FSK - Prospect Capital May Have Bottomed Yielding 11.86%

2023-09-01 08:45:00 ET

Summary

• PSEC's fiscal Q4 earnings show positive growth in net investment income and distribution coverage, indicating a potential rebound.
• PSEC has a long history of successful capital deployment and focuses on secured lending and senior loans.
• PSEC's real estate investments and private REIT strategy could be lucrative in the future, especially with rising rents and potential rate declines.

I wrote an article about Prospect Capital (PSEC) on July 7 ( article can be read by clicking here ) as its valuation had gotten very interesting. In the article, I indicated that I wanted to wait until their fiscal Q4 earnings were released so I could see some additional data prior to starting a position in PSEC. While all the metrics I reviewed indicated that PSEC met my investment criteria, I wanted to see if there was negative news coming down the pipe that would warrant the discounted levels PSEC traded for. Since the article, PSEC has declined by -2.1% while the S&P 500 has appreciated by 2.53%. When the distributions are taken into consideration, the total return for PSEC since July 7 has been -0.21%. After reading through the Prospect Capital fiscal Q4 earnings report , I believe the worst is behind PSEC, and I plan on adding PSEC as a new position in my Dividend Harvesting Portfolio series on Seeking Alpha ( article can be read by clicking here ).

Please keep in mind that just because I am bullish on PSEC or the fact that I plan on starting a position does not mean PSEC will rebound or turn into a positive investment. I have done my due diligence, and PSEC fits within my investment parameters, which could be significantly different than what you're comfortable with.

PSEC reported its fiscal Q4 earnings, and I am very happy with what I am seeing

Due to the downward trajectory of PSEC shares, I wanted to wait until the latest earnings were released to see if there was any concerning information being released prior to starting a position. PSEC grew its net investment income ((NII)) to $112.8 million or $0.23 per share in Q4, which was a -$0.01 miss on the consensus estimates. Despite missing the consensus estimates, PSEC grew its NII by 25.35% YoY and 10.37% QoQ. PSEC not only grew its NII, but its distribution coverage increased while the NII return on common net asset value ((NAV)) also increased. Sometimes, when a company misses the consensus estimate, it isn't a catastrophe, and in PSEC's case, the company is expanding its earnings capability.

PSEC has a long history of deploying capital and distributing cash to its shareholders. Since its inception in 2004, PSEC has invested $20.2 billion across 418 investments. The team at PSEC is selective about the investments they make and evaluates thousands of opportunities annually. PSEC has the ability to invest in different segments of corporate capital and prefers secured lending and senior loans. At the end of their Q4, PSEC's portfolio was comprised of 56.5% first lien debt, 16.4%, second lien debt, 8.6% subordinated structured notes with underlying secured first lien collateral, and 18.5% unsecured debt and equity investments. This has resulted in 81.5% of PSEC's investments being assets with underlying secured debt, which benefits from collateral that the borrowers have pledged. I like this structure because it allows me to gain exposure to many different investments I wouldn't have access to. By investing in PSEC, I am piggybacking off an experienced team and generating ongoing cash flow from corporate debt.

What I found enticing is PSEC's originations and the real estate sector. PSEC grew its total originations by 305.94% QoQ from $91.7 million to $372.24 million. The largest increase came in the middle-market lending sector, as it accounted for 69% of its total originations compared to 26.1% in the March 2023 quarter. PSEC had $122 million of repayments, sales, and exits, which helps validate its capital preservation objective. Real estate has been under pressure due to the rising rate environment and Fed Chairman Jerome Powell's continued hawkish tone at the FOMC press conferences. PSEC has been deploying large amounts of capital toward real estate through its private REIT strategy. PSEC primarily focused on multifamily workforce, stabilized yield acquisitions, and expanded its investments into senior living over the past year. In 2023, PSEC acquired nearly $4 billion in 105 properties across multifamily, including 81 multifamily properties, eight student housing properties, 12 self-storage properties, and four senior living properties.

PSEC's private REIT has benefited from rising rents in recent years, which has acted as a hedge against inflation. The nature of the property segments continues to have optimal occupancies, allowing PSEC to generate increased levels of cash yields and income growth alongside its corporate credit business. This information has made me more interested in PSEC, as I believe the real estate sector will see an upswing when rates start to decline. PSECs investments could prove to be extremely lucrative down the road after enduring the adversity many property owners have faced.

The board has declared PSEC's dividends through October

I invest in BDCs to generate larger amounts of yield than I can get from investing in traditional equities. PSECs board has declared monthly distributions of $0.06 per share for September and October, which represent the 73rd and 74th consecutive $0.06 per share cash distributions. The board will announce the next series of distributions in November.

The current level of distribution is well covered by PSEC's NII. In Q4, PSEC generated $112.78 million of NII, which was $0.23 per share and paid out $0.18 per share in distributions. In the previous two quarters, PSEC generated $0.21 per share of NII and paid $0.18 out to shareholders via its $0.06 monthly distribution per share. While the distribution was reduced in 2015 and 2017, the current distribution has been paid at this level for six years, and it is well covered. I am comfortable with the current coverage ratio and am not too concerned about a future distribution cut.

How PSEC stacks up against its peers

I track the following BDCs, and PSEC looks undervalued compared to this peer group:

• Main Street Capital ( MAIN )
• Prospect Capital Corp ( PSEC )
• FS KKR Capital Corp ( FSK )
• Barings BDC ( BBDC )
• Blue Owl Capital Corporation ( OBDC )
• MidCap Financial Investment Corporation ( MFIC )
• Goldman Sachs BDC ( GSBD )
• Oaktree Specialty Lending Corporation ( OCSL )
• Golub Capital BDC ( GBDC )
• Ares Capital ( ARCC )
• Gladstone Investment ( GLAD )
• Sixth Street Specialty Lending ( TSLX )

I am adding a new metric to my BDC comparisons going forward. I will now compare these REITs in the following categories:

• Market Cap to Net Investment Income Multiple
• Discount or Premium to Net Asset Value
• Debt to Equity
• Dividend Yield

I want to pay the lowest multiple I can for a BDCs NII. The peer group has an average market cap to NII multiple of 8.5x, and PSEC is trading at 5.8x. PSEC trades at the lowest multiple in the peer group and looks undervalued based on this metric.

I am more than happy to pay a premium on a BDCs NAV if I feel it's a good deal, but I am even happier paying a discount. The peer group trades at an average discount of -0.71% on their NAVs. PSEC has the largest discount at -34.31% to its NAV. Mr. Market has placed PSEC's assets on the liquidation aisle.

This is a new metric that I am starting to look at as I want to see how much total debt there is on the balance sheet in relation to the total equity. The peer group average has a 105.57% debt-to-equity ratio. PSEC has the lowest debt-to-equity ratio at just less than 50%, which is very interesting.

As I indicated earlier, I invest in BDCs for income, and PSEC has the third largest yield in the group. The peer group has an average yield of 10.09%, and PSEC's distribution has an 11.86% yield.

Conclusion

When looking at PSEC's chart, and then going over its balance sheet, I believe there is a decent chance that shares have bottomed. I could be wrong, but PSEC trades at a -34.31% discount to its NAV and is growing its total and net investment income. I think the valuation at these levels is enticing as PSEC trades at the lowest market cap to NII multiple, has the largest discount placed on its NAV, and has the lowest debt-to-equity ratio of its peer group. When I look at this with the 11.86% yield and the investments that PSEC has made, I am coming to the conclusion that PSEC is a broken stock. I could be completely wrong, but I am going to add PSEC to my Dividend Harvesting Portfolio series and start a position in my main dividend account.

For further details see: