PSEC: Trades At A Discount For A Reason

seekingalpha11-04 04:41

Prospect Capital (PSEC) operates as a business development company that generates its earnings through a portfolio of various debt investments.PSEC maintains a primary exposure to the real estate ...

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This presents unique sensitivity to changes in the interest rate.The current dividend yield sits above 14% but the coverage remains thin. An decrease in portfolio quality could negatively impact the coverage.Non-accruals remains incredibly low at the moment, totaling only 0.3% of fair value.The price currently trades at a massive discount to NAV. This could indicate an opportunity if PSEC can improve performance going forward.   piranka  Overview Prospect Capital (NASDAQ:PSEC) operates as a business development company that generates its earnings through a portfolio of various debt investments. What makes PSEC unique is their majority focus on real estate related companies, which gives off a bit of a mixed outlook in the current high interest rate environment. The real estate exposure makes PSEC a lot more sensitive to fluctuations in the interest rate environment compared to most other BDCs that do not have real estate exposure.  I previously covered PSEC back in June and the performance since then has been lackluster. Unfortunately, the performance on a YTD basis has been poor and I believe its because the underlying portfolio of debt investments feel the weight of elevated interest rates. On a YTD basis, we can see that the price has fallen a bit over 14%, while distributions help offset this to a negative total return of about 4.4%. Following the price deterioration, PSEC now trades at a massive discount to net asset value, which may be an opportunity if you are optimistic about the BDC's future performance. Data by YCharts What makes PSEC a bit enticing at this price point is that the current dividend yield sits slightly over 14%. Not to mention, the distributions are paid out to shareholders on a monthly basis, which can be attractive if you are an income investor that depends on the supplemental cash flow generated from your portfolio. However, further underperformance has a possibility of leading to distribution reductions if things don't improve. Therefore, I aim to provide an unbiased and updated perspective around PSEC's current financials, portfolio strategies, and outlook moving forward. Portfolio Strategy Part of PSEC's strategy is to maintain a high level of diversity across industries. However, real estate makes up the bulk of their portfolio of investments, making up 19.1% of total assets. This real estate portion of their portfolio primarily consists of multifamily properties with value-add potential and has 110 different investments in it. As a result, PSEC remains vulnerable to shifts in both the real estate sector specifically and changes in the interest rate. This exposure is followed by weight in health care providers and consumer finance, accounting for 10.6% and 9.4% respectively. The breakdown of their portfolio is as follows:  52% is dedicated towards middle market lending. These are typically to companies with an EBITDA up to $150M and consists of a senior first lien loan basis. There are 337 different investments in this segment of the portfolio. 19% is dedicated towards middle market buyouts. These consists of businesses with a high current income and have the potential for equity upside. 19% is the mentioned real estate exposure. 7% is to subordinated structured notes. This is a bit more risky because subordinated notes sit below senior secured debt in the capital structure, meaning that it has a lower priority for repayment.    PSEC Presentation It's important to note that 81% of their portfolio is structured on a first lien, secured, or underlying secured asset basis. This helps reduce the overall risk of losing invested capital in a bad deal, especially when structured on a first lien basis. First lien debt sits at the top of the capita structure and this form of debt has the highest priority for repayment. So in cases where a borrower is going through a default and liquidating assets, PSEC's debt would have first priority before other forms of debt. Valuation Since PSEC operates as a BDC, the price can trade at a difference from the underlying value of its assets. As a result, PSEC currently trades at a massive discount to NAV of 41.3%. For reference, the price has traded at an average discount to NAV of only 31.20% over the last three year period. This could indicate that PSEC is either massively undervalued or the portfolio is deteriorating in quality over time. Wall St. seems to be on the pessimistic side of the spectrum because their average price target currently sits at $4.50 per share. This would indicate a potential down side of about 12.3% from the current level. However, I remain a bit more optimistic on PSEC's turnaround.   CEF Data As mentioned, the majority of PSEC's portfolio is exposure to the real estate sector. Real estate, a sector full of businesses that are reliant on access to affordable debt financing, tends to be suppressed during times of higher interest rates. This doesn't necessarily represent anything wrong with PSEC's strategy by itself, but instead shows the natural cycle vulnerability that PSEC may have to go through. This vulnerability can be displayed by looking at the price relationship between PSEC and the federal funds rate.  When interest rates were cut to near zero levels following the pandemic in 2020, we can see that PSEC quickly moved to the upside and approached the $9 per share mark. The correlation here is that lower interest rates encourages higher levels of borrowing as the debt becomes a lot cheaper to access and hold on the balance sheet. Similarly, existing borrowers also see a bit of relief through reduced interest expenses on the loans they hold. Since debt is so cheap during times like this, it encourages these businesses to allocate these borrowed funds to growth initiatives such as acquisitions, construction of new locations, and market research and development.  