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Prospect Capital: Differing Views Following The Earnings Release

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NEWS

As reported in the BDC Daily News, Prospect Capital (PSEC) reported IVQ and full year results for the period ended June 2018 on August 28,2018.

Net Investment Income Per Share at $0.22 was above the prior quarter and analyst expectations.

Moreover, book value increased to $9.35, from $9.23 the quarter before and $9.32 a year previously.

The monthly dividend remained unchanged at $0.06 per share.

The market was surprised by the better-than-expected results and has pushed the stock price up to $7.58 at the close on August 30, an increase of 7.0% on a dividend adjusted basis.

PSEC has been on an upward price trend since May 3, 2018, up 20.0% as of August 30, 2018. See the chart below:

However, not all market analysts are impressed by PSEC”s results or ultimate prospects.

On August 31, 2018 National Securities reiterated its SELL Rating and set a $4 price target, a 47% reduction from the current level.


ANALYSIS

Here are the bullet points made by Chris Testa of National Securities:

  • “PSEC earned NII/share of $0.22 for fiscal 4Q18 versus our estimate of $0.19 and the dividend of $0.18.  Interest income from control investments jumped to $56.1 million from $45.9 million sequentially Q/Q and CLO equity income increased to $34.7 million from $31.3 million Q/Q.

  • While we can understand that resets and refinances in prior quarters drove increased GAAP effective yield on CLO equity and thus more income, we think a quarterly increase of 22% in interest income from controlled investments is worthy of significant skepticism. 

  • First Tower had its PIK interest rate increased by 300 bps on the quarter and the position was marked up by $7.0 million. For fiscal 2018, NPRC recorded $8.8 million of “other income” compared with zero the previous fiscal year, with management citing structuring fees and to a lesser extent royalty agreements.  We are unsure of why structuring fees were not earned in previous years or at least not recorded as “other income” within NPRC.

  • The company exercised its warrants to take a control position in Interdent, a company we previously had written about.  In the 9/30/17 quarter PSEC magically pushed out the maturity to 12/31/17 despite it being due 8/3/17, didn’t define it as past due or non-accrual, barely wrote it down, reduced the LIBOR spread by 425 bps, now finally acknowledges “customer attrition” and that it is past due, which is good for being marked at 93 cents of cost, apparently.  We’re scratching our heads wondering how this can go on. 

  • We are revising our fiscal 2019 NII/share estimate to $0.74 from $0.65 and rolling out our fiscal 2020 NII/share estimate of $0.65.  Our $4 price target represents a 53% discount to our fiscal 4Q20 NAV/share estimate of $8.49 which we believe is fully warranted given what we feel are outlandish marks and inflated portfolio company valuations”. 


VIEWS

Potato and Po-Tah-To

We speak regularly with Mr Testa about a wide range of BDCs and have a great deal of respect for his analysis.

As a result, we were intrigued by the wide divergence between National Securities view and that of the market.

End Up In Same Place

While we do not agree with Mr Testa on every BDC, our own research reaches similar conclusions about PSEC – a perennially controversial BDC.

With the publication of the BDC’s 10-K we had an opportunity to take a first pass review of the portfolio, including some of the items covered by National Securities.

Historical Record

Concern about PSEC is in order – short term investor enthusiasm notwithstanding – because credit and financial performance has been mediocre in recent years.

Although NAV Per Share increased this quarter, since FY 2014 PSEC’s book value per share has dropped 11.5%, from $10.56 to the current level.

Moreover, PSEC has registered material credit losses in each of the past 3 years totaling $139.2mn, or about 14% of net Investment Income in the period.

In this past fiscal year the losses included a loss of $3mn in Primesport Inc. and a $14mn realized loss on Nixon, Inc. and a small loss on RGIS Services, LLC.

Can’t Pay. Won’t Pay.

Moreover – one of the metrics most (over) used by investors – also increased sharply in FY 2018: the cost and fair value of loans on non-accrual.

As page 171 of the 10-K discusses – although the number of non-performing loans dropped from 7 to 5 – the dollars involved increased.

At June 2017, non accruing loans at cost were $316mn, 10% higher than the year before.

At fair market value, these loans were valued at $144mn, suggesting poor recovery prospects.

As a percentage of total assets, non accruals at fair value increased to 2.5% from 1.3% in the prior quarter, a worrying trend.

Know Thyself

Then there are reasonable – and long standing – concerns about risk taking at PSEC, which the Investment Advisor does not admit to.

In fact, on Conference Calls and in presentations, the managers of PSEC deliver the message that the BDC is conservative and a low risk taker.

Here’s an example from the latest Conference Call:

We have learned when it is more productive to reduce risk than to reach for yield, and the current environment is one of those time periods”.

Not Borne Out

Yet the 10-K shows that the investment yield – at a time of spread compression – on income producing assets was 13.0% at June 30, 2018, up from 12.9% the quarter before and 12.2% a year earlier.

Moreover, PSEC continues to have the largest proportion of CLO equity and debt tranches in its portfolio of any larger BDC.

At June 30, 2018 the BDC had invested nearly $1bn in CLO investments.

Heavy Load

Again, the BDC’s own disclosures show that this junior capital in 4 dozen CLOs sits underneath a mountain of $18bn of debt.

In fact, total assets in the CLOs (almost all in the form of debt) are nearly four times as large as non-CLO assets on PSEC’s own books.

