PSEC Q3 2023 Updates By Scott Kennedy

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Related to the stocks in this article:

CWMF is long: RITM-D, GPMT-A, DX-C, EFC-A, MFA-C, RITM-C, EFC-B, PMT-C, PMT-B, CIM-B, AGNCP, CIM-D, RITM, SLRC, MFA, GPMT, RC.

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The rest of this post is from Scott Kennedy.

Summary

• This 25th earnings assessment article reviews PSEC’s NAV and NII performance during calendar Q3 2023.

• This article also discusses how PSEC’s quarterly change in NAV and NII “matched up” to expectations. Earnings remain a key driver to stock performance.

• PSEC’s NAV was a minor-modest outperformance while its NII was a modest outperformance.  PSEC's NII outperformance was largely due to non-recurring structural fees on NPH.

• No change in PSEC’s percentage recommendation ranges or risk rating. PSEC is currently deemed undervalued.  PSEC continues to trade at a steep discount to peers (hence, SOME value).

• Based on PSEC’s sector-worst 4.5 risk rating, this investment should ONLY be considered by investors with a high-very high risk tolerance who are looking for a quick value “flip”.

Introduction:

Hi subscribers. For new members, my name is Scott Kennedy and currently I fully cover 20 mortgage real estate investment trust (mREIT) and 15 business development company (“BDC”) common stocks within this Investing Group regarding research/data, subscriber questions, weekly projected book values/net asset values (BV/NAV), and common stock recommendation ranges. Colorado (“CO”) Wealth Management handles the mREIT preferred stocks and he and his team handles all other applicable REIT sectors outside the mREIT sector. CO also provides some mREIT common stock and BDC articles from time-to-time which are more of an “overview/introduction” discussion; typically based either on my or our combined research/data. This also includes some macroeconomic trends and data. My name is always attached to all Investing Group articles I personally wrote so there is no confusion for subscribers.

This REIT Forum article is part of a series of articles over a span of 6-7 weeks which will analyze my previously projected BV/NAV and core earnings (or core earnings equivalent)/net investment income (“NII”) figures and compare these metrics to each mREIT’s and BDC’s actual reported results, respectively. For readers who are familiar with my public mREIT and/or BDC articles, these types of articles are beneficial to readers who desire to pursue a more active investing strategy and/or want more “real time” thoughts/analysis.

I hope my services/contributions ultimately help enhance a subscriber’s total investment returns or minimize their total investment losses within the mREIT and BDC sectors. At the very least, I hope subscribers will gain more insight into the mREIT and BDC sectors by reading my/our exclusive REIT Forum articles.

1) PSEC’s NAV and NII Calendar Q3 2023 Performance (Projected Versus Actual Results):

On 11/8/2023, Prospect Capital Corp. (PSEC) reported the company’s earnings results for the calendar third quarter of 2023 (fiscal first quarter of 2024). Table 1 below provides PSEC’s NAV and earnings summary.

Table 1 – PSEC Calendar Q3 2023 NAV and Earnings Summary

Source: Taken Directly from the REIT Forum’s © Analytical Spreadsheets/Data

Hi subscribers. I was able to review PSEC’s calendar Q3 2023 (fiscal Q1 2024) earnings results in more depth. PSEC's calendar Q3 2023 NII of $0.252 per basic common share was a modest outperformance versus my prior projection of $0.225 per basic common share. PSEC’s calendar Q2 2023 NII was $0.226 per basic common share. As such, I projected a NII decrease of ($0.001) per basic common share. In actuality, PSEC reported a NII increase of $0.026 per basic common share during the calendar third quarter of 2023. The institutional analysts’ consensus average was NII of $0.221 per basic common share. Let us reconcile PSEC’s quarterly NII outperformance.

First, when reviewing PSEC’s investment portfolio, the company had quarterly loan originations funded at close and add-on investments of $131 million during the calendar third quarter of 2023. In comparison, I projected quarterly loan originations funded at close and add-on investments of $125 - $225 million (mean of $175 million). PSEC recorded loan prepayments/repayments/restructurings of ($94) million during the calendar third quarter of 2023. In comparison, I projected quarterly prepayments/repayments/restructurings of ($125) – ($225) million (mean of ($175) million). When calculated, excluding fair market value (“FMV”) fluctuations, PSEC increased the company’s investment portfolio size by $37 million during the calendar third quarter of 2023. In comparison, I projected PSEC would report, after a robust prior quarter, an unchanged investment portfolio size. So, a very slightly larger investment portfolio size when compared to my expectations.

