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Prospect Capital: IVQ 2016 Earnings

BACKGROUND: Prospect Capital (PSEC) announced fourth quarter earnings after the close on February 8, 2017. Some observers have been concerned about the ability of the Company to maintain its $0.25 a quarter/$1.00 a year distribution following a soft IIIQ 2016, when Net Investment Income Per Share (which we call NIIPS) dropped to $0.22 for the quarter. Many investors look at Net Investment Income “coverage” of a BDC’s distribution liability as a key factor in determining whether a pay-out is sustainable, or likely to be cut. The Company sought to address such concerns in its press release at the time in an unusually direct way, by arguing what “could have been” if the BDC had been “fully invested: Here is an extract from the press release at the time:

…We were underinvested during the first half of fiscal 2017, carrying an average cash balance of $167.7 million. If we had booked another $460 million of 10% annualized coupon earning assets July 1, 2016, utilizing our uninvested cash and financing the remainder (approximately $300 million) from our revolving credit facility, our fiscal year to date NII would have increased by $14.5 million, before any structuring fee income earned in connection with such originations.

NEWS:

“Associated Press

NEW YORK (AP) _ Prospect Capital Corp. (PSEC) on Wednesday reported fiscal second-quarter net income of $100.9 million, after reporting a loss in the same period a year earlier.

The New York-based company said it had profit of 28 cents per share. Earnings, adjusted for investment gains, were 24 cents per share.

The results beat Wall Street expectations. The average estimate of five analysts surveyed by Zacks Investment Research was for earnings of 23 cents per share.

The business development company posted revenue of $183.5 million in the period, which missed Street forecasts. Three analysts surveyed by Zacks expected $184.8 million.

Prospect Capital shares have climbed nearly 5 percent since the beginning of the year. In the final minutes of trading on Wednesday, shares hit $8.76, a rise of 54 percent in the last 12 months.”

Here is the full press release from Prospect Capital itself for the IVQ 2016.

Judging from the AP’s comments, and the fact that NIIPS jumped to $0.24 from $0.22, and the positive market reaction, everything is OK at PSEC. Right ?

Unfortunately, we don’t think so as we’ll explain at length, as well as trying to explain why evaluating a dividend’s sustainability by looking at NIIPS is a dangerous short hand for investors.

HORSE’S MOUTH

We are helped in this endeavor by PSEC’s own earnings release for the quarter.

In an unusual departure for a BDC earnings release, the Company provided a considerable amount of information about the status of its Taxable Income.

TAX MAN

Of course, a BDC’s distributions to shareholders are not paid out of Net Income (like many corporations), or even on Net Investment Income but from Taxable Income.

However, the problem for most BDCs is that-like your tax liability and mine-a BDC never knows what it’s tax position is until months after a financial reporting period is past.

Many BDCs even have tax years that differ from their financial reporting year.

GUESS WORK

That’s why if you read any BDC’s quarterly filing disclosure about its current taxable income it is very vague to the point of being useless.

This issue is compounded in any BDC where there is a wide discrepancy between how taxable income and GAAP income is calculated.

Spoiler Alert: CLO investments are subject to highly complex tax calculations which can vary widely from GAAP.

BDC Chief Financial Officers-and a battery of tax accountants-just have to do their best until the end of the tax year rolls around and make reasonable estimates.

PSEC must be a nightmare for tax evaluations given the eleven different business segments in which the BDC invests, its huge size and complex accounting.

CLO ELEPHANT IN THE ROOM

Compounding the problem-and at the center of this quarter’s earnings release-is PSEC’s major exposure to Collateralized Loan Obligations equity investments:

As of December 31, 2016 we were invested in 41 structured credit investments with a fair value of $1.09 billion

That’s nearly a fifth of PSEC’s total portfolio assets, which are just under 6.0bn.

QUICK SUMMARY

Here’s what happened in a nutshell as far as we can tell from the press release:

In recent weeks PSEC re-calculated the taxable income generated from those CLO investments as far back as calendar 2015, and through much of last year.

Remember the mini-crisis in the leveraged debt market in the fourth quarter of 2015 and through the first 6 weeks of 2016 ?

Spreads were widening, new loan activity was slowing and existing loans were trading at increasing discounts to par.

The managers of many of these CLOs sold some of their loan assets during this period at less than they had paid for them.

Ding ! Taxable Loss. Impact on GAAP: None.

BOTTOM LINE IMPACT

However, it’s taken many months for the news to filter through to PSEC.

As a result, PSEC has had to re-calculate its Taxable Income for several quarters.

Taxable Income for the IVQ 2016 was $0.20 per share, same as for the IIIQ 2016.

That means Taxable Income over the last two quarters was 13% below GAAP Net Investment Per Share.

Taxable Income Per Share was 20% below the shareholder pay-out.

