Hercules Capital Stock: benefits from rising interest rates (NYSE:HTGC)
If you are looking for a high yield investment that will benefit from rising interest rates, you should consider the business development corporation (“BDC”) sector.
BDCs offer retail investors high yield exposure to private companies, and some of them, such as Hercules Capital, Inc. (NYSE: HTGC) focus on companies that are already backed by venture capitalists. These other companies do not want to lose their investments and will continue to support these companies. This has been crucial during the pandemic.
HTGC primarily focuses on pre-IPO and M&A, venture capital-backed, high-growth, innovative companies as they expand (corporate growth) and established stages in a highly diverse variety of businesses. technology, life science and sustainable and renewable technology industries.
HTGC holds a portfolio of $2.41 billion, with a market cap of over $2 billion and $430 million in cash.
HTGC’s bond investment portfolio comprises 94.7% floating rate loans, with interest rate floors. His bond investments have short-term amortization maturities (36 to 48 months) and the majority of them also have warrants for additional total return potential.
Management estimates that a 100 basis point increase in the prime rate would add $0.16/share to HTGC’s EPS, while a 200 basis point increase would add $0.35/share. The current prime rate is around 4.38%, down from 3.25% a year ago.
92.2% of the portfolio is in bonds, 6.2% in equity securities and 1.5% in warrants:
There are 103 warrant holdings, showing an unrealized gain of approximately 25%; and 76 equity stakes, showing an unrealized gain of approximately 11.5%, as of 03/31/22.
Management’s illustration of potential gains on warrants assumes 50% will be misses, but even so, potential gains can range from $0.47 to $1.06/share:
Drug delivery, software, and consumer and business Internet services make up 81% of the portfolio’s sector exposure, much more concentrated than the other BDCs we’ve covered:
A key factor in times of volatility is the quarterly rating of a BDC’s underlying holdings, ie the private companies to which it lends. BDC’s management uses a scale of 1 to 5, with 1 being the healthiest and 5 the lowest.
The highest grades 1 and 2 constituted 73% of the portfolio at 03/31/22, compared to ~80% a year ago, with grade 3 increasing from 19.5% to 26.4%. No investment was rated Grade 5, the lowest level, in Q1 22.
While total investment income fell -5% in Q1 22, NII increased 3.56% from Q1 21, due to lower net operating expenses. The NII/share was flat at $0.30 and the NAV/share fell -4.75%, due to a portion of the distribution coming from previously undistributed assets.
HTGC recorded a lower weighted average cost of borrowings composed of interest and fees of 4.0% in Q1 22 compared to 5.5% in Q1 21, with a 21% decrease in interest expense. The decrease is primarily due to refinancing completed in 2021 and early 2022 and higher utilization of lower cost SBA loans.
Realized gains in Q1 ’22 were -2.38M, due to a non-recurring loss on extinguishment of debt of $3.7M.
Total investment income in 2021 fell -2%, with NII down -4.5% and NAV/share ~stable. Interest charges fell by -8.7% in 2021:
This management chart shows that HTGC has a history of outperforming its BDC peers over the past few years:
HTGC has had 3 companies that have completed their IPOs so far in 2022, and 5 companies that have listed for their IPOs or entered into agreements to go public via mergers or SPAC transactions.
HTGC had record total gross new debt and equity commitments totaling $615.2 million and gross new funding totaling $351.6 million in Q1 22. This record Q1 origination activity was driven by HTGC’s technology and life sciences teams. HTGC financed the capital of