Second, unlike a majority of BDC peers, PSEC actually experienced a modest decrease in the company’s weighted average annualized yield during the calendar third quarter of 2023 when compared to the prior quarter. This was correctly anticipated mainly due to the following: 1) new loan originations had lower stated interest rates when compared to existing loans; 2) a couple controlled portfolio companies had amended, lower stated interest rates; and 3) PSEC’s collateralized loan obligation (“CLO”) sub-portfolio continued to experience more subdue returns. PSEC reported a weighted average annualized yield of 13.40%, 13.30%, and 12.70% for the calendar first, second, and third quarter of 2023, respectively. When calculated, this was a quarterly decrease of (0.10%) and (0.60%), respectively. This past quarter, this matched my expectations. This metric should begin to plateau towards the end of 2023. In addition, it should be noted the higher LIBOR/SOFR/PRIME rises, the more underlying credit risk (non-accruals) needs to be respected (and monitored). This will have heightened importance as we head through 2023 and into 2024.

At this point, some readers could be asking if PSEC only had a very slightly larger investment portfolio and a modest decrease in weighted average annualized yield, how did the company report a modest increase in quarterly NII? Simply put, it all came down to PSEC’s largest portfolio company, National Property REIT Corp. (“NPH”). As a refresher, NPH invests in real estate assets (mainly multifamily properties), online consumer loans, and CLOs via several wholly-owned subsidiaries. PSEC owns 100% of NPH (key consideration regarding the discussion below). During any given period, PSEC can be “active” within the company’s investment in NPH. This typically involves NPH prepaying loans to PSEC, receiving additional funding from PSEC, and/or converting debt to equity or vice versa. At least one of these scenarios happens every quarter. However, I would point out since NPH technically does not have (and has not had) “earnings and profit” (just another term for taxable income) to pay the company a dividend (a taxable equity distribution would be classified as dividend income at the parent level), PSEC periodically charges “structuring fees” whenever certain terms are amended. To be frank, it is a “slick” way of generating accrued GAAP revenues when/if needed since, again, NPH does not have taxable income.

Again, PSEC owns 100% of NPH. As such, PSEC can “dictate” when to change the underlying debt/equity structure of the subsidiary and record structuring fees. PSEC has been doing this for years and I have discussed this specific relationship in the past. With that in mind, PSEC reported other income of $14.1 million directly related to NPH during the calendar second quarter of 2023. This was solely related to royalty, net profit, and revenue interests (pretty standard/customary). However, PSEC reported other income of $29.5 million directly related to NPH during the calendar third quarter of 2023. This included royalty, net profit, and revenue interests of $14.0 million (very minor quarterly decrease) and structuring fees of $15.5 million. When calculated, this was a proportionately very large quarterly increase in PSEC’s total other income (over 100%). PSEC’s term loan A, D, and E were amended during the quarter (slight reduction in stated interest rate) which were previously undisclosed by management (hence why I did not project them this quarter).

So, with a very slightly larger investment portfolio size, matched expectations regarding PSEC’s quarterly weighted average annualized yield, and a very large proportionate increase in other income (solely isolated to a very large amount of structuring fees regarding NPH), the company reported a modestly higher total quarterly investment income figure when compared to my expectations. PSEC reported total investment income of $236 million during the calendar third quarter of 2023. In comparison, I projected PSEC would report total investment income of $225 million. When calculated, including the incentive fee offset from higher total pre-incentive fee income, this $11 million variance ultimately resulted in a NII outperformance of $0.026 per basic common share when compared to my expectations.

When the variance above is combined with a remaining $0.001 per basic common share operational expense net outperformance (mainly very slightly higher-than-anticipated base management fees and interest expense directly due to a slightly larger investment portfolio size partially offset by lower-than-anticipated business overhead + other expenses), this fully reconciles back to PSEC’s NII outperformance of $0.027 per basic common share when compared to my expectations for the calendar third quarter of 2023.

Moving on, PSEC reported a NAV as of 9/30/2023 of $9.25 per common share (0.1% increase) versus my projection of $9.00 per common share (2.6% decrease). I consider this a minor – modest (greater than a 2.5% but less than a 5.0% variance) outperformance and was within my $8.65 - $9.35 per common share range (towards the top end). So, a bit of an outperformance regarding PSEC’s quarterly NAV fluctuations during the calendar third quarter of 2023 when compared to my expectations. Let us see where this NAV outperformance occurred.

