TPVG - Hercules Capital: This 10% Yield Is Solidly Covered By NII (Upgrade)

2023-11-14 08:00:00 ET

Summary

• Hercules Capital remains a top choice for passive income investors despite a high premium to NAV.
• The BDC showed strong growth in net investment income and benefited from floating-rate debt investments.
• Credit quality remained solid, with only a slight deterioration, making Hercules Capital a safe investment with a 10% yield.

Hercules Capital, Inc. (HTGC) , despite a big 47% premium to NAV, remains an anchor BDC investment for passive income investors. The BDC produced robust results for the third quarter driven by an ongoing upswing in NII and which was supported by the BDC's floating-rate debt investments.

Credit quality suffered a bit, but overall credit quality, portfolio performance and non-accruals look good. As a leading specialty BDC, with a focus on tech companies, I think that Hercules Capital is a great choice for passive income investors that require predictable dividend income from their high-yield stock investments.

My Rating History

A full valuation recovery took place for Hercules Capital in August . Based on Hercules Capital's third quarter earnings, the BDC continued to show strength in NII and is set to profit from ongoing rate hikes.

The BDC's portfolio quality did experience a bit of a deterioration as one more debt investment was added to the company's non-accruals, but the earnings release in its totality was strong.

I think that the drop in BDC's NAV valuation, solid overall credit quality and big jump in NII are reasons for passive income investors to buy HTGC, despite its high NAV multiple.

Strong Growth In Net Investment Income

Hercules Capital positioned itself for rising interest rates and presently has 96% of its investments invested into floating-rate debt. Hercules Capital's investments remained largely concentrated in First Liens, which accounted for 83% of investments, in the third quarter whereas Second Liens accounted for 10% of investments. The remainder was spread out over Unsecured Debt investments and Equity. In total, Hercules Capital's debt investment portfolio was valued at $3.1 billion.

In the third quarter, as well as throughout the last year, Hercules Capital has seen substantial NII tailwinds from rising interest rates. The BDC's interest and dividend income in 3Q-23 totaled $110.3 million, reflecting a boost of 36% YoY. Hercules Capital's NII surged 54% YoY to $76.8 million which also was a new record for the BDC.

The growth in NII and, hence, the generation of excess portfolio income, was the reason why the BDC declared $0.08 per share per quarter supplemental distributions this year.

Credit Quality

Hercules Capital's credit quality, the last time a check was possible in the second quarter, was extraordinary: the BDC had a non-accrual ratio of 0.0% (based on fair value) and it had only one debt investment that was non-performing.

In the third quarter, Hercules Capital put one more debt investment on non-accrual which caused the non-accrual ratio to increase to 0.8%, (2 total debt investments were on non-accrual status at the end of 3Q-23), reflecting an investment value of $24.6 million. Overall, HTGC's credit quality remained solid.

Hercules Capital has been positioned for higher interest rates for a while and the BDC's latest interest rate table shows that the net effect on higher rates is a positive one for the BDC.

A 50-basis point increase in the prime rate is expected to yield $0.08 per share in incremental earnings per share. For BDC and its shareholders, of course, a decrease in interest rates would be a negative catalyst for earnings growth.

A Look At Hercules Capital's Debt

Hercules Capital has a well-staggered debt maturity table that shows that the BDC has no substantial near-term debt maturities. Between 2023 and 2024, Hercules Capital has just $275 million in maturities, meaning the BDC won't have to refinance the majority of its debt at high present interest rates.

Hercules Capital's weighted average cost of debt was approximately 4.8% in 3Q-23, reflecting a 0.4 percentage point increase compared to the year ago period. The higher weighted average cost of debt was due to the rise in interest rates but also because of an increase in outstanding debt: Hercules Capital had $1.6 billion in weighted average debt outstanding at the end of 3Q-23 compared to $1.4 billion in 3Q-22.

Hercules Capital's debt structure mainly consists of long-duration notes that give the BDC ample of time to refinance its debt. Since the expectation is for interest rates to fall in 2024 , I think that Hercules Capital will be able to refinance most of its debt at a lower weighted average cost of capital than 4.8%.

Since Hercules Capital is overwhelmingly positioned in floating-rate assets and about 50% of the company's total capitalization includes Equity, a rise in interest rates will benefit HTGC more on the asset side than it hurts the BDC on the liability side.

Why I Think The 10% Yield Is Safe

Hercules Capital earned $0.52 per share in NII in the third quarter which reflected an increase of 33% year on year. The growth in NII has been driven by new originations, rising yields in the debt portfolio as well as positive tailwinds from higher interest rates.

The dividend coverage ratio in the third quarter amounted to a solid 130% which reflects a minimal decline compared to the second quarter dividend coverage ratio of 136%.

Hercules Capital already declared $0.48 per share in dividends for the third quarter and this pay-out includes a $0.08 per share supplemental dividend. Including the supplemental dividend, Hercules Capital had a 3Q-23 dividend coverage ratio of 108%.

Trading At A Premium Valuation For A Reason

I wrote about a peer BDC in the tech sector recently, TriplePoint Venture Growth BDC, Inc. ( TPVG ) ,in which I said that despite a high percentage of bad loans in the portfolio, good dividend coverage and a discount to NAV were good enough reasons to acquire TPVG stock .

Hercules Capital, on the contrary, is selling at a big premium to NAV because the BDC has a solid history of growing its NII over time (it was up 15% on average annually since 2012) and distributed excess portfolio income to shareholders consistently.

Also a point: the dividend has been solidly covered by NII (see above). The result has been a 47% premium to NAV (based on a 3Q-23 NAV of $10.93) which makes HTGC one of the most expensive BDCs for passive income investors.

Key Risks For Passive Income Investors

Hercules Capital profits from higher interest rates as long as the central bank is on a quest to counteract inflation, but clearly interest rates are tapering off.

With interest rates probably set to fall in 2024, the BDC's high floating-rate exposure is set to lead to falling NII as well. Though the dividend is still well-covered, I would expect a decline in the degree of excess dividend coverage. I don't see the dividend at risk, but a lower margin of dividend safety may be on the horizon for Hercules Capital.

My Conclusion

Hercules Capital is one of the best-managed BDCs that I have analysed so far: The BDC still has solid portfolio quality despite a QoQ increase), has a reasonable degree of diversification build into its portfolio (through the inclusion of Equity and Warrant positions), a strong tilt towards floating-rate loans which translates to NII upside, and offers passive income investors a covered 10% yield.

Other BDCs are available to passive income investors that offer higher dividend yields, but Hercules Capital has delivered strong results (in terms of portfolio, NAV and NII growth) for a very long period of time. The 10% yield, in my view, is one of the best and safest BDC yields that passive income investors can buy in the BDC sector. Strong Buy.

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