Prospect Capital Corporation (PSEC) Q2 2020 Earnings Report, Transcript and Summary

Good day, and welcome to the Prospect Capital Corporation Second Fiscal Quarter Earnings Release and Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to John Barry, Chairman and CEO. Please go ahead, sir.

Good morning, Chuck. Thank you very much. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Kristin Van Dask, our Chief Financial Officer. Kristin?

Thanks, John. This call is the property of Prospect Capital Corporation. Unauthorized use is prohibited. This call contains forward-looking statements within the meaning of the securities laws that are intended to be subject to Safe Harbor protection. Actual outcomes and results could differ materially from those forecast due to the impact of many factors. We do not undertake to update our forward-looking statements unless required by law. For additional disclosure, see our earnings press release and our 10-Q filed previously and available on the Investor Relations tab on our website, prospectstreet.com. Now I'll turn the call back over to John.

Thank you, Kristin. For the December 2019 quarter, our net investment income was $67.9 million or $0.18 per share, down $0.01 from the prior quarter. Our ratio of NII to distributions was 103%. In the December 2019 quarter, our net debt-to-equity ratio was 64.1%, down 2.2% from the prior quarter and down 10.9% from December 2018 as we continue to maintain a prudent leverage profile and cautious approach to capital deployment in the current environment. Our net loss for the quarter was $11.2 million or $0.03 per share, a decrease of $0.08 from the prior quarter, primarily due to a decrease in portfolio valuations during the December 2019 quarter. We are announcing monthly cash distributions to shareholders of $0.06 per share for each of February, March and April, representing 141 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in May 2020. Since our IPO 16 years ago, through our April 2020 distribution at our current share count, we will have paid out $17.88 per share to original shareholders, aggregating over $3 billion in cumulative distributions to all shareholders. Our NAV stood at $8.66 per share in September, down $0.21 from the prior quarter. Our balance sheet as of December 2019 consisted of 86.3% floating rate interest assets and 95.8% fixed rate liabilities. In recent months, we have trimmed our cost of term debt issuance commensurate with reductions in treasuries while also retiring more expensive upcoming maturities. Our percentage of total investment income from interest income was 86.9% in the December 2019 quarter, a decrease of 3.3% from the prior quarter and an increase of 2.8% from the December 2018 quarter. Thank you. I will now turn the call over to Grier.

