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Prospect Capital: Dividend Cut Coming ?

We posted the following on Seeking Alpha after reviewing Prospect Capital’s (PSEC) latest earnings and 10-Q. Our conclusion may not be what existing PSEC shareholders may want to hear, but forewarned is forearmed. Also, we could be wrong, but we anticipate a major change in the distribution level going forward and we show our calculations straight out of the latest filing:

” We made a quick review of the 10-Q This is a $6bn BDC with multiple moving parts, and more than an average amount of footnotes to peruse, so this was not a definitive review.

Our main goal was to understand why Net Investment Income was down, whether the factors causing the decline are likely to improve/stand pat/worsen in the quarters ahead. We also wanted to determine what is happening to Taxable Income because – as we’ve written about in the prior quarter- that’s a key determinant of the future distribution and was headed downwards last we checked.

Anyway, the 10-Q generously calls out the reasons for the drop in Net Investment Income between this quarter and a year ago. (We’re on our own when comparing to last quarter and we’ll do that later). Investment Income is down about ($14.5mn), or 5 cents a share, which is a round 20% from 25 cents a share last year in the calendar IQ. The drop comes from lower income from the $1bn plus CLO portfolio. Readers of the BDC Reporter will know that CLO income has been hit by the huge refinancing wave that’s been occurring in credit. That has narrowed spreads and diminished what CLO equity holders receive, even if they’ve been able to refinance their own liabilities by a few basis points. Not surprisingly this has worked it’s way down to the income of PSEC.Unfortunately, this is not a phenomenon that’s going to go away in the next few quarters most likely. Even if the refi wave breaks, the new, lower spreads are baked in till the next credit disruption.Thankfully, credit loss expectations seem to be unchanged despite what’s happening in Retail, so this drop is all bout “technical factors” in the life cycle of CLOs.

The worser news is that the number of non-accruing loans on the books has increased from 7 to 9 and that has affected income too. That’s a whopping $183mn in loans now not generating any income. From what we can see the new names are Edmentum and Nixon (no relation to our former President). Without knowing the details, it’d hard to determine if there’s any hope of relief amongst the 9 non-accruals, but we’d be surprised and this drop in income is likely to continue. The BDC Credit Reporter will eventually get into the subject and ascertain the details.

Finally (and this is one of those items that makes PSEC so controversial), the BDC appears to have restructured its loan to one of its biggest portfolio companies (First Tower Finance) and is now charging a lower rate, which has impacted income. The prior rate was 22% (!), and has been reduced to “only” 17% (see page 33). That’s on a quarter of a billion dollar advance to the consumer finance lender, so a 5% drop adds up. This too is not going away.

With PSEC towards the top of its self stated leverage level (see the Company Presentation) we don’t see how the drop in Net Investment Income might be offset by additional lending. Nor do we expect to see a big jump in fees and dividends, which are already performing OK.

The picture where Taxable Income is concerned is murky because there’s such a delay between GAAP results (using a June year end) and the tax return, which uses an August year end and is estimated through the tax year. Still here is the problem as we see it: Last year through August 2016 PSEC paid out Net Investment Income of $356mn. However, Taxable Income coming in was only $310mn. The BDC elected a “spillback dividend” from previously booked income. Going forward PSEC has three problems: First, Taxable Income is coming in lower than GAAP Income we see in the financial statements. Second “spillback income” is diminishing (we couldn’t find the current balance but it’s common sense given that last year’s Taxable Income was lower than distributions). Third, income generally seems to be on a downward trend, as we discussed above.

Of course there may have been items in 2016’s Taxable Income calculation that brought down income that will reverse this year. We don’t know. The other two problems are not going away and PSEC has been adding to its share count so the number of shares to pay out the $1.0 a year distribution has only increased, up about 1% over last year this time.

All this points to an almost inevitable need to reduce the distribution to be in line with Taxable Income. What that number will be from the 2018 Tax Year (starting in September) is hard to say. For our purposes let’s assume 20% off the 2016 number (following the trend of Net Investment Income). That would be about $240mn on 360mn shares. That might mean a 33% drop in distributions if the goal was to pay out what was coming in.

Of course, we could be wrong and we’ve tried to be as quantitative as possible, but that’s what the filings suggest (with a few assumptions thrown in): a one third cut in the distribution coming up sometime in 2017.