and is therefore dilutive to common shareholders. The additional capital raised has not been invested in a productive manner and has not benefitted common shareholders. Author created from public filings PSEC’s shares trade at a large discount to NAV and have for an extended period of time. The why is a topic of much debate. Regardless of why, the large discount makes it a poor choice for PSEC to sell shares and raise additional capital for investment, as that would result in significant dilution to common shareholders – a further decline in NAV per share. Instead, the BDC has chosen to raise capital through the issuance of preferred stock, which also causes dilution of assets available to common shareholders. Again, the question is why? I must admit I don’t have an answer for that. I can only guess that it has something to do with (1) the convertible features of the preferred shares, (2) the control provisions given to preferred shareholders based on certain events like non-payment of preferred dividends, and (3) the ownership of the preferred shares. What I do know is that the issuance of more preferred shares is bad for common shareholders in two ways – NAV per share and cash available for the common dividend are both negatively impacted. Current Income It is harder to argue that PSEC has failed to generate current income for investors. But, since 2015 the dividend has been cut twice for a total reduction of 45%, from $1.32/year/share in 2014 to the current level of $0.72/year/share. And, as stated, I believe that the current dividend is at an increasing risk of being cut again as PSEC is not generating sufficient cash flow to cover it. Is the Dividend Safe? No, I don’t believe the dividend is safe. Cash available to common shareholders only covered the annual dividend by 63% for FY 2024 and that coverage has been declining over the past few years. Additionally, given that PSEC has taken to raising capital by issuing more and more preferred stock, and unless the use of PIK interest declines significantly, the dividend coverage for common shareholders will continue to decline. While Net Investment Income is the normal metric BDC investors gravitate to when determining dividend coverage, it is not the best metric when calculating PSEC’s dividend coverage. First, as evidenced by the August 28, 2024 earnings announcement, PSEC reported the number as NII per common share. They failed to deduct the ever-growing preferred dividends from the NII, resulting in an overstatement of the amount available to common shareholders. Second, the level of PIK interest included in NII results in a very significant difference between reported income and cash available. Author created from public filings While NII “per common share” as reported by PSEC, has grown 36.3% from $0.75/share for FY 2021 to $1.02/share for FY 2024 (blue line), in reality, after deducting preferred dividends, the NII truly available to common shares (orange line) only grew by 5.0% from $0.74/share to $0.78/share over the same time frame. Both cover the $0.72/share dividend. But after deducting the preferred dividends, coverage for 2024 was only 108.3%, much lower than the 141.3% you get from the PSEC reported number. Preferred shareholders are paid before the common shareholders. PSEC has been issuing increasing amounts of preferred stock in recent years, and it is putting pressure on the coverage of the common dividend. Preferred dividends have grown from a low of $1.7MM in 2021 to $98.1MM in 2024. The final nail in the dividend coffin is the PIK interest. PIK has grown by 78.1% from 2021 to 2024 - $75.5MM to $134.5MM. Deduct this non-cash income from NII and you wind up with the grey line. Cash available to common shareholders to cover the $0.72/share dividends paid declined by 16.8% from 2021 to 2024. It declined to $0.45/share from $0.54/share. Cash coverage of the common dividend declined from 75.7% to 63.0% from 2021 to 2024. To be clear, the declining CASH coverage of the common dividend is the result of increased use of PIK interest and rapidly growing preferred dividends. Long-term Capital Depreciation Given the significant discount that PSEC shares trade at relative to NAV, other than shares issued under the DRIP program, it appears that PSEC has chosen to not raise additional capital for investment through the sale of common shares. Instead, since 2021, PSEC has raised $1.6 billion of capital through the issuance of various series of preferred stock. Either method of raising capital is dilutive to the common shareholder at this point, or at least, not accretive. Despite raising the $1.6 billion and making additional net investments of $1.7 billion over that same time frame, the NAV available to common shareholders declined by 16.7%. Author created from public filings Risks Insufficient Cash Flow PSEC does not generate sufficient cash flow from NII to cover the common dividend. The question is, is it possible for the company to fix this issue? From my perspective, it is possible but not probable. If half of PIK were to be collected (no longer PIK), the shortfall in dividend coverage would decline to roughly $0.13/share from the current level of $0.32/share. This improvement will be offset by the decline in NII resulting from declining interest rates, so it could be a $0.17/share shortfall with the current 50bp rate cut and $0.19/share at 100bp. Yes, that is only my best guesstimate, so don’t take it as a hard fact. The reduction of PIK interest would need to be accompanied by increases in dividend income and other income, but because the vast majority of the PSEC’s NII is interest income, we need to look for a significant reduction in PIK to solve the issue first. The remaining shortfall under the scenario I laid out above is still roughly $78MM. Declining NAV While I am concerned about the continued destruction of common shareholder value, it is possible, and in this case, more probable than the dividend being maintained at its current level, that PSEC may be able to record an improving NAV. This could result from declining interest rates and the resulting positive impact on portfolio companies, yielding improved cash flows and fair values. But, this would also require that the company restrict or eliminate the issuance of additional preferred stock, given the negative impact it has on common shareholder NAV. Conclusion  While many claim to have benefitted from owning Prospect Capital shares, it is crystal clear that the BDC has failed to achieve their own stated investment objective. They have been a poor steward of shareholder capital, destroying value, as evidenced by a long-term decline in NAV as well as a 45% reduction in the dividend since 2014. The increased use of PIK interest to an unacceptably high rate coupled with increasing levels of preferred dividends are putting the dividend at risk for another cut. The most recent trend of the BDC issuing preferred shares to raise capital for investment has led to continued deterioration of the coverage of the common dividend, and any further issuance will exacerbate the situation. Additionally, issuance of more preferred shares will not be accretive to NAV per common share and, if recent history is any indication, it will only serve to erode it further. Good luck to those who believe they will continue to benefit from this holding. I will not be participating as I strongly believe there will be a material reduction to the dividend and investors will see continued NAV deterioration.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","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":"4.29.1","shortVersion":"4.29.1","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/2472308524"}