Prospect Capital: Surprisingly Well Covered 14% Dividend Yield (NASDAQ:PSEC)

Prospect Capital Corporation (NASDAQ:PSEC) is a well-managed business development company that has not had any problems in the past year covering its dividends with net investment income.

In fact, Prospect Capital currently has a better one dividend payout ratio than some of its larger and more highly regarded BDC cousins.

Prospect Capital’s credit profile also improved QT as the non-accrual ratio fell to a low of 0.3%, suggesting impressive credit quality for the business development company.

I do not believe that the large discount to the net asset value is justified when we take into account the robust financial position and performance of Prospect Capital. The dividend yield of 14% is sustainable in my opinion.

My rating history

My final stock rating for Prospect Capital was Buy as a longer-term higher rate environment benefited Prospect Capital and the business development company had good credit quality.

Prospect Capital’s loan quality continued to increase in Q4, and the dividend was even better covered by net investment income than in the previous quarter.

Portfolio and income review

Prospect Capital is structured as a business development company under the Investment Company Act of 1940 and is therefore required to distribute 90% of taxable income to shareholders.

The business development company has a large portfolio of lower middle market loans and has considerable exposure to real estate investments. Real estate made up about a fifth of Prospect Capital’s investment portfolio as of June 30, 2024, which was valued at $7.7 billion.

Prospect Capital earned $102.9 million in net investment income in the quarter ended June 30, 2024, reflecting a 9% year-over-year decrease. The majority of this revenue comes from interest income on Prospect Capital’s First and Second Lien debt, and the business development company has built a floating rate position worth 82.1% of assets.

What is going well for Prospect Capital right now is the performance of its portfolio. The business development company has a very small amount of non-employment in its portfolio, which translates into substantial excess coverage for passive income investors.

Prospect Capital’s low accruals of 0.3% based on fair value help separate BDC from some of its peers, particularly companies like Oaktree Specialty Lending Corp. (OCSL) which recently experienced a surge in defaults, sparking concerns about the dividend.

The dividend payout ratio is actually impressive

The business development company does not have the best reputation in the BDC industry, as Prospect Capital has occasionally earned its dividend with net investment income, which in some cases has resulted in dividend cuts.

Additionally, Prospect Capital’s net asset value isn’t the best either, with BDC reporting a long-term decline in NPV.

Either way, Prospect Capital’s dividend payout and credit quality look great right now. Prospect Capital earned $0.25 per share in net investment income last quarter, which equates to a dividend payout ratio of 72%.

Prospect Capital’s dividend payout ratio over the past 12 months was even better: BDC paid out only about 70% of its total net investment income.

Most of the BDCs we’ve reviewed lately, including industry heavyweights such as Ares Capital Corp. (ARCC) or Blue Owl Capital Corp. (OBDC) had higher dividend payout rates. Ares Capital Corp. paid 85% of NII, while Blue Owl Capital paid 73% of net investment income.

Excessive NAV reduction

Prospect Capital’s shares are selling at a 40% discount to net asset value, which seems a bit excessive when you consider that the credit profile (no accruals) is healthy and the business development company has not had problems in covering the dividend. payment.

Prospect Capital’s net asset value was $8.74 per share as of June 30, 2024 (my implied intrinsic value estimate), reflecting a decrease of $0.25 per share primarily due to net realized and unrealized losses.

It seems to me that a 40% reduction in net asset value is quite excessive given that BDC’s most important KPIs are actually looking pretty good and in some cases even better than BDCs which have a higher perceived investment. quality such as Ares Capital Corp.

Why the investment thesis could disappoint

The central bank is poised to cut short-term interest rates next month, indicating weaker leverage for net investment income growth, especially for those BDCs that are heavily concentrated in floating rate BDCs.

Prospect Capital is not the most aggressively positioned floating rate BDC, but the company has considerable exposure to high interest rates.

Dividend-wise, though, I don’t see any major issues, but I would like to say that watching Prospect Capital’s dividend payout ratio is a must.

My conclusion

Prospect Capital, like it or not, looks pretty solid as a BDC investment right now, and I’d suggest that the business development company’s 14% yield is relatively safe.

The steep 40% discount to net asset value, along with the 70% LTM dividend payout ratio and low non-accrual borrowings make Prospect Capital’s 14% yield surprisingly competitive.

Prospect Capital’s credit quality and dividend payout ratio look compelling, and I don’t see any major issues in BDC’s portfolio or earnings trend that would indicate to me that the dividend is headed for the chopping block.

With such a large discount to net book value, I believe Prospect Capital remains an exceptionally attractive investment choice for passive income investors and I believe PSEC should be able to trade at a much lower discount to NAV going forward .