Cash yields in the latest quarter on these CLO investments exceeded 20%, which should say enough about the risks embedded in investing in these instruments.

Starting Point

So – in a nutshell – National Securities, the BDC Reporter and others have reason to be vigilant and concerned where PSEC is concerned even if some shareholders seem untroubled.

This quarter – as on prior occasions – the locus of concern – as expressed by Mr Testa in his analysis – is the validity of income and asset values of PSEC’s Control and Affiliate investments.

These are investments which PSEC completely or partly exercises legal control.

As a result – and a frequent cause of controversy – PSEC has great latitude in setting pricing and investment values.

In dollar terms these Control/Affiliate investments represent an ever greater proportion of PSEC’s total portfolio (42% as of June 2018).

80/20 Rule Or Thereabouts

Yet, the number of investments involved – as we’ll discuss in greater detail – is relatively small and most the value and income is derived from just 2 names in a PSEC portfolio of 135 different counterparties.

We count 20 Control and Affiliate companies.

Of those, let’s leave out 2 with no value (written off Nixon Inc and Wolf Energy).

That leaves us 18 names.

Of those 11 are under-performing to varying degrees and are on our Watch List.

Included therein are 3 or 4 names (the variable is Interdent – discussed by National Securities).

Effectively only 7 of the Control/Affiliate names are performing normally.

Two of those seven are non income producing investments with little in FMV (Targus International and Gulf Coast Machine & Supply).

We are now left with just 5 names: CCPI Inc, Credit Central Loan Company, Echelon Transportation and – most importantly – First Tower Finance and National Property REIT Corp.

These all generate income and have been copiously valued by PSEC.

Context

We counted $344mn in fair value over cost in these 5 companies (to be called the Famous Five) , of which $317mn was concentrated in the last two names, or over 90%.

In toto these 5 companies have a FMV of $1.692bn or 30% of the entire portfolio and 35% if we leave out CLOs.

First Tower and National Property have a value together of $1.5bn or over a quarter of the entire portfolio and nearly a third of the BDC’s investments in portfolio companies (as opposed to special purpose vehicles).

To put that into further proportion, $1.5bn represents 44% of PSEC’s book equity and 55% of its market value.

Stating The Obvious

It’s fair to say what happens to these two Control investments will be critical to PSEC.

Don’t Ask. Don’t Tell.

Unfortunately, we know very little about the inner workings of any Control investment.

The irony is that these types of companies tend to be even more opaque than non controlled investments where we often get the benefit of other BDCs valuations and the presence of third parties.

Thank Goodness For Quarterly Reporting. (You Get The Reference).

What we do know – at least for the BDC Reporter – is often worrying.

For example, we note that loan pricing on Control companies is often far higher than in Non Control businesses.

All the Famous Five have one or more loans on the books priced at a yield above 12.00%, and four have yields above 15%.

National Property REIT charges LIBOR + 6.0% plus 10.50 PIK, according to the 10-K.

CCPI has a Term Loan B priced at 12.00% plus a 7.00% PIK, or 19%.

Credit Central is paying 10% cash interest and a 10% PIK on its Subordinated Loan.

Compared To Regular Borrowers

These are not market rates and unlikely to be sustainable.

We looked through the hardly inexpensive non-control, non-affiliate loan portfolio of 65 different borrowers and could not find one borrower who had agreed to pay over 15% on any loan.

Only a handful were being charged over 12.00% as even second lien advances are being priced below that level.

Everyone’s Doing It

Nor was it only the Famous Five paying very, very high rates in the Control/Affiliate group.

All the performing Control companies with any kind of debt were paying between 12.00% and 20.00% for the privilege of borrowing from their parent.

Nor – as we mentioned above – are all these businesses doing so well that they can afford to pay 60%-80% more than the going rate.

Very often the equity or Preferred of these companies have been written down substantially but are paying rates well above 15%.

This Is Us

Everybody assesss acceptable risk differently.

For the BDC Reporter’s part this mix of heavy concentration in a small (tiny ?) number of Control companies; the unsustainably high interest rates being charged; the frequent chopping and changing of the structure and valuations of the businesses (a subject which have not broached above, but is referenced by National Securities in their report) and the absence of much in the way of company information is unacceptably high.

Add to that the high exposure to BDC equity – whose income may be switched off in a financial crisis or recession.

Big Picture

That leaves – by our rough calculation – PSEC with $2.31bn of non-Control/Affiliate, non-CLO investments (performing decently but hardly without their own challenges).

At the same time PSEC also has debt outstanding of $2.3bn.

If things should go south, they might go and never come back.

From our standpoint – and here we differ with Mr Testa – there is no appropriate Target Price for PSEC even at $4.0 given that we know so little about the true credit quality of the portfolio.

Shareholders could wake up one morning and find out some hard truths which could cause the stock price to tank to some unknown depth.

That level of risk is not worth any yield PSEC might currently be paying.

To Be Fair

Of course,PSEC may continue to motor along without fear or favor.

After all, this management team has been in place for over a decade and this investment strategy for many years.

In fact, the stock price might rise further.

No Go Zone

Nonetheless – and without any hesitation given the huge uncertainties involved – we won’t be placing ourselves at risk.

Going Nowhere

We continue to keep an open mind and will continue to monitor the situation every quarter.

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