Shares of Prospect Capital are rallying after the company posted better headline earnings than many were expecting. The company earned $0.26 per share in the fourth quarter as a result of $0.25 per share in operating income (net investment income), plus $0.01 per share in net capital gains.
The results made for a good headline, but a deeper look into the financials tell a different story.
1. The capital gainsProspect Capital's gains this quarter, and for the full year, were concentrated in a handful of its controlled companies. Its investments in Harbortouch were written up by $40.8 million this quarter. First Tower was written up by about $10.5 million. Actually, all of its subprime lenders -- First Tower, Credit Central, and Nationwide Acceptance -- were written up in the fourth quarter.
In its annual report, Prospect Capital gives a thin breakout of Harbortouch's results for the past 15 months, which imply about 2% year-over-year revenue growth. It also notes that Harbortouch lost $48.9 million in 2015, mostly because of what appears to be goodwill amortization. If you add it back in, it's about breakeven.
Despite this outcome,Harbortouch is carried at a valuation of nearly $377 million against a cost basis of $305.5 million, with the premium attributed to the equity.
When asked on the conference call about the markup, management deferred to the fact that an independent company determines its valuations and that other "fintech" companies were getting similar valuations. I take that as a non-answer. Harbortouch sells point-of-sale systems and transaction processing services and is apparently growing revenue at a snail's pace, which doesn't exactly scream "fintech." Investors should wait eagerly for the full annual report for Harbortouch, which will be filed later this year.
But just for the record, Harbortouch's writeup added about $0.12 per share to NAV in the fiscal fourth quarter alone.
2. The CLO bookInvestors have long wondered whether Prospect Capital's CLO valuations are truly accurate. As many BDCs report declining values for their CLOs, Prospect Capital continues to hold its CLOs at a premium to their cost basis.
This quarter, Prospect Capital's combined "fleet" of CLO equity investments were held at a 4% premium to their cost basis. By contrast, TICC Capital marked its CLO equity investments at an 8.9% discount to their collective cost basis last quarter.
If Prospect Capital wrote down its CLOs to its cost, it would result in a $0.12 hit to net asset value per share. Marking them at a discount of 5% to the cost basis would result in a $0.28 hit to NAV per share.
Given that its peers carry their CLO equity investments at discounts, Prospect Capital, which bills itself as one of the world's largest CLO equity investors, should probably mark its book similarly. Keep in mind that the most recent sales of its CLO equity investments generated capital losses -- they were sold below their respective cost bases.
3. The very interesting dividendThis one is a weird one. In the fourth quarter, Prospect Capital:
1. Invested $1.876 million into the equity of a portfolio company.
2. Took $1.981 million back out of the company in the form of a dividend.
These kinds of transactions trigger red flags. In one quarter, Prospect Capital invested more capital in a portfolio company, took a similar amount right back out, and booked it as dividend income.
This transaction added about a half-cent to per-share net investment income, helping it "cover" its dividends with net investment income this quarter.
What's next?Management spent the better half of the question-and-answer session of its conference call defending its portfolio marks, the stability of the business, and the plans about its spinoffs. I still have my concerns.
Given the sudden and significant increase in Harbortouch's value, the fact its CLOs are still carried at a premium, and the very weird portfolio company dividend, I think it's fair to call this quarter a very "smoothed" one. This story is far from over, but let the 245-page annual report tell the tale, not the press release.
The article Prospect Capital Earnings: Look Beyond the Headline 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.
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