LESS TO SPILL

What’s more, PSEC had to greatly reduce its “Spillback” balance.

Spillback is essentially undistributed shareholders taxable income from prior periods.

Some BDCs and many investors take comfort in Spillback income being available to meet future dividend obligations as if this was a savings account that can be tapped when needed.

In fact, given the uncertainty about what the final tax liability might be, Spillback is just an estimate, and is subject to constant adjustment.

That was very much the case for PSEC this quarter. Spillback has been reduced by two-thirds at a stroke of the pen:

In the prior quarter, we estimated that our available spillback income was $96.6 million, $62.2 million more than the $34.4 million reported this quarter.

That’s $0.17 per share gone, or about two months of distributions.

As a result, PSEC has only $34mn of Spillback at December 2016, equal to $0.10 a share, to “subsidize” any future shortfall in Taxable Income versus the distribution liability.

WHAT NEXT ?

PSEC has very appropriately pointed out that new assets purchased by CLO Managers at a discount to par during the IVQ 2015-early 2016 should eventually result in taxable income and taxable gains.

This will happen “in the future”, but begs the question as to what will be happening in the next few quarters.

With Taxable Income already running at a 20% lower level than distributions, and the Spillback shrunken (or possibly non-existent as a recalculation can happen at any time, as PSEC states in its press release), can PSEC generate enough income to pay out in distributions in 2017 ?

If not, will PSEC maintain the distribution, which will result in shareholders receiving their pay-out partly as a return of capital ?

Or will the distribution need to be cut from its $1.0 per share annual level ?

FULLY STRETCHED

Before we answer our own question, it’s fair to say PSEC is scouring every nook and cranny to boost investment income.

The BDC’s overall yield-at a time when most BDCs are suffering from the impact of narrower spreads-was up at 13.2%, up 0.4% in just one quarter.

That’s one of the highest portfolio yields of any BDC, and is even more remarkable given the $6bn size of the portfolio.

To achieve this feat PSEC is greatly aided by the CLO portfolio, which contributes more than a fifth of GAAP income thanks to an “annualized GAAP yield” of 14.8%.

Then there’s an increasing foray into consumer lending, which PSEC calls out in its press release:

…We…continued our investment in the online lending industry with a focus on super-prime, prime, and near-prime consumer and small business borrowers. We … currently have exposure to $846.6 million of loans directly and through securitization interests, across multiple origination and underwriting platforms. Our online business is currently delivering a yield on our invested capital exceeding 14% (net of all incurred costs and expected losses).

It’s hard to imagine any shortfall in investment income can be generated from further pumping up portfolio yield, but you never know.

GROWING THE BOOK

Another avenue-which the Company continues to point to in its press release-is to increase the size of the portfolio.

To return to a portfolio size equal to that of year-end 2015, PSEC will need to add about $250mn in new yielding assets, or about 4% asset growth.

Using the 10% yield bogey PSEC itself suggests, we estimate that could add 4 cents a share a year, or 1 cent a quarter, after deducting management fees and incremental expenses.

Will that be enough to make up for the shortfall in Taxable Income that’s shown up in the last six months ?

We don’t think so.

WHAT ARE THEY WAITING FOR ?

PSEC’s own press release shows that in the last six months Distributable Income (i.e. Taxable Income) is running $33mn behind distributions paid out.

That’s $66mn annualized.

If you think in cash terms (PSEC has a lot of Pay In Kind income) the number is more like $84mn, or $0.23 a share.

So why not “right-size” the dividend level now ? (In fact, the Company has already announced distributions through April 2017) ?

HIGH HOPES

We’re guessing that management is hoping that some combination of higher rates, new CLO tax estimates and more investments will do the trick.

Maybe the increase in second lien investing in the quarter is related to the need to narrow the gap between Taxable Income and distributions.

Cutting the dividend will cause the now familiar uproar amongst investors which any BDC seeks to avoid if possible.

PSEC- which has huge flexibility in what it invests in and controls a third of its investments-may just be able to pull it off.

CONCLUSION

However, the BDC Reporter’s own view (which is where we started this essay) is that something will have to give, and the likeliest candidate is the distribution.

It’s not a certainty (what is ?) but existing and prospective shareholders may want to consider the issue at a time when the stock price is rising to a level not reached since December 2014.

POST SCRIPT

We just listened to the PSEC Conference Call and were disappointed both by management and the analysts involved.

Neither side made any comment about the big drop in Taxable Income and the two-thirds reduction in Spillback income, or anything covered above.

That’s despite the fact that the subject represented a goodly portion of the earnings press release and represents a major development.

Maybe the BDC Reporter is over-reacting and this drop in Taxable Income will pass like a summer storm.

Nonetheless, we’re surprised that nobody sought fit to even discuss the subject…