3 Things to Watch in Prospect Capital Corporations Third-Quarter Report

By Markets Fool.com

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All eyes are on itsrights offering, but Prospect Capital's earnings reports are just as important now as they have ever been. As the quarter came to a close on March 31, here's what I'll be watching when Prospect Capital reports earnings.

1. Fee income
Prospect Capital recently reduced its dividend to $0.833 per month, or $0.25 per quarter, a level it believed it could cover with its run-rate net investment income. At the time, it noted that it needed just $0.01 per share in quarterly extras likefee income to cover its reduced dividend.

I find it unlikely that Prospect Capital generated anything close to $0.01 per share in fee income this quarter given what we know now. By my count and estimation from numbers obtained through its 497 filings with the SEC, Prospect deployed $189 million in the March 2015 quarter, which, with a very generous average fee of 1.5%, would result in fee income of about $0.008 per share. It's a small "miss" of sorts, but it highlights Prospect Capital's difficulty in generating fee income when it can't make robust new investments by expanding its balance sheet.

2. Troubled assets and a new nonaccrual loan
Prospect Capital wrote down several investments in its second fiscal quarter (which ended Dec. 31, 2015), but one asset could face further write downs. Its $50 million loan to Edmentum could go on nonaccrual this quarter.

New Mountain Finance, a competing BDC, has a similar loan on its balance sheet. In its most-recent conference call, management expected to put a portion of its Edmentum investment on nonaccrual in the March 2015 quarter. It marked its loans to the company at 50% of their principal value; Fifth Street Financeholds its Edmentum loan at 40% of principal value.

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How BDCs marked their second-lien loans to Edmentum

Company

New Mountain Finance

Fifth Street Finance

Prospect Capital

Fair value/Principal value

50%

40%

86%

Source: SEC filings

Prospect is a clear outlier in how it marked its Edmentum investment compared to other investors. (Prospect shares at least 11 other investments with other leading BDCs by my count, which are marked in line with peers' valuations -- Edmentum is just one obvious standout.)

If Prospect marks its Edmentum loan at the midpoint value other BDCs ascribed to similar loans, it would result in an unrealized loss of $0.06 per share against its last-reported net asset value of $10.35 per share. This, of course, assumes no further deterioration or improvement in the company since last quarter.

Similarly, United States Environmental Services, previously identified as a company that provides services to oil companies, could face additional write downs this quarter. It makes up roughly 1.4% of net assets at fair value, or $0.14 per share. Lenders have opined that the situation for oil services companies is more dire than oil producers, since service companies do not employ hedges against falling oil prices. It was last marked at a 14% discount to Prospect's cost, which may widen this quarter.

3. Potential exits
Rumors swirled that Prospect was shopping around its payment processing company, Harbortouch, at a valuation in the range of $500 million. This would be a substantial exit for Prospect, given that it makes up nearly 9% of the company's net asset value after a solid write up in its valuation last quarter.

Recent SEC filings haven't pointed to its sale, but this will be something to take note of on the company's conference call. Liquidating Harbortouch would give it liquidity to strengthen its capital position, make new investments, and allow it to realize a much-needed gain in its portfolio to offset some recent losers.

Keep in mind that Prospect's gains and losses are magnified at the margin. At the end of the 2014 calendar year, Prospect had a debt-to-equity ratio of 1.8:1, perilously close to the 1.85 maximum leverage limit needed to maintain an investment-grade rating.

As we saw recently with Fifth Street Finance, which lost its investment-grade rating to a leverage problem, credit agencies don't mess around when it comes to leverage limits. Unlike Fifth Street, Prospect has the ability to raise equity by issuing shares at prices below NAV, but that's a "nuclear option" that shareholders would prefer it doesn't have to use.

The article 3 Things to Watch in Prospect Capital Corporations Third-Quarter Report 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.