One of Prospect Capital Corp.'s (NASDAQ:PSEC) largest investments is a subprime lender known as First Tower, which it acquired in 2012.
Other than a few tidbits in Prospect's financial filings, some press releases here and there, and occasional commentary on conference calls, First Tower has always been a bit of a black box. We've known little about it, even though it makes up nearly 10% of the business development company's net assets.
This quarter, though, Prospect gave us a glimpse into the numbers behind the business. Let's dive in.
First Tower's core business
When Prospect Capital acquired First Tower in 2012, the personal loan company had "more than 150 offices" in three states: Mississippi, Louisiana, and Missouri.
Today, thanks to its website, we know it now has 207 offices and has expanded into Alabama and Illinois, which have 16 and 17 offices, respectively.
In the 2012 press release announcing the acquisition, Prospect also revealed that First Tower was a disciplined underwriter, with net charge-offs fluctuating in a "band between 6.5% and 10.1%" of its loan receivables from 2002 to 2012. That sounds high, but you should take into account that First Tower deploys capital at a significantly higher rate than most lenders.
Dividing its most recently reported revenue of $50.2 million in the first quarter by its $395.9 million in loans gives us an annualized yield of just over 50%. These are not low-cost loans; at their 2013 investor day, Prospect Capital executives noted that First Tower's loans are structured with fees and interest, a common practice in unsecured personal lending.
The economics of First Tower
You'll notice that the metrics Prospect Capital breaks out for First Tower look nothing like a typical profit and loss statement or balance sheet for a finance company. These aren't fully fledged financials, but they're a lot more than we usually see about the company. (Don't spend too much time looking at these, because we're going to do some adjusting!)
If you simply look at First Tower's quarterly earnings, they're negative for the first quarter of 2015. That's because Prospect Capital structured First Tower to carry a ton of debt on its balance sheet, most of which yields 22% annually to Prospect and its partner. Basically, First Tower is structured so that virtually all of its profits flow out in the form of interest on its subordinated debt.
I think you can get a better look at First Tower if you treat Prospect's debt as equity. It's hard to make the argument that subordinated debt yielding 22% per year is truly debt, particularly when Prospect Capital owns 80.1% of the company. Besides, I'm interested in the earnings power to Prospect; whether those earnings are called dividends or interest doesn't really matter.
When you treat Prospect's debt investment as equity and remove the associated interest expense, the income statement looks very different:
Adjusting and then annualizing its results for the quarter ended March 31, 2015, Prospect Capital should be earning roughly $39.2 million on its total investment in First Tower. The entirety of its First Tower investment is carried at $355.1 million, or about nine times Prospect's share of its earnings.
Is that reasonable? It's probably in the ballpark.
First Tower's offices are pretty productive on a per-store basis. First Tower has roughly $1.9 million in loans per store, generating quarterly revenue of $242,000 per location.
It's no Springleaf (UNKNOWN:LEAF.DL), which has about $4.3 million in receivables per branch, but First Tower's business is dominated by higher-yielding personal loans. Springleaf's loans have lower yields on average, due in part to its greater diversification into lower-yielding secured loans and auto loans.
The only thing that concerns me is that this "high touch" form of lending is expensive. First Tower's efficiency ratio clocks in at about 71%, leaving little room for loan losses. The company reports only its total revenue, which leads me to believe that some provisioning for loan losses flows into my assumption about its noninterest expenses.
On the other side of the coin, some costs could probably be eliminated if First Tower were merged with another lender. In fact, its branches are located near many of Springleaf's Midwestern locations when you include Springleaf's recently acquired OneMain Financial branches.
As for First Tower's role in the Prospect Capital portfolio, it will probably be there for a very long time. It's a high-yielding asset with some room to grow. While this information doesn't abate many of my concerns about Prospect Capital as an investment, it's good to see some hard data on its big portfolio companies every once in awhile.