Prospect Capital Corporation (NASDAQ:PSEC) took a dive after missing earnings estimates. Investors now question its ability to cover its current dividend going forward, and some are running for the exits. Shares are down sharply since the earnings report was released during the last week of August.
It's only natural to think that this may present a buying opportunity. And while there are no guarantees that Prospect Capital will trudge higher, there are three reasons that the stock could rise from here.
1. Cheaper borrowing can fuel profits
Prospect Capital currently pays a pretty penny for leverage on its balance sheet. The company makes use of long-term notes, which have, on average, cost more than 5% per year. Less expensive funding sources, such as the company's credit facility, offer better opportunity.
Recently, Prospect Capital extended its credit facility and inked a deal to reduce the rate to LIBOR plus 2.25%, down from LIBOR plus 2.75% per year.
This puts its all-in cost of the credit facility at about 2.40% per year, less than half the rate the company pays on its longer-term debt obligations. Borrowing at just over 2% to make investments with yields in the double digits would dramatically improve its profitability.
My back-of-the-envelope figures, using data from its most recent annual report, suggests its cost of debt could decline from roughly 5.6% to 5% annually if Prospect Capital were to use half its credit facility on an on-going basis.
Historically, Prospect has used its facility to make new investments before promptly issuing new long-term debt to pay off the credit facility. However, with the dividend in question, its view of its cheaper financing sources may change.
2. Yield rotation could add to dividend coverage
Prospect Capital outlined a plan to shift out of lower-yielding securities to invest in higher-yielding investments. Management pointed to assets that were yielding 6%-7% as being targets for a rotation. I went back to the annual report to find how much of its assets were yielding below 6%-8% per year.
If sub-8% yielding investments were sold, and the proceeds reinvested at a 2.5% higher return, I calculate that the impact could be in the neighborhood of $0.015 per share in net investment income per quarter. In addition, Prospect Capital could earn $0.06 per share in one-time origination and structuring fees on reinvestment, assuming a 2% average fee.
For a single quarter, this is not a trivial amount of money. Origination fee income of $0.06 per share plus $0.015 in additional interest income puts it close to covering its dividend next quarter. This quarter, Prospect Capital earned $0.25 per share in net investment income, roughly $0.08 per share less than its dividend payments.
Of course, future quarters will need more support, as origination and structuring fee income is one-off in nature. On the recent conference call, one analyst surmised that Prospect Capital would need to increase its yields on its whole portfolio by roughly one percentage point to cover its dividend. The math checks out -- Prospect Capital does need to increase its investment yields by about 1% across its portfolio to earn its dividend.
Consider this a step in Prospect's pursuit of covering its dividend, not the end game.
3. It could trade back to NAV
Business development companies are typically valued based on their net asset value, or NAV. Prospect Capital Corporation currently trades under its last-reported NAV of $10.56 per share.
Analysts have differing views of Prospect Capital's true fair value. A Wunderlich analyst takes the high-water mark, suggesting shares could trade to $13. That seems high -- at that price, the company would likely be issuing new shares to accretively grow the balance sheet. Others put fair value in the range of $10.50-$11.00 per share.
A realistic fair value is probably in the range of its net asset value per share, or roughly 2% higher than shares currently trade. Though it seems insignificant, a 2% discount represents roughly two months of dividend payments. Wall Street may find it difficult to pay book value, however, until uncertainty about its current dividend comes to a rest.
Jordan Wathen has no position in any stocks mentioned. 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.