Thank you, John. Our scale business with over $6 billion of assets and undrawn credit continues to deliver solid performance. Our experienced team consists of approximately 100 professionals, which represents one of the largest middle market credit groups in the industry. With our scale, longevity, experience and deep bench, we continue to focus on a diversified investment strategy that covers third-party private equity sponsor related and direct non-sponsor lending, Prospect-sponsored operating and financial buyouts, structured credit, real estate yield investing and online lending. As of December 2019, our controlled investments at fair value stood at 45.8% of our portfolio, up 1.8% from the prior quarter. This diversity allows us to source a broad range and high volume of opportunities, then select in a disciplined bottoms-up manner the opportunities we deem to be the most attractive on a risk-adjusted basis. Our team typically evaluates thousands of opportunities annually and invests in a disciplined manner in a low single-digit percentage of such opportunities. Our non-bank structure gives us the flexibility to invest in multiple levels of the corporate capital stack with a preference for secured lending and senior loans. As of December 2019, our portfolio at fair value comprised 41.5% secured first lien, 24.7% secured second lien, 15% subordinated structured notes with underlying secured first lien collateral, 0.9% unsecured debt and 17.9% equity investments, resulting in 81.2% of our investments being assets with underlying secured debt, that benefits from borrower pledge collateral. Prospect's approach is one that generates attractive risk-adjusted yields. In our performing interest-bearing investments, we are generating an annualized yield of 12.8% as of December 2019, up 10 basis points from the prior quarter. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generate distributions. We've continued to prioritize senior and secured debt with our originations to protect against downside risk while still achieving above-market yields through credit selection discipline and a differentiated origination approach. As of December, we held 120 portfolio companies, down five from the prior quarter due to repayments and exits with a fair value of $5.27 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration, the largest is 16.8%. As of December, our asset concentration in the energy industry stood at 2.2% and our concentration in the retail industry stood at 0%. Non-accruals as a percentage of total assets stood at approximately 1.6% in December, a decrease of 0.8% from the prior quarter. Our weighted average portfolio net leverage stood at 4.75x EBITDA, up 0.06 from the prior quarter. Our weighted average EBITDA per portfolio company stood at $69.5 million in December, up from $62 million in the prior quarter. Originations in the December quarter aggregated $327 million. We also experienced $432 million of repayments and exits as a validation of our capital preservation objective and sell-down of larger credit exposures, resulting in net repayments of $105 million. During the December quarter, our originations comprised 43.7% agented sponsored debt, 31.7% non-agented debt, including early look anchoring and club investments; 19.9% rated secured structured notes; and 4.7% corporate yield buyouts. To date, we've deployed significant capital in the real estate arena through our private REIT strategy largely focused on multifamily workforce, stabilized yield acquisitions with attractive 10-year plus financing. NPRC, our private REIT, has real estate properties that have benefited from rising rents, strong occupancies, high-returning high value-added renovation programs and attractive financing recapitalizations, resulting in an increase in cash yields as a validation of this income growth business alongside our corporate credit businesses. NPRC has exited completely over 20 properties, with an objective to redeploy capital into new property acquisitions, including with repeat property manager relationships. We expect our exits to continue and have identified multiple additional properties for potential exit in calendar years 2020 and beyond. Our structured credit business has delivered attractive cash yields, demonstrating the benefits of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities. As of December, we held $791 million across 39 non-recourse subordinated structured notes investments. These underlying structured credit portfolios comprised around 1,700 loans and a total asset base of around $18 billion. As of December, the structured credit portfolio experienced a trailing 12-month default rate of 51 basis points, representing 88 basis points less than the broadly syndicated market default rate of 139 basis points. In the December quarter, this portfolio generated an annualized GAAP yield of 14.6%. As of December, our subordinated structured credit portfolio has generated $1.16 billion in cumulative cash distributions to us, representing around 83% of our original investment. Through December, we've also exited nine investments, totaling $263 million with an average realized IRR of 16.7% and cash-on-cash multiple of 1.48x. Our subordinated structured credit portfolio consists entirely of majority-owned positions. Such positions can enjoy significant benefits compared to minority holdings in the same tranche. In many cases, we receive fee rebates because of our majority position. As a majority holder, we control the ability to call a transaction in our sole discretion in the future, and we believe such options add substantial value to our portfolio. We have the option of waiting years to call a transaction in an optimal fashion rather than when loan asset valuations might be temporarily low. We, as a majority investor, can refinance liabilities on more advantageous terms, remove bond baskets in exchange for better terms from debt investors in the deal and extend or reset the investment period to enhance value. We completed over 25 refinancings and resets over the last two years. So far in the current March quarter, we've booked $322 million in originations and received repayments of $78 million, resulting in net originations of $245 million. Our originations have comprised 77% agented sponsored debt, 16% non-agented debt and 7% rated secured structured notes. Thank you. I'll now turn the call over to Kristin.

Thanks, Grier. We believe our prudent leverage, diversified access to matched-book funding, substantial majority of unencumbered assets and weighting toward unsecured fixed-rate debt demonstrate both balance sheet strength as well as substantial liquidity to capitalize on attractive opportunities. Our company has locked in a ladder of liabilities extending 23 years into the future. We are a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, develop a notes program, issue under a bond ATM, acquire another BDC and many other lists of firsts. Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry, which we have taken toward construction of the right-hand side of our balance sheet. As of December 2019, we held approximately $3.94 billion of our assets as unencumbered assets, representing approximately 73% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, where in September we completed an extension of our revolver to a refreshed five-year maturity. We currently have $1.0775 billion of commitments from 30 banks with a $1.5 billion total size accordion feature at our option. The facility revolves until September 2023, followed by a year of amortization with interest distributions continuing to be allowed to us. Outside of our revolver and benefiting from our unencumbered assets, we've issued at Prospect Capital Corporation, including in the past two years, multiple types of investment-grade unsecured debt, including convertible bonds, institutional bonds, baby bonds and program notes. All of these types of unsecured debt have no financial covenants, no asset restrictions and no cross defaults with our revolver. We enjoy an investment-grade BBB rating from Kroll and investment-grade BBB rating from Egan-Jones and an investment-grade BBB negative rating from S&P and an investment-grade Baa3 rating from Moody's. So a total of four investment-grade ratings. We have now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 23 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we substantially reduced our counterparty risk over the years. In the December 2019 quarter, we repurchased $3 million of our April 2020 notes, $36 million of our July 2022 notes, and $96 million of our program notes. We also continued our weekly programmatic InterNotes issuance. If the need should arise to decrease our leverage ratio, we believe we could slow originations and allow repayments and exits to come in during the normal ordinary course as we demonstrated in the first half of calendar year 2016 during market volatility. We now have eight separate unsecured debt issuances aggregating $1.5 billion, not including our program notes, with maturities extending to June 2029. As of December 2019, we had $622 million of program notes outstanding with staggered maturities through October 2043. Now I'll turn the call back over to John.

