Prospect Capital Corporation's 3rd Quarter: 3 Hits, 1 Miss

Prospect Capital Corp.'s third-quarter earnings were more than solid, with First Tower and its CLO business reporting strong performance.

Jordan Wathen
Jordan Wathen
Nov 5, 2013 at 7:09PM

Last week, I posted my checklist of the three things that move the needle at Prospect Capital Corporation (NASDAQ:PSEC). Now it's time to check in to see how the company performed in the last 90 days:

1. Towering higher
Prospect Capital's multi-line finance company, First Tower, grew its loan book significantly in the first fiscal quarter. The company reported that First Tower's loan portfolio grew to $405.7 million, up from $378.3 million in the prior quarter.

First Tower is by far the most important asset on Prospect Capital's balance sheet. The company now values it at $313.7 million, most of which is attributed to a debt investment that currently yields 20% per year. That loan alone is worth 9.1% of Prospect Capital's net assets.

First Tower is interesting on two fronts. First, it provides a substantial amount of annual cash flow. Secondly, it is the subject of a lot of investor scrutiny. As a high-interest lender to individuals, it has some regulatory risk and exposure to pro-consumer financial reform. However, as it stands today, First Tower is wildly profitable and, so far, outside of the scope of regulators.

2. CLOs carry on
Prospect Capital's credit investments are particularly important for the bottom line. As an investor in collateralized debt investments, it owns the equity in CLOs.

This quarter, the company's CLO income dwindled modestly to $26 million from $28 million. However, Grier Eliasek, Prospect Capital's COO, noted that the decline was mostly the result of declining reinvestment spreads. That is, differences between what the company currently earns on its CLOs and what it would earn if it had to reinvest those funds elsewhere.

Eliasek later said, "At the end of September, we were, I believe, below 0.2% in terms of our default rate within the CLO business compared to market average of over 2%." Lower rates of default mean higher returns for Prospect Capital, which is the first to lose should default rates rise. Investors should watch its quarter-to-quarter CLO defaults as a vital sign for this very important cash generator.

3. Loan quality
Prospect Capital's lending portfolio continued to perform well. The company reported only .3% of assets currently not paying as a percentage of total assets. This was unchanged from the previous quarter.

Source: Prospect Capital November company overview.

Likewise, the company continued seeking higher-quality, first and second lien loans. A chart from its November company overview shows 96.7% of its loans are in the first or second lien position, little change from the previous quarters.

4. Dividend stability
In only one area did Prospect Capital fall flat: covering its dividend. The company earned $0.32 per share in net investment income, while paying out just more than $0.33 in dividends to shareholders. The slight miss doesn't necessarily risk the company's dividend, as it announced increasing dividends all the way to June 2014.

Prospect Capital had $0.26 per share in undistributed income as of June 30. After this quarter, it should have roughly $0.25 in undistributed income to fund its dividend in the event it can't earn its dividends in future quarters.

Its worth noting that Prospect Capital is currently leveraged at .59 times equity, under management's ideal range of .70-.75 times equity. Leveraging the company with cheaper debt in lieu of equity would allow Prospect Capital to more than cover its monthly distributions to shareholders.

The Foolish takeaway
All in all, Prospect Capital reported a solid quarter, which should leave investors satisfied. The company marked up its First Tower investment as it heads into the fourth-quarter busy season, while nearly covering its dividend from net investment income. Its beefy dividend yield of nearly 12% should continue to keep shareholders interested in this high yielder.