Monday, May 11, 2009

Prospect Capital: A Relatively Safe 17% Dividend Yield

Conservative Fair Value Estimate: $15

Current Dividend: 17.6% Yield or $1.60/share

Strategy: Buy stock @ $10.25, and sell June 2009 Puts strike 10 for at least .50 for a 5% yield.

Prospect Capital is a private equity, mezzanine debt firm that specializes in investing in the energy/industrial sectors. Occasionally, the firm will also make investments in other industries when the opportunity exists. The company has been beaten down like many other business development and publicly traded private equity firms because of the usual suspects: worries about financing, sustainable dividends, health of the portfolios, excess use of leverage to juice returns, dearth of attractive investment opportunities, etc.

So let's go over these weaknesses that the market likes to point out...


With $25mil in cash and $138mil in debt, Prospect has about $113 million in net debt vs. $428mil in equity. In the last quarter interest costs totaled approx $2mil against expected distributable cash flows of $50million for the year. I would say financial health is not of any concern at PSEC. Charges-offs have been minimal and the revenue/interest streams have been stable, even in the rough patches of the end of 2008. NAV for the firm is above $14/share. PSEC also has a total credit line of $200mil (all their debt is via their credit line), and are seeking to expand it.


Dividend payout is $1.6/share annually, or $48million total. With $50million in cash flows (adjusted to cancel out asset valuations, one time charges, depreciation), these guys make more than they are paying out. A lot of peer companies have a history of paying out more than they earn in constant interest, mostly because firms like to return a portion of the proceeds from capital gains to investors via dividends as well. However, that is not good fiscal management since it inherently keeps expectations of dividends higher than what can be sustained in a market where asset values are declining.


The health of the portfolio is arguably up for debate since we don't have access to information on every company in the portfolio. However, energy and energy related businesses comprise for a large portion of Prospect's investment portfolio. In 2Q (for Prospect that Oct-Dec 2008), oil prices reached their low in the $30's per barrel, MLP/pipeline investments and all other energy-related businesses also reached their lows in that quarter. With oil now at $55+, a lot of those investments have regained ground from their lows last year (or from beginning 2009).


With lower valuations and a tightened credit market, Prospect's services in providing financing are high in demand. Prospect's low debt structure, solid cash flows, and sound dividend policy, Prospect should be able to increase their credit line and make attractive investments for at least the next year or so as their peers hoard cash and fix-up their balance sheets.

All in all, all of these factors have led this stock fall only about 30% in the last year, many other companies in this space did not fare nearly as well, with many dropping 50%+. Take comfort in the fact that management bought in at prices around $8-9/share recently as well - that is why selling the June 2009 strike 10 puts look especially attractive since they will make your buy price be $9.50 should the market get volatile and these shares fall again.

At the end of 5 years, I can see Prospect averaging at minimum $25mil in net investments per year. Earn a little less than 10%, and the total additional distributable income looks to be about $12.5 million. Conservatively, that will make the company worth at least $15 per share and a 50% nominal gain. However you will also be making 17%/year on your dividends, which can give you another 120% in returns. Total net returns can total 170% in 5 years, conservatively. Should oil prices rebound further or more opportunistic investments are made, these return calculations will probably prove to be very conservative.

Disclosure: Planning to go long PSEC by buying stock or selling put options.


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