Thank you, Kristin. Well, we're done for now. Let's see if we have any questions.

We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Matt Tjaden with Raymond James. Please go ahead.

Hi, morning everyone.

Good morning.

So first question is on PGX Holdings. So $100 million second lien marked at about 85. So I guess, two kind of questions. So first, it looks like last May, there were some regulatory issues with the CFPB? And then secondly, with that, kind of looking at the first lien, more liquid debt that's trading in the high 40s as far as we can tell. Any commentary on the asset going forward?

Sure. Grier, you want to take that? Well, I have a bunch of things to say, but Grier is always a better person to go first, Matt.

Okay. So Matt, first of all, it's a clarification. If you're examining the services like market, oftentimes those services, that one in particular, will have a price, which actually is a result of zero trades. So my understanding is there have been zero trades in the last nine months in that paper. So that's not a real price on the first lien. Secondly, pertaining to the business and its outlook. We've been a lender to that company for many years, the company provides a valuable service to consumers to really correct errors in their credit reports, which, of course, helps consumers and helps them improve access to in terms of credit as a result of improving their credit scores through that error-correction process. So it's a valuable consumer service. This is not a debt-collection company. It's a service for primarily individuals. The company is dealing with some regulatory issues right now that are somewhat technical in nature, and will take a very long time to resolve as we understand it. But we understand folks in the picture are positively disposed. No guarantees, of course, for a positive outcome for the business. And the company continues in the meanwhile, business as usual to provide its services to consumers, consumers subscribe, they get the benefits from the company of credit score error fixing and the follow-on benefits to their credit. And again, we've been a lender to this company for many, many years from when it was a much smaller business and it has seen a lot of organic growth over the years. So those are some of my comments. John, do you want to add to that?

Yes. Well, Matt, thanks for asking because the value of each security in our portfolio is set either precisely by an outside valuation firm, in this case, Lincoln, or within a range, which is also set by Lincoln. And I think it's accurate, Grier, to say that the deal team and H.I.G. and other people were amazed at the valuation that [low] [ph] put on this security. But we can't do anything about it because we are limited to valuing every security at the exact valuation provided by Lincoln unless there's a range, in which case we can be within the range. So that's the first thing to know. Our opinions on how these things – if we disagree with Lincoln, those opinions, I guess, are interesting. The first problem is this CPFB. Is that what it's called? The unit of the Fed that it is a consumer protection bureau has a beef with the company. And Grier, I'm trying to remember what it is. What is, in fact, the assertion that the CPFB is making?

Well, it's a technical aspect associated with whether or not one is allowed to charge a fairly modest subscription relative to the benefits received at the beginning of the subscription versus at the end after definitive benefits have been delivered. So that's the layman's gist of it.

Right. And Grier, would I be misstating if I said the lawyers and the business people view this as one of these regulatory actions that will take time to resolve, but not one that will end up requiring a substantial change to the company's business model?

Correct.

