Total return potential through 12/31/06 is 33% consisting of $3.25 in appreciation to a target price of $18.50 and $1.72 of dividends, including the dividend payable 12/29/05 and available to buyers of the stock today.
Quarterly Net Investment Income (NII) projection:
All figures in MM except per share amounts, yields, and multiples
I submitted PSEC a year ago to a cool reception on VIC with a 4.7 rating. From the $12.20 price at the time of that submission, an investor to date would have a total return of $3.525, consisting of $3.05 in appreciation and three dividends totaling $.475. Expressed as a percentage, PSEC produced a 29% total return. But astute investors had the opportunity to buy in at significantly lower prices due to market concerns over the Dallas Gas Partners lawsuit, the revolving door of CFOs, the change in auditor, and the pace of investing activity. If one believed the underlying thesis expressed a year ago, one was a buyer at prices in the 11’s and even sub $11.00. Total returns of 40% were easily achievable in this stock, and the thread on VIC was updated to further recommend a long position.
Now, a year later, PSEC still offers significant return potential, absent much of the baggage that weighed on the stock a year ago. It is in the sweet spot of ‘new’ BDC operations, at the onset of leveraging its IPO capital. The Dallas Gas Partners lawsuit has been recommended for dismissal in the District Court, and the cash restricted to indemnify a third party bank lender for an adverse outcome has already been released by the lender. The outsourced CFO function has been stable, and with the new auditor, the first full 10K has been filed, with faster 10Q filings expected going forward. The pace of originations has been moderate, but in light of the vociferous negative commentary on John Barry, CEO of PSEC, by two VIC members last year, I’m impressed by the refusal to be tied to an investing timeframe, versus investing intelligently. As a shareholder, it is more important to get the portfolio right for the long term, than eke out a couple extra cents of dividend in a current quarter by a rushed investment. The discipline evidenced can only be viewed positively.
Admittedly, the slower origination pace and litigation costs greatly delayed the net investment income (NII) growth modeled a year ago. But the potential to invest and leverage that capital remains, non recurring organizational and litigation expenses are likely to fade, and the combination will fuel that previously expected growth during the year ahead.
The next significant headline will be an announcement reporting the closing on a credit facility enabling PSEC to leverage its original capital. That could come in the next two weeks, but certainly should occur early next quarter at the latest.
With a year of reporting in place, a higher level model is available, incorporating some cash flows off of the common and preferred portions of the portfolio. With the pre-announcement of Q2 FY06 NII (ending 12/31/05) via the dividend press release of 12/12/05, there is hard information to compare the model to, allowing verification of my modeling premises.
Origination pace is the most volatile variable, and I’ve maintained a conservative stance. In the trailing 3 quarters, originations have averaged just under $17MM/qtr. Going forward through calendar year 2006, the model averages the same 17MM/qtr, and assumes 9MM of originations late in the current quarter, but producing no revenue in the quarter. Given less distraction over litigation, and a year of planting seeds in its markets, I think this pacing is reasonably conservative.
On this basis, and with expense assumptions discussed with both PSEC IR and the outsourced CFO operation to the limits of reg FD, the model projects NII at Q2 FY07 (ending 12/31/06) at $.39/share. BDCs are required to pay out virtually all of their NII as dividends, so allowing for a little lag in dividend payout to NII, I expect at least .38/share in Q2 FY07; and this means a $1.52 annualized payout rate. If yield pricing is the dominant force setting the share price, an 8.2% yield attached to this dividend rate equates to a share price of $18.50. With BDCs, another cross check is stock price premium to net asset value (NAV). Allowing no portfolio appreciation from the present value, an $18.50 price implies a premium of 1.26x NAV. The current premium to NAV is 1.04x.
Premium to NAV is the best pricing comparison for externally managed BDC’s, as EPS amounts breakdown as dividend proxies when incentive fees on realized capital gains occur. [My estimates assume no realization events, but in comparing to other peers, the consensus EPS amounts may have realized gain incentive fee reductions to NII, unfairly penalizing the peers in comparison.]
PSEC has a very attractive forward yield, with the second lowest premium to NAV. The premium to NAV for AINV confirms my end of 2006 premium to NAV is realistic (AINV already incorporates some leverage). NGPC is at a much higher level of cash and treasuries (relatively ‘uninvested’), and further from moving into the ‘leveraging’ phase of its business cycle, with the associated higher cash yield relative to NAV.
Downside risks would be a slower origination pace or the blowup of an existing investment. Given the strong commodity prices in the energy sector (and PSEC’s typical requirement that the commodity prices be hedged), there is reason to expect solid cash flows from these energy related investments. I think the unaccelerated pace of origination in my projection is reasonably conservative. The lifting of the various clouds over PSEC, and a year of building contacts and prospects, if anything, should enhance the origination pace.
Finally, as BDCs are limited to 1:1 leverage, at some point PSEC will have to conduct a follow on offering. My model times this in the second calendar quarter of 2007. At a 20% higher origination pace, this moves to the first calendar quarter of 2007. The concern with a first follow on is that it significantly deleverages the company in the near term, temporarily flattening the NII growth rate. The importance of this is that it would be unrealistic to say the last fully leveraged NII will equal the dividend in that quarter. Some will have to be held back to keep a level dividend in the next deleveraged quarter of the follow on. My projection either pushes this out well past the one year time frame, or with higher originations, produces a higher NII in the quarter preceding the follow on. In either case, a $.38 dividend projection for Q2FY07 ending 12/31/06 is realistic.
Sharp ramping of dividend payout with full capital investment and further leveraging.