Prospect Capital Corporation's SEC Drama Is Creating a Buying Opportunity

Over the past month, Prospect has experienced a series of unfortunate, but not necessarily bad, news events. As a result, shares are trading at a big discount.

Jun 3, 2014 at 1:22PM

Shares of Prospect Capital Corp (NASDAQ:PSEC) dropped by nearly 3% Tuesday morning on the news that several class action lawsuits have been filed against the company.

These though its possible these complaints could have a adverse short-term impact on the company, this is creating an opportunity to buy into Prospect's excellent business at an even better discount than it was already trading for. The past month or so has been a series of unfortunate events for the company which has produced the opportunity to get into Prospect very cheaply.

The allegations: Do they have any merit?
In at least three separate class action lawsuits, it is alleged that Prospect Capital violated U.S. securities law by making false or misleading statements about some of its investments. Specifically, one of the lawsuits claims Prospect "fraudulently announced inflated revenues, earnings, and earnings per share." Another lawsuit alleges the company's financial statements were false, and its internal and financial controls were inadequate.

This all stems from the May 6 earnings release by Prospect where it disclosed ongoing discussions with the SEC about possibly needing to consolidate certain holding companies. Shares fell about 5% after that announcement, but recovered in the subsequent weeks.

As far as the allegations or misrepresentation and inflation of earnings go, Prospect said in a press release about a week after the discussions with the SEC were made public that there would be no negative effects on the company's taxable income or leverage ratio resulting from the possible consolidation.

While the ongoing discussions do create uncertainty, unless the company's press release is completely false, it's going to be very tough to say the company inflated earnings, or deliberately misled investors. From what it sounds like, the SEC said some of Prospect's wholly owned companies may be miscategorized for accounting purposes, and the company is cooperating fully in order to rectify the situation.

Higher credit commitments spooked investors recently as well
In between the announcement of the SEC issues and the class action suits, Prospect announced two separate increases to their revolving credit facility commitments, which investors reacted negatively to. In the same press release where it emphasized the non-effects of the possible consolidation of assets, Prospect also announced it has increased its revolving credit commitments by about 5%, or $45 million.

Just recently on May 30, Prospect announced another $20 million increase, bringing the total to $857.5 million of the company's $1.0 billion revolving credit facility.

Now, it may frighten investors that Prospect's credit facility is getting closer to being maxed out, but I don't think this is a big deal. On the contrary, it means more money for Prospect to do what it does best: Lend to and invest in mid-market companies and collect more in interest than it pays. Since the recession, the quality of the company's credit portfolio has been pristine.

The benefits greatly outweigh the risks
Prospect's track record of delivering for its shareholders should help put investors' minds at ease. The company has never cut its dividend since it began making monthly payments in 2010, and actually raises the dividend a little each month.  In fact, the company has already declared its monthly payments all the way through December, which will be the 54th consecutive increase.

After the decline in the stock price, which I feel is overdone and will be temporary, Prospect pays a 13.8% annual dividend. What makes this even sweeter is the monthly payment schedule since your investment will compound more frequently, bringing the yield up to an effective annualized yield of about 14.7%.

So, while Prospect works out its issues with the SEC, you'll get paid extremely well for your patience. And don't forget that once all this drama blows over and we see in black and white the non-effects of the accounting changes, the added certainty could push the share price higher, giving you the potential for capital appreciation as well.

Is this a better investment than Prospect Capital?
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Matthew Frankel owns shares of Prospect Capital. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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