Right. That's my impression. Number two, we were quite surprised, Matt, to see a – I don't know if it's a single trade at market, allegedly in the 40s, who would sell in the 40s, somehow is factored into the valuation of the entire company. You couldn't go by that first lien at 40. Go out there and try it. You couldn't buy it at 50 or 60 or 70 or 80 – well, we're told, you can't buy it at 100. No, I haven't conducted my own investigation, but that's what I've been told. And then number three, there is a reason for concern, but it's not those two things. It's the fact that Google is a very big portal, has been, I think – Grier, was it 18% or 20% of the revenue? And I forget the EBITDA. And Google now has a new stricture that allegedly does not allow company, credit repair companies, to advertise through Google, a paid advertisement. But if you go on Google, you'll see plenty of paid ads by credit repair companies. So you wonder, well, what is this stricture? And is it only impacting Progrexion? Further, if you go on Google, you'll notice that Progrexion comes up on the first page in the non-paid area. So what is the impact? And what we've heard is it – the impact is yet to be seen. It's not going to be positive. It's not clear how impactful or how long any impact will occur. But in my mind, Matt, that is the substantive reason. Well, that is a – how would I put it, a proper reason for concern, whereas these other – this market thing is absolutely, in my mind, is not. And then as far as this CPFB claim, from what I've been told, that is of a lesser concern as well. So it's this Google item. And Grier, do you want to comment more on this Google item?

Sure. And we analyze "Google risk" quite frequently increasingly with information-based companies that originate customers online, starting with whether or not Google itself is a potential competitor. We view that as very unlikely in this area of offering error-correction services. It's quite legal in nature. You have to have law firms involved in the back and forth with the credit bureaus. It seems to be pretty far afield from the type of businesses information-based that Google is focused on. That's number one. Number two is, from an origination standpoint, as with many direct marketers, there's multiple channels in which customers get originated, referrals from existing customers, paid search, free search, direct mail, many different channels, as you can imagine. So one of those many different origination channels, which is the paid search mechanism, there seems to be a somewhat visceral blanket, new policy. It's catching up a bunch of companies in it, including Progrexion. But when you type in credit repair and do various keyword searches along the lines of what the company offers, it shows up very close to the top anyway on a free-search basis. So it remains to be seen what type of financial impact that will have on the company, if any, but there are multiple levers and mitigants with how the company originates customers, so what is a very clear consumer need that the company addresses as the market leader in this space.

And I had one other thing, Grier did and Matt did, I just remembered too. I think the – our attachment point, if I'm not mistaken, Grier, is around three, less than three. Is that right?

A little bit higher than that. We had to check in a precise number, but it's in a comfortable – range of underwriting.

Under four – yes, it's under four, and if you took out – if you said, well, 20%, I think I heard it was 18% to 20% of the revenue or the increase were coming from through Google. So if you take all that out, you're still at a low – relatively low attachment point for a pretty steady Eddie business. So Matt, you asked a question about a company that, amongst others, caught my attention as being – how would I put it is a valuation that seems to be, in my mind, oblivious to some fundamental business things going on there. And if you were to talk to the deal team, you'd hear an earful about that. So that's Progrexion, no one can predict the future. You never know with these litigations, right. They scare people. But yes – hey, Matt, go out and try and buy the first lien at 40 or at 50 or at 60 or at 70 or at 80 or at 90, okay. And give us a call if you're able to get any, okay. All right. Any other questions, Matt?

Yes, two more things. Again on the – that's all…

Matt, I like your question. Okay. By the way, if you could buy any for below par, I will pay you a commission. I hope it's legit, okay. I'm not going to do anything that's not permitted. But we'll be very surprised if you're able to buy anything at – even in par. Okay. Where to next?

Okay. So the next two, kind of similar to questions I asked last quarter, so an update on InterDent. So it looks like 11% markdown on the Term B, any update there, given the size of the asset from last quarter?

