What Lies Ahead for Prospect Capital Corp. in 2015

By Markets Fool.com

Prospect Capital Corp. had a rough year in 2014. The company's share price fell 27%, and, adjusting for reinvested dividends, investors lost roughly 15%.

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A new year brings new opportunity, however. Let's look at some of the ups and downs that will likely define the company's 2015 calendar year.

The upside
The upside to any deeply depressed stock price is that simple reversion to the mean can bring big returns. Currently, shares trade at about a 22% discount to Prospect's last-reported net asset value of $10.47 per share. If the stock simply trades back to book value, it would net investors a nearly 28% return.

In addition, the company's recently reduced dividend is likely now sustainable. Prospect Capital reduced its dividend to $0.0833 per share, per month, which it believes it can sustain with its net investment income, assuming it can generate $0.01 in other income each quarter.

Previously, the company paid roughly $0.11 in dividends per month, which required significant new originations and resulting fee income to be covered with net investment income.

Better income and a better share price
Prospect Capital has a few levers it can pull to create new income and potentially generate a higher share price.

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On the income side, Prospect Capital has planned for several quarters to rotate out of low-yielding investments and reinvest the proceeds at higher yields. I count nearly $600 million in assets that yield less than 8% on its balance sheet as of Sept. 30, 2014. Swapping these investments for assets that yield 4% more on average would more than seal the gap of $0.01 in quarterly fee income per share necessary to sustain its current dividend.

In addition, Prospect Capital sees spinoffs as a source of value creation. The company owns a portfolio of consumer "peer-to-peer" and small-business loans, real estate assets, and collateralized debt obligations, all of which could be spun off into separate businesses. The hope is that these assets would, as a pure play, collect a higher multiple of earnings than they would in the BDC structure. Details remain sparse, given that the announcement was made when Prospect reported results last quarter.

The downside
I remain concerned about the influence of compensation on the management team's decisions. Because Prospect Capital is externally managed -- as many BDCs are -- the external manager earns more fees from shareholders as the asset base grows.

This has the incentive of encouraging growth, even if it that growth isn't in the best interest of existing shareholders. More so than other BDCs, Prospect Capital has grown its balance sheet with dilutive equity sales, offering shares at prices under book value. In general, shareholder-friendly BDCs issue new shares at the largest possible premium, not discount, to net asset value.

Prospect Capital currently has one of the highest fees of all externally managed companies. Over the long run, I'm confident these fees will make a big impact on performance, and they are, in my view, one of the reasons why Prospect trades at a discount to its peers. On balance, higher operating costs restrict profits and, ultimately, the valuation investors are willing to pay for its shares.

Recent portfolio markdowns
Some recent markdowns on Prospect Capital's portfolio companies suggest there could be more losses to the company's asset value. It recently sold a handful of collateralized loan obligation investments at a loss, despite carrying them at a premium at the end of the prior quarter. CLO equity made up about 18% of Prospect's portfolio at fair value as of Sept. 30, 2014.

Likewise, the recent quarter-end report revealed some markdowns on a handful of controlled investments, even after sizable movements following the accounting changes at the beginning of the new fiscal year. In addition, it made a significant markdown on portfolio company United States Environmental Services (USES), which, among other things, provides services to the oil and gas industry. Future markdowns could come as the oil and gas sector cuts spending in light of oil price declines. (USES is not included in the company's reported level of energy exposure of 5.1% of the portfolio at fair value.)

I've always believed the only time to buy an externally managed BDC is when it trades at a discount to net asset value, and Prospect Capital clearly trades at a substantial discount. However, for long-term Foolish investors, the above-average expenses are a costly line item that will weigh on performance over the long haul, whittling away the advantage of an appealingly "cheap" entry price relative to NAV. And for that reason, I'm not yet tempted to take the bait of a seemingly cheap price relative to reported book value.

The article What Lies Ahead for Prospect Capital Corp. in 2015 originally appeared on Fool.com.

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.