HRZN - Is Horizon Technology's 11% Yield Sustainable?

2023-06-28 06:49:10 ET

Summary

• Horizon Technology Finance, a business development company, currently offers an 11% dividend yield. The company invests in development-stage companies, particularly those with products already generating revenue and backed by established venture capital firms.
• The sustainability of Horizon's dividends depends on factors such as market liquidity and the potential for a deep recession.
• While I expect the company to sustain its dividend under most market conditions, I don't expect them to grow much either.

Horizon Technology Finance ( HRZN ) is a business development company that currently pays a generous dividend yield of 11%. In this article, we will examine the sustainability of such dividends.

The company mainly focuses on funding development-stage companies and mostly uses secured debt as its main investment vehicle. It generally operates in technology, healthcare, life sciences, sustainability and information services industries and mainly invests in companies located and operating within the US.

Horizon is somewhat picky about what type of companies it invests in. The company mostly invests in companies that already have one or more products generating revenues and are close to turning a profit if not already turning one. It doesn't invest in companies in the early stages of their development such as the conception stage. Also, almost every business invested by Horizon is already backed by at least one established venture capital firm, so the company is almost never alone in its investments.

In this particular business, the best time for business development companies to invest in a company is shortly before it makes an IPO or gets acquired. This will allow them to make large profits without taking on a huge risk, but there are also time periods like the last year or two where IPO activity has mostly dried up (especially compared to the highly exceptional 2020-2021 period where we'd see several IPOs every week and almost every IPO was an instant success). When IPO activity and acquisitions dry up due to tighter liquidity in the overall market, payouts will be less generous for business development companies.

One of the advantages of business development companies like Horizon is that they don't have to worry about bank runs the same way regional banks are. BDCs don't have depositors, and they don't have to worry about people panicking and pulling their money away in a very quick fashion. Obviously, the biggest risk for these companies is a deep recession and tight liquidity conditions because many of this company's customers are already struggling to turn a profit as it is (not because they are inherently bad businesses but because they are mostly start-ups that are getting established) and they are hungry for cash. When cash dries up, they can have trouble paying off their debt in a timely manner.

Now that we discussed the company's business and how it operates, let's talk about numbers. In the last decade, HRZN's performance resulted in a total return of 151% but all of this performance came from dividends since the stock price is actually down 11% during this period. The company's stock performance suffered greatly since 2022 due to the Fed's tightening actions and interest rates rising. The pain could continue on for a bit more while the Fed continues hiking rates, but it is also more likely that the worst of the Fed's tightening is already behind us, and it will be much less aggressive moving forward unless inflation suddenly blows up unexpectedly.

The stock's dividend yield is very rich, but it also has a history of reducing dividends in the last decade, which I find more worrisome than the fact that the stock price has been down 11% in the last decade. Basically, the company's annual dividends dropped from $1.38 to $1.26 between 2013 and 2023. This may not sound too bad at a first glance, but keep in mind that this looks worse when you factor in the inflation we've seen in the last decade, especially the last couple of years. The relatively good news is that the annual dividends seem to have bottomed at $1.20 in 2019 and risen slightly to $1.26 since then, so this isn't one of those companies that just cut dividends year after year like many mREITs or some BDCs are. All in all, if you are investing in this stock, don't expect dividend hikes but also don't worry about deep dividend cuts either. In the long run, dividends seem more or less stable with this one if you don't count inflation.

Horizon trades at a price very close to its book value, and last year, it had an earnings yield of 16%. Currently, it trades at a P/E of 7 which gives it an earnings yield of 14%. Considering these, the current yield of 11% seems sustainable for the time being. In fact, the company is on track to earn about $1.60 per share for this year and next and pay a dividend of $1.32 which gives it even some room to hike dividends if it wanted to.

One major risk in front of HRZN's dividends is the possibility of a recession this year. Since the company invests in more than 300 companies in 5 different industries already backed up by venture capital firms, it is highly unlikely that a large number of its loans will fail under normal conditions, but what if we get conditions that aren't quite normal? A deep recession lasting more than one year can easily put a dent on this company's earnings as well as its dividends. Most of the company's debt is secured, but we all know how "secured" debt goes when companies go bankrupt. It turns out that a company's assets aren't worth as much as originally thought, and a lot of secured debt becomes not so secured because there isn't enough asset to back them all once a company's assets drop in value after they go bankrupt.

Still, the company is well managed, and it is highly unlikely that we will get a recession deep and long enough to put many of its investments out of business at once (though still possible). If that were to happen, many other stocks would suffer tremendously too, and the pain wouldn't be limited to HRZN.

Generally speaking, HRZN generates about 9-11% of interest from its typical loan outs. The company can generate another 1-2% from commitment fees and end of term payments, and another 2-3% from pre-payment fees. Most of HRZN's moat actually comes from warrants and equity rights, where it historically earns a yield of 13-18%. In a given year, the company's total income yield could depend on the mix of investment types and the mix of fees it generates. When interest rates rise, the company's book value should drop, but its interest income should be higher.

With regional banks failing, we could see more small companies getting their financing from venture capital companies and business development companies in the near future. This will increase the addressable market potential for HRZN as long as it has access to additional funding, which means HRZN can continue growing as long as it can get more funding resources. Keep in mind, though, investors don't always reap full benefits when a BDC grows because a lot of times that growth comes from dilution. For most investors, it may not make much difference whether a BDC grows or not if it doesn't translate into higher dividends because higher growth coupled with more dilution might mean no growth for most investors. In the graph below, you can see the ever-rising share count for HRZN throughout the years. While it hasn't hurt the dividends, it didn't help them either.

HRZN is a pretty good business development company overall and it supports a nice stable yield. I can see the company sustaining its current dividend levels for quite some time give or take a penny per share unless something highly disruptive happens in the near future like a multi-year deep recession (in which case all stocks would suffer anyways). While I don't see this company cutting its dividends, I also don't expect them to hike the dividends much either, except for 5-6 cents or so. If you are worried about inflation returning in a blowout fashion, you might be worried about lack of growth in HRZN's dividends, but if you believe that prices will stabilize moving forward, this shouldn't be a huge issue.

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