Regarding PSEC’s total investment portfolio, which consisted of 128 portfolio companies as of 9/30/2023, there were a handful of portfolio companies which simply had less unrealized depreciation/more unrealized appreciation when compared to my expectations. This includes, but is not limited to, the following portfolio companies: 1) Valley Electric Company, Inc. (Valley Electric); 2) R-V Industries, Inc. (R-V); 3) First Tower Finance Company LLC (1^st Tower); 4) Credit.com Holdings LLC (Credit.com; new entity created by the PGX Holdings Inc. [PGX] Chapter 11 bankruptcy); and 5) Town & Country Holdings Inc. (Town & Country). To be frank, I will simply state I believe most of these valuation fluctuations were/are “overly bullish/optimistic”. On a related note, outside the listed portfolio companies above, there were a couple instances where PSEC’s FMV of the same exact broadly-syndicated debt investment also held by some other BDC peers was 10% - 15% higher as of 9/30/203 when compared to the peers. Again, as a reminder, this is typically the “name of the game” with PSEC (higher valuations, overly optimistic assessments regarding valuations). Just something to highlight here for perspective. Getting back to the NAV reconciliation, PSEC recorded a combined net realized loss and net unrealized appreciation of ($8) million during the calendar third quarter of 2023. In comparison, I projected a combined net realized loss and unrealized depreciation of ($90) million. When calculated, this $82 million variance directly led to a NAV outperformance of $0.21 per common share when compared to my expectations.

When the variance noted above is combined with the aforementioned NII outperformance of $0.027 per basic common share discussed earlier and a NAV outperformance of $0.01 per common share in direct relation to less-than-anticipated issuance of common stock (slightly less severe NAV dilution), this directly reconciles back to PSEC’s NAV outperformance of $0.25 per common share when compared to my expectations.

Regarding credit risk, I correctly anticipated PSEC would put 1 new portfolio company on non-accrual status during the calendar third quarter of 2023. This was previously highlighted in our weekly mREIT and BDC articles series (credit section). PSEC’s second lien debt investment in Strategic Materials Holding Corp. (Strategic Materials), with a principal balance of $7 million, was placed on non-accrual status during the quarter. As such, a small-sized loan. In addition, 2 portfolio companies were taken off non-accrual status during the quarter. First, PSEC’s 2 debt investments in Rising Tide Holdings, Inc. (Rising Tide) were restructured during the quarter (1 second lien debt investment was previously on non-accrual status). A majority of Rising Tide’s previous debt was restructured into equity and a new, very small debt investment was placed back on accrual status during the quarter. Not the “ideal” outcome for a portfolio company (a “distressed” exchange/restructuring). Rising Tide will have heightened monitoring in future quarters. Second, PGX received approval of the company’s Chapter 11 bankruptcy (after an initial bankruptcy filing earlier in the year) in late September 2023. As a part of this process, PGX sold the vast majority of the company’s assets to Credit.com. PSEC “rolled over” the company’s first lien accrual loan into 2 first lien loans and provided some new equity into the newly-formed entity. However, PSEC fully wrote-off the company’s second lien non-accrual loan and recorded a total net realized loss of ($181) million. Simply put, a massive permanent loss of capital but this was already written-down in prior quarters (a small “silver lining”). Therefore, a pretty bad outcome for this portfolio company in my professional opinion but, at this point, PSEC avoided a total/100% write-off of the company’s entire PGX investment via the newly-created entity. Similar to Rising Tide, Credit.com will have heightened monitoring in future quarters.

As such, PSEC’s non-accrual percentages decreased during the calendar third quarter of 2023. However, this was directly due to 2 distressed exchanges/restructurings which “skews” PSEC’s percentages more favorably. As of 9/30/2023, PSEC’s non-accrual percentage, based on amortized cost basis and FMV, was 2.2% and 0.2%, respectively. However, PSEC’s cumulative net realized loss increased from ($1.31) per common share as of 6/30/2023 to ($1.80) per common share as of 9/30/2023. A larger cumulative net realized loss is a negative factor/trend which “counters” PSEC’s lower non-accrual percentages. Just something to highlight.

