Prospect Capital (NASDAQ:PSEC) may seem appealing to investors with its attractive dividend yield of around 11%. However, in my view, several key concerns make it an unattractive stock for long-term investment. Firstly, PSEC has experienced a consistent decline in its net asset value (NAV) per share over the past four consecutive quarters, primarily driven by unrealized mark-to-market depreciation. This trend raises questions about the company's asset quality, particularly given its high exposure to equity investments in smaller non-publicly traded companies, which adds to the risk of further mark-to-market losses.
Secondly, PSEC's risk profile is considered elevated due to its significant exposure to subordinated investments in U.S. middle market companies and concentrated investments in collateralized loan obligations (CLOs), real estate, and consumer finance. These riskier subordinated investments accounted for a significant portion of its overall portfolio and at a much higher level than that of its peers in the sector. Moreover, there are concentration risks related to unrealized gains in the equity portfolio, particularly with five specific companies contributing a substantial amount to PSEC's net asset value. While the current dividend may appear sustainable based on Net Investment Income coverage, the lack of dividend increases in recent years raises doubts about its long-term viability. All in all, caution is advised for potential investors, given PSEC's declining NAV, elevated risk profile, concentration risks, and some uncertainty surrounding the long-term sustainability of its dividend.
Asset quality and net asset value
Concern has increasingly been raised about PSEC's seemingly riskier asset profile. DBRS Morningstar has suggested that PSEC has a higher risk profile due to its significant exposure to subordinated investments in U.S. middle market companies, along with concentrated investments in collateralized loan obligations (CLOs), real estate, and consumer finance. DBRS Morningstar noted that:
At December 31, 2022, the inherently riskier (relative to first lien) subordinated portion of the Company's investments collectively accounted for 47% of total investment portfolio (at FV) comprised of second lien debt (18.5%), subordinated structured notes (9.0%) and equity investments (19.3%). While the portion of the portfolio comprised of subordinated investments improved from 53% at December 31, 2021, it remains well above the DBRS Morningstar BDC peer median of 20%.
From PSEC's most recent results, it is clear that there has been some improvement in this respect from the numbers considered by Morningstar, with this portion of its portfolio now representing just over 44% of its total portfolio. A continued shift into seemingly safer investments such as 1st lien and senior secured lending might see a rerating from investors in the longer term. However, at present, its exposure to this riskier portfolio remains highly elevated and above my personal comfort zone.
PSEC has also reported several declines in its net asset value per share. In its most recent earnings call, management noted that "Our NAV stood at $9.48 per common share in March, down $0.46 and 4.6% from the prior quarter, largely due to unrealized mark-to-market depreciation." The chart below shows that PSECs NAV per share has declined in each of the past four consecutive quarters. PSEC's high exposure to equity investments further increases the risk of additional mark-to-market losses, given the inherent difficulty in valuing investments in smaller non-publicly traded companies. While equity investments as a percentage of its total portfolio have declined, it remains somewhat elevated at more than 17% of its total portfolio.
Concerns in respect of the substantial portion of PSEC's NAV influenced by unrealized gains in its equity portfolio have also been raised persuasively by BDC Buzz. In a recent article, BDC Buzz presents a table indicating that the total unrealized gains from equities in just five companies (National Property REIT, PGX Holdings, InterDent, Valley Electric, and First Tower Finance) amount to over $1 billion of PSEC's total net asset value, contributing $2.50 to NAV per share. If the value of unrealized gains on these equity positions were overestimated, it could result in a fairly substantial decline in NAV per share. Given these elevated risks, I would be wary of entering into a long-term position in PSEC at present.
The dividend and its sustainability
PSEC offers a dividend yield of around 10.91% which is the second-highest dividend yield of the seven largest BDCs by market capitalization. This dividend yield appears very appealing and may encourage investors to seek to initiate a position in PSEC. However, it is important to note that PSEC has not increased the dividend in several years and has also not reduced the dividend since a cut in 2017.
The dividend currently appears to be adequately covered by Net Investment Income (NII). In the third quarter, the BDCs NII coverage of its common distribution was at around 117% while its one-year average NII coverage ratio was at around 118.72%. This indicates that PSEC's dividend is currently adequately covered by NII even though its more recent NII coverage ratio is slightly lower than its 1-year average NII coverage ratio.
Therefore, the dividend appears to be safe for the time being. However, the fact that PSEC has not increased its dividend once since 2014 raises some concern over the likelihood of future dividend increases. The last dividend increase by PSEC occurred when the dividend was increased from $0.1105 to $0.1106 on 05 May 2014. This was followed by a dividend cut from $0.1106 to $0.0833 on 5 December 2014 and a further cut from $0.0833 to $0.06 on 28 August 2017. This is the level where the dividend has remained since. While it is of course true that past results are not an indication of the future, PSEC's past of limited dividend increases makes me wearier of investing in the stock over the longer term.
Key risks to the sell rating
A key risk to my negative investment thesis is that PSEC's management might take proactive measures to address the elevated risk profile and concentration issues discussed in this article. They may strategically reduce exposure to riskier assets and shift towards safer investments, such as first lien and senior secured lending. Such actions could lead to a potential rerating of the stock by investors in the longer term, mitigating some of the highlighted risks.
Another risk to the thesis is that PSEC's dividend yield continues to attract income-seeking investors. As long as the company sustains its current dividend payments and its NII coverage remains adequate, some investors might find the allure of a high dividend yield appealing and be willing to overlook the other risks discussed in this article.
Valuation
PSEC is trading at around 0.7 times NAV, which represents a discount to NAV of around 30%. This is also the highest discount to NAV of the major BDCs by market capitalisation. This substantial discount to NAV may again make the stock appear appealing to some investors. The discount is also slightly higher than PSEC's 3-year average discount to NAV of around 25%.
Despite the discount to NAV being higher than the 3-year average, I do not believe that the stock is undervalued. Throughout most of the three-year period, PSEC had an expanding NAV, whereas the current trend shows a declining NAV per share. The risk of continued NAV declines certainly justify an increased discount to NAV.
Furthermore, growth in NII per share has slowed down. In the third quarter, PSEC reported a 3% quarter-over-quarter decline in NII. This slight decline does not in itself give rise to substantial concern but might be an early indication that NII growth is slowing down.
Conclusion
In conclusion, Prospect Capital presents a mixed picture for potential investors. The company's appealing dividend yield of nearly 11% may initially attract income-seeking investors, but underlying risks and concerns temper the investment thesis. Declining NAV, an elevated risk profile from concentrated and riskier investments, and concentration risk in the equity portfolio poses significant challenges. Furthermore, the sustainability of the dividend remains uncertain, with a lack of dividend increases in recent years. While there is potential for management to address some risks strategically, investors should exercise caution and carefully assess their risk tolerance before considering an investment in PSEC. Personally, PSEC exceeds my risk tolerance, particularly considering that there are other higher-quality BDCs that pose less of a risk.
Young Investor Analytics
I am a young individual investor with a strong focus on long-term wealth creation. My investment strategy revolves around selecting stocks with strong growth potential as well as stocks with stable dividend yields. I firmly believe that patience is key, allowing my investments to compound over time. For me, dividends play a vital role in generating income and bolstering my overall portfolio value. I carefully select companies with strong fundamentals and a consistent history of dividend payouts. In my writing here, I principally focus on financial stocks including banks and BDCs.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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