Data by YCharts Conversely, when interest rates are increased, we can see that the value of PSEC instantly started to retract to the downside throughout 2022 and 2023. The Fed recently implemented their first 50 basis point interest rate cut back in mid-September and I believe that there will be additional rate cuts announced over the next twelve months. If this happens, these rate cuts can serve as a positive catalyst for growth for PSEC and its underlying borrowers. There are already estimates that anticipate cuts happening in both November and December. While I cannot provide an exact estimate when these rate cuts will happen, I do believe that there are economic indicators that help support a high probability of these cuts happening soon. For instance, the US unemployment rate has continually trended upward over the last twelve months and now sits at 4.1%. This has been accompanied by an inflation rate of 2.4% that still remains above the Fed's targeted 2% range. Not to mention, we are also getting closer to the results of the US Presidential elections, which are known to create a market environment of higher volatility and uncertainty. The combination of these factors are likely to incentivize the Fed to begin reducing interest rates. Financials & Risk Profile PSEC reported their Q4 earnings at the end of August the the results were solid. Most notably, net investment income landed at $0.25 per share for the quarter. Net investment income amounted to $102.9M, which was an improvement over Q3's amount of $94.3M, but a decrease from last year's total of $112.7M. Interest as a percentage of total investment income also remains in a similar range to prior quarters but the net income loss per share combined with the failure to grow total assets resulted in a decreased NAV. The NAV per share amounted to $8.74, a sizeable decrease from the prior year's NAV of $9.24 per share.   PSEC Q4 Earnings Additionally, originations totaled $161M but this was a decrease from the prior quarter's total of $242M. Originations refer to the amount of capital or sourcing of new loans and investments into new portfolio companies. A decreasing origination amount indicates to me that PSEC isn't trying to aggressively grow their portfolio at the moment. However, total sales and repayments increased to $253,198, which means that PSEC saw an increase in cash through the sale of assets or receiving payments from borrowers. So if they are selling off assets without investing that capital back into new deals, it comes as no surprise why the NAV would shrink. However, this is offset by news that PSEC recently boosted their revolving credit line to over $2.1B. Additionally, cash and equivalents now sit at $81.9M, which could indicate that management is simply waiting for the right opportunity to start investing a lot more cash into future growth of their business. My guess is that the amount of capital they reinvest into new deals will grow once interest rate cuts happen. Lower interest rates could cause an influx of new borrowers and opportunities for PSEC since the environment for borrowing becomes a lot more attractive. When it comes to measuring the risk profile for BDCs, I typically refer to the non-accrual rate as the first indication of the portfolio's overall health. The non-accrual rate represents the amount of underlying borrowers that are underperforming expectations and can no longer keep up with their required debt maintenance. Therefore, these borrowers are not contributing towards the BDC's reported net investment income and decreases the health of the entire portfolio. For reference, the last time I covered PSEC, the non-accrual rate sat at a very low rate of 0.4% of fair value. The most recent earnings call actually indicates that this has improved! Non-accruals now sit at 0.3% of fair value, which is a sign that the overall health of the underlying borrowers are starting to improve. I anticipate an even stronger credit quality of borrowers if the Fed continues to reduce interest rates over the next twelve months as well. Just as a point of reference, here are some relevant non-accrual rates for peer BDCs:  PennantPark Floating Rate Capital (PFLT): 1.1% non-accrual rate of fair value. Main Street Capital (MAIN): 1.2% non-accrual rate at fair value. Ares Capital (ARCC): 0.7% non-accrual rate at fair value. Capital Southwest (CSWC): 1.9% non-accrual rate at fair value.  So while PSEC has a much healthier non-accrual rate than peers, all of these peers have outperformed on a YTD basis. I believe this to be directly linked to PSEC's vulnerability to interest rates and the lack of any meaningful amount of technology focused exposure. The tech sector is where the innovation and high earnings growth companies reside, so a lack of tech exposure means that PSEC isn't able to capitalize on price and NAV growth the same way these peers are. Not to mention, all of these peers also have a strong dividend coverage than PSEC. Data by YCharts Dividend As of the latest declared monthly dividend of $0.06 per share, the current dividend yield sits at about 14%. While the yield is high, it doesn't make sense to take a position in PSEC if investors are always under the constant threat of the distribution being cut. Looking over the last decade, we can see that the dividend here has been reduced before. While the dividend has remained untouched since 2018, I still remain cautious about the sustainability just because of the fact that the coverage is so weak.   Seeking Alpha As previously mentioned, the net investment income for the last quarter came in at $0.25 per share. If we take the monthly dividend and multiply it by 3 to get a quarterly amount, we get to a quarterly distribution amount of $0.24 per share. This would indicate that the underlying earnings only cover the distribution by 104.17%. While supported at this moment, I worry that this coverage could be easily reduced by a slight uptick in non-accruals or failure to grow the portfolio with new investments over time. While the past performance is no indication of the future, it is not very reassuring. This means that long term holders of PSEC haven't received any sort of base dividend increases or supplemental distributions for the last decade. This is what ultimately makes PSEC a very unappealing pic for income investors because peers BDCs have been able to efficiently capitalize on this higher interest rate environment and reward shareholders accordingly. For instance, I recently published an article on Main Street Capital, which has been able to reward shareholders with an abundance of supplemental distributions since the pandemic. Lastly, it's worth mentioning that the distributions from PSEC are classified as ordinary dividends. Ordinary dividends have less favorable tax treatment compared to the qualified dividends that you'd receive from a more traditional dividend paying stock. Therefore, it may be best to utilize PSEC inside of a tax advantaged account to offset the potential impact of taxes. Based on your own situation and needs, I would consult with a tax professional. Takeaway  In conclusion, I maintain my Hold rating on PSEC because the financial outlook is a bit unclear. Management hasn't been increasing the rate of originations yet, but did manage to boost the revolving credit facility. This could mean they are simply waiting for the right opportunity to start aggressively allocating capital towards new investments as interest rates continue to get cut. The price currently trades at a massive discount to NAV over 41%, which could be an opportunity if you believe in the turnaround. After all, non-accruals remain incredibly low at the moment. However, the distribution coverage remains a but weak and I would prefer to see a stronger margin of coverage moving forward. I plan to revisit next quarter to see if internal performance and metrics improve. For now, I am on the sidelines and observing performance. 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