Yes. Here, why don't I see how well I do if I go ahead at Grier, and then he can go after me. So InterDent, as Matt, I'm sure you know, you seem quite well acquainted with our portfolio, has hundreds of millions of dollars of revenue and anywhere from $10 million to $30 million of EBITDA, depending on how things are going. So InterDent lost – well, InterDent had, I wouldn't call it a black swan event, although that jumps to mind, InterDent had a whole set of customers, diversified, some higher-margin than others. The two of the largest customers, merged. Then that ended up being – and it happened to be also the two of the highest margin customers. So your two highest margin customers merge. One big high-margin customer and you lose that contract. That's called bad news. They'd entered in corporate headquarters. We've changed the management there. We have two great people running this company. They are indefatigable. They are determined. They are improving the company from top to bottom. We add a sales person, maybe it was nine months ago, whose job it was to improve sales. He did, as far as I know, a good job, but he also spent a lot of money doing it, and that all hit the bottom line in the last nine months. Some people felt this salesperson was carried away. I haven't yet gotten the manifest on whether what the return was on this sales expenditure – series of expenditures. And as you know, Matt, you spend a lot of money on sales? Well, the sales and the profit don't all come in the next morning. So that money was spent. That hit the bottom line that has hurt the company's EBITDA in the last quarter and the last year. As well, the company is behind plan. So the company has a plan. It's ambitious. No one should be surprised that ambitious plans often take longer to achieve than the management hopes. We rather have people be ambitious and shoot for the stars than accept low levels of revenue and EBITDA. So the company's plan – the company is behind plan. Then when it comes to our view of the future, it's optimistic. We have actually given the company more money than the company needs because we see high internal rates of return on expenditures such as leasing, purchasing, leasing new equipment, new drills, new digital equipment, refurbishing reception areas, hiring new dental hygienist, paying them more. I don't know if – I don't know how many people on this phone call saw the editorial in The Washington Post of all places, but wage gains for the bottom quartile of the labor force have been growing faster than wage gains for the top three quartiles, something The Washington Post editorial writer said has never occurred in our economy. Well, that's impacting a company like InterDent. Frankly, we're glad to see those wage gains across the bottom quartile of the labor force, real dollar wage gains. But it means that our expenses for hygienist, receptionist and lower-paid personnel across the board have exceeded our projections. So the turnaround at – really, the recovery in turnaround at InterDent is taking longer. But I think Matt that these are prized companies and we feel that we're on the right track there.

Just to add to that, InterDent. So recall, Matt, we may have covered some of this in the past, but as an update, InterDent has two primary current businesses, which is its Oregon-based Medicaid business and its fee-for-services business in other largely contiguous – primarily contiguous states. The business grew substantially in Oregon Medicaid business and then gave a bunch of that back with a surprising contract loss that John referenced before. There's an annual contracting period that just wrapped up and InterDent actually regained some of its lost volumes, not all of it, but some of it in Oregon, which is encouraging. And they're laying the groundwork to win more in the future, basically, with putting up quality of care, positive statistics for payers there. Outside of Oregon, a lot of blocking and tackling, pertaining to getting customers that come in for their every six-month hygiene visits, managing doctor and hygienist retention, boosting same-store, same-office revenues. The company has been positively trending in all those areas in recent months. So we're happy with that progress. They're also looking to potentially grow in California in the Medicaid business there and leverage its core expertise in Oregon that could be a pretty nice needle mover in the future over the next couple of years. As John mentioned, these are highly valued businesses, strategically and private equity-backed as recurring revenue companies. We also feel like we've got a nice recession-resilient business because the Medicaid roles tend to go up when you have a downturn in the economy, and that helps a business like this. So those are some additional points for consideration about InterDent, Matt.

Okay. Last kind of asset-specific question would be on a non-accrual, specifically Pacific World Corp. So about as I can tell, a $38 million write-down there. Was that a specific calendar 4Q 2019 event? Is that a reflection of kind of future assumptions? Any color you can provide there?

Go ahead, Grier.

So PWC, Pacific World has been impacted by company-specific issues as well as sector-related issues, a confluence of events. And it's a pretty significant write-down versus original cost at this point. That write-down you referenced is on the heels of several quarters, actually. It's been a very tough situation there involving a change out of management and really a failed strategy and execution of the prior business owner and prior management that charged into low margins/no margin private label and then fail to execute, pay vendors on time, wasn't able to fulfill orders, made customers unhappy. So in taking over the company, we've encountered tremendous challenges to – in conjunction with new management, to rebuild customer relationships to refocus on profitable lines of business and to reexamine potential profit drivers for the future, including third-party brand distribution as opposed to trying to be all things to all people with a large fixed cost structure. So the company is going through a process of rationalizing its cost structure and becoming much more asset light, but it's been also hampered by macro factors, including some of the private label trends, tariffs in China, some of which continues, coronavirus more recently, just a lot of issues on the macro side on top of the company-specific ones to deal with. So we have intense focus internally and externally with the management team on improving the company, but it's going to continue to take additional time and capital to do so.

Okay. Thank you. That's all from me. Appreciate the color guys.

Hey, Matt, thanks very much.

Thank you, Matt.

This concludes our question-and-answer session. I would like to turn the conference back over to John Barry for any closing remarks. Please go ahead, sir.

Okay, everyone. Thank you for joining the call. Have a wonderful afternoon. Bye now.

Thanks all.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.