September 5, 2022
Summer officially comes to a close, just after the BDC sector has absorbed three weeks of lower prices, as discussed in the BDC Common Stocks Market Recap in the BDC Reporter. That's hard on anyone long BDC stocks of late - including ourselves - but good news for those looking for attractive "entry points", and not spooked by the doom and gloom pervading most markets.
We did some counting in the Expected Return Table and found that 31 individual BDCs offer a "superior" return for the long term investor ready to sign for a 5 year tour of duty. 11 names promise a 20% or better annual return and another 20 are showing returns between 15%-20%. Of course, investors are having a hard time psychologically recognizing that this is very good news. After all, we may still be several quarters away from when the economy bottoms out and when the way forward for GDP, inflation and all that jazz becomes clear.
There are too many fish in this week's barrel to discuss in great depth, so we'll focus on just one. Amongst the top 11 names, we noticed there are 4 venture-debt BDCs (out of 5) listed, including Hercules Capital (HTGC). According to our model, the BDC offers investors an expected annual return of 20.4%, which includes a current yield of 14.7%. HTGC closed Friday at $13.45, way down from a 52 week high of $19.09. The leading venture lender- and the one with the longest history and one of the most solid balance sheets - lost investor support back on April 20 of this year and has since dropped (30%) in price, and is trading close to its 52 week high.
That may be because the current record breaking distribution level at HTGC - estimated to reach $1.9800 this year - is built on a number of "special" distributions, which were the result of paying out "realized gains". Sensibly enough, investors must figure there will be less in the way of realized gains in the next year or two and - maybe - some net losses. If nothing else that should reduce distributions going forward. Not that we disagree, are we are projecting a total HTGC payout of "only" $1.5800 in 2023 and a hum-drum increase to $1.6000 by the end of 2026.
Still, note that the analysts have been raising their EPS projections for this year to $1.36 and $1.54 next year. Plus, HTGC has $1.18 per share of undistributed taxable income on its books, which we expect to readily make up any difference between future earnings and the projected distribution. Only a few cents every year of these unused earnings being rolled over into the payout should allow HTGC to meet the projections. (Not figured in to our assumptions are a return to realized gains somewhere down the road, which might fatten HTGC's payouts beyond what we've budgeted).
We're also counting on a higher multiple in Year 5. After all, HTGC is an investor favorite that tends in good times to trade at a huge premium to net book value and at a high multiple of earnings and distributions. Our model assumes a price to payout multiple of 12.50x - which seems relatively reasonable to us - which would result in a Target Price of $20.0. If reached, that would be a new all-time price record, but only modestly above that $19.09 reached just a few months ago.
We understand investor doubts about HTGC in the short term. On the other hand, this BDC which has been through the Great Recession; the sudden loss of its CEO and a host of other challenges while increasing its NAV Per Share by 4.7% since the end of 2017 is a proven performer. The bold investor enjoys a rare opportunity for a 100% return over the next 5 years. (By the way, Seeking Alpha shows that HTGC's "total return" over the past 5 years is 129%, so this sort of outsized gain is not out of the ordinary for this name). Thankfully, regulatory leverage is at a decent level of 1:1; liquidity is plentiful and the market for financing technology and life science companies is not going any where. In fact, with equity investors taking a breather after years of furiously financing any idea that moved, this might be an ideal environment for what HTGC and the other venture lenders do best.
Otherwise, this week, we note that Cion Investment (CION) remains - as has been the case for some time - the top potential performer, offering a 33% annual return over 5 years. Poor old CION cannot get any traction with the investor community. There was a brief period between late June and late August - as the chart below shows - where CION's price surged upwards by more than 20%. However, we're back to seeing CION slide. At $9.46 on Friday, the BDC was some way from its 52 week low of $7.83, but still...Nonetheless - swimming in the other direction - are the BDC's EPS estimates, expected to reach $1.32 this year and $1.37 in 2023. For those of you who look at price to future earnings ratios, CION is trading at a very low 6.95X and at a current yield of 13.1%, going just by the recently increased regular distribution alone.
We have what must seem like an Impossible Dream Target Price of $18.20 - nearly a doubling. "Je ne regrette rien" , as Edith Piaf would say, and we remain hopeful there will be a change of heart about CION over time. After all, we're only projecting an annual distribution of $1.40 in 2026 versus the latest quarterly EPS annualized of $1.36, and that analyst estimate for 2023 of $1.37. CION does not have to climb very far from a fundamentals standpoint to reach the Promised Land. When and why the market may take a more favorable view is harder to handicap, but we're hopeful. (There's also always that possibility that some huger asset manager might come along and absorb the parent which might give CION a price jolt).