The 12% Yield at Prospect Capital Is Safe… For Now

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With the S&P 500 (NYSEMKT: SPY  ) near all-time highs, yield looks more attractive than ever.

Prospect Capital (NASDAQ: PSEC  ) is one of the most popular plays for yields, placing its at 12%. However, in the last two quarters, Prospect Capital has failed to earn its dividend, paying out more in dividends than it earned from its investment portfolio.

Why the dividend isn't at risk... yet
Failing to earn your dividend is a big no-no in the high-yield space. In the past year, a number of high-yield stocks, including BDCs and mREITs, have failed to keep earnings in line with their large distributions to shareholders.

Dividend cuts ensued.

But a dividend cut at Prospect Capital looks unlikely. On the recent earnings call, management revealed the company had $0.26 per share in retained earnings -- earnings in excess of its dividend. This provides a safety net for investors. At the current pace, Prospect Capital could fail to earn its dividend for up to three years and yet continue to pay ever-increasing monthly distributions.

But wait, there's more!
Prospect Capital's second-quarter conference call also revealed a potential strategy for meeting or exceeding its dividend with earnings. An analyst from National Securities recommended Prospect Capital increase its leverage from about 0.56 times equity to 0.7 times equity with a low-cost funding source. Doing so would push earnings above Prospect's monthly dividend distributions.

Keep in mind that Prospect Capital has a very attractive credit facility priced at LIBOR plus 2.75%. Prospect can essentially borrow at less than 3% per year to displace capital from stock issuance, which effectively costs 12% per year due to the dividend.

Adding more leverage could add up to $0.08-$0.10 to Prospect Capital's annual net investment income. The math checks out; it's as easy as that. Besides, the company pays 1% per year on its unused credit line, so the marginal cost of borrowing is really LIBOR plus 1.75% -- practically nothing.

Will Prospect Capital take the advice?
Prospect Capital CEO John Barry responded positively to the idea of juicing the company's portfolio with its low-cost credit facility, stating:

When you get to $1 billion [in the credit facility], it's more prudent to be into the leverage of the credit facility in larger amounts and for larger periods of time, which I think is a point of your question and that's exactly the direction we wish to go.

While Prospect Capital has failed to earn its dividend, shareholders shouldn't be concerned. All it has to do is use the low-cost funding it has on hand. Shareholders should continue to watch Prospect's leverage, which is the most important variable in the company's dividend coverage.

Is Prospect Capital the best dividend stock you can buy?
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Read/Post Comments (5) | Recommend This Article (3)

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  • Report this Comment On February 13, 2014, at 11:52 AM, sold4gain wrote:

    Your comment that "management revealed the company had $0.26 per share in retained earnings" appears to be misleading. The next sentence in the earnings statement says "For the

    six months ended December 31, 2013, distributions were in excess of NII by $8.8 million and $0.03 per share, distributing some of the

    excess which was built up in the previous two fiscal years." That $0.03 is not much and I don't think it would cover the 3 years you mentioned.

  • Report this Comment On February 13, 2014, at 1:50 PM, keyhoetay wrote:

    "The company had $.26 per share in retained earnings". They had to tap into that to the tune of $.03 per share to cover the $.66 (and change) per share they paid in 6 months of dividends. Earnings covered $.63.

    If necessary, the remaining $.23 still in surplus can cover future earning shortages (assuming the same rate of $.06/yr) for 3+ years.

  • Report this Comment On February 13, 2014, at 2:11 PM, TMFValueMagnet wrote:

    Sold4gain, the company had about $0.26. They used up about $0.03 per share in this quarter. So that takes them to $0.23 per share in excess earnings.

    Now, I averaged some recent results to get my run-rate. At $0.23, Prospect Capital can afford its dividend for almost two years. Including prior quarters in the average, where the coverage was stronger, you can get to about 3 years.

    There are several variables at play here -- leverage, yields, and cost of funds -- but I think it's safe to say that if results continue, and leverage wavers up and down, up to 3 years of dividend coverage isn't much of a stretch at all.

  • Report this Comment On February 13, 2014, at 2:13 PM, TMFValueMagnet wrote:

    Keyhoetay, I should have refreshed before I posted my comment. Your comment explains the logic in the article very well.

    Thanks,

    Jordan

  • Report this Comment On February 13, 2014, at 2:19 PM, sold4gain wrote:

    Thank you keyhoetay and TMFValueMagnet for correcting me. I agree with you and I did misread the statement.

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