So, all-in-all, a modest outperformance on PSEC’s NII (variance of $0.027 per basic common share) and a minor – modest outperformance on the company’s NAV (variance of 2.7%). So, when simply looking at the “top-line” metrics, it would appear to be a very good quarter for PSEC. However, I would point out PSEC’s NII outperformance was basically solely isolated to “one-time” structuring fees generated from NPH (which PSEC basically controls due to 100% ownership). In addition, I believe a good portion of PSEC’s NAV outperformance was directly due to “overly bullish/optimistic” assumptions regarding a handful or portfolio company valuations.

In addition, through numerous prior restructurings and rising recessionary/credit risk, PSEC still has a handful of underperforming/troubled portfolio companies that need heightened monitoring.

Furthermore, PSEC continues to have above average management/performance-based incentive fees and the company continues to issue shares of common stock (through the reinvestment of dividends) at a notable discount to CURRENT NAV which continues to cause some quarterly NAV dilution (which has negative cumulative impacts). I am also not a complete fan of the continued issuance of preferred stock. While yes, the cost of capital is fairly attractive, it does “take away” from a growing amount of NII being allocated to common shareholders as well. As a reminder, this service does not rate/cover PSEC’s preferred stock as I personally believe it continues to not be an attractive investment from a yield/risk perspective (especially more recently).

That said, to remain non-bias, PSEC’s capitalized “payment-in-kind” (“PIK”)/deferred income, as a percentage of the company’s total investment income, increased from 11.4% during the calendar fourth quarter of 2022 to 21.8% during the calendar first quarter of 2023 but has since decreased to 9.8% during the calendar third quarter of 2023. However, a large portion of this decrease was directly due to the 100%/total write-off of PSEC’s second lien debt investment in PGX (discussed earlier). In addition, there was some timing differences within certain CP Energy Services Inc. (CP Energy) and Valley Electric loans regarding this specific metric. So, again, a bit of a “caveat” to this notable decrease (worthless/written-off loan and timing issues). Again, this is solely considering PSEC’s capitalized PIK/deferred income (not the portion of PIK income currently paid in cash during any particular quarter). If subscribers want a better understanding of this metric, a very detailed discussion was provided within PSEC’s earnings chat note during the calendar first quarter of 2022. Along with PSEC’s capitalized PIK rate, the company’s percentage of restructured investments is also very high. This is one of the main reasons why our PSEC percentage recommendation ranges (relative to estimated CURRENT NAV) are at the largest discount when compared to the other 14 sector peers I/we currently cover. This was the case even before PSEC’s downgrade earlier this year.

Therefore, when taking PSEC’s recent and projected performance into consideration, along with macroeconomic trends/events (mainly Fed monetary policy, the general projected movement of rates/yields, and projected economic performance over the foreseeable future), no change to my/our PSEC percentage recommendation ranges (relative to CURRENT NAV) or risk rating (remains at a 4.5). PSEC remains a “below average” BDC in my/our opinion.

At a closing price as of 11/17/2023 of $5.73 per share, PSEC is deemed to be UNDERVALUED (price target of $7.35 per basic common share). PSEC is currently one of the more undervalued BDC stocks that I/we cover. That said, I would be a bit hesitant owning this particular BDC; even when it presents an attractive valuation. This has been something I/we have continuously stated over the past several quarters. Based on PSEC’s sector-worst 4.5 risk rating, this investment should ONLY be considered by investors with a high - very high risk tolerance who are looking for a quick “flip”/short-term investment when the valuation is attractive enough (closer to a NOTABLY UNDERVALUED/STRONG BUY recommendation). I cannot stress this enough.

Conclusions Drawn + BUY, SELL, or HOLD Recommendation:

Readers have continued to request that I provide these types of “earnings assessment” articles showing how my previously disclosed quarterly projections “stacked-up” to each covered mREIT’s/BDC’s results. I believe the analysis above accomplishes this request for the REIT Forum subscribers.

In summary, here is how PSEC performed when compared to my expectations regarding the third quarter of 2023 (includes any risk rating and BUY, SELL, or HOLD recommendation range changes; as well as current recommendation):

1) PSEC

NAV: Minor-Modest Outperformance (Within Range; Towards Top End)

NII: Modest Outperformance (Slightly OUTSIDE Range)

Percentage Recommendation Range (Relative to CURRENT NAV): No Change (Reasoning Provided Above)

Risk Rating: No Change

Table 2 – PSEC Notecard (As of 11/17/2023)

(Source: Taken Directly from the REIT Forum’s © Subscriber-Accessible Spreadsheets. Earnings Projection is Taken Directly from Either the Prior Quarter’s Actual Reported Figure or the Institutional Analysts’ Consensus Average and Annualized. At the End of Each Current Quarter, I Provide My Own Finalized Core Earnings/Core Earnings Equivalent or NII/Adjusted NII Metric Which Will Differ from the Estimate Provided Above.)

Important Note: As always, please check the Google shared spreadsheets when it comes to intra-week recommendations as stock prices fluctuate.

Along with the data presented within this article, this recommendation considers the following BDC catalysts/factors: 1) projected future high yield/speculative-grade credit spreads; 2) managerial expertise/underwriting due diligence (regarding credit risk); and 3) projected near-term (up to 1-year) dividend per share rates. These recommendations also consider the 8 Federal (“Fed”) Funds Rate increases by the FOMC during December 2016-2018 (a more hawkish tone/rhetoric when compared to 2014-2016), the three Fed Funds Rate decreases during 2019 due to the more dovish tone/rhetoric regarding overall monetary policy as a result of recent macroeconomic trends/events, and the very quick “plunge” in the Fed Funds Rate to near 0% in March 2020. This also considers the previous wind-down/decrease of the Fed Reserve’s balance sheet through gradual runoff/partial non-reinvestment (which began in October 2017 which increased spread/basis risk) and the prior “easing” of this wind-down that started in May 2019 regarding U.S. Treasuries and August 2019 regarding agency MBS (which partially reduced spread/basis risk when volatility remained subdued). This also considers the early Spring 2020 announcement of the start of another round of quantitative easing (“QE”) that includes the Fed specifically purchasing agency MBS (and “rolling over” all principal and interest payments into new agency MBS) which bolstered prices while keeping long-term/mortgage interest rates near historical lows (which lowered spread/basis risk for quite some time when volatility remained subdued). This also includes the recent “taper” of the Fed’s most recent QE program regarding its monthly purchases of $80 billion of U.S. Treasury securities and $40 billion of agency MBS. This taper began in November 2021 and market speculation around this future event caused a rise in spread/basis risk and during the summer of 2021 (as correctly previously anticipated) and the second half of the fourth quarter of 2021-October 2022. This includes the FOMC’s previously accelerated taper and the continued very quick rise in the Fed Funds Rate which began in March 2022.

Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader’s current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions.

Understanding My Valuation Methodology Regarding mREIT Common and BDC Stocks:

The basic "premise" around my recommendations in the mREIT common and BDC sectors is value. Regarding operational performance over the long-term, there are above average, average, and below average mREIT and BDC stocks. That said, better-performing mREIT and BDC peers can be expensive to own, as well as being cheap. Just because a well-performing stock outperforms the company’s sector peers over the long-term, this does not mean this stock should be owned at any price. As with any stock, there is a price range where the valuation is cheap, a price where the valuation is expensive, and a price where the valuation is appropriate. The same holds true with all mREIT common and BDC peers. As such, regarding my investing methodology, each mREIT common and BDC peer has their own unique BUY, SELL, or HOLD recommendation range (relative to estimated CURRENT BV/NAV). The better-performing mREITs and BDCs typically have a recommendation range at a premium to BV/NAV (varying percentages based on overall outperformance) and vice versa with the average/underperforming mREITs and BDCs (typically at a discount to estimated CURRENT BV/NAV).

Each company’s recommendation range is "pegged" to estimated CURRENT BV/NAV because this way subscribers/readers can track when each mREIT and BDC peer moves within the assigned recommendation ranges (daily if desired). That said, the underlying reasoning why I/we place each mREIT and BDC recommendation range at a different premium or (discount) to estimated CURRENT BV/NAV is based on roughly 15-20 catalysts which include both macroeconomic catalysts/factors and company-specific catalysts/factors (both positive and negative). This investing strategy is not for all market participants. For instance, not likely a “good fit” for extremely passive investors. For example, investors holding a position in a particular stock, no matter the price, for say a period of 5+ years. However, as shown throughout my articles written here at Seeking Alpha since 2013, in the vast majority of instances I have been able to enhance my personal total returns and/or minimize my personal total losses from specifically implementing this particular investing valuation methodology. I hope this provides some added clarity/understanding for new subscribers/readers regarding my valuation methodology utilized in the mREIT common and BDC sectors. Please disregard any minor “cosmetic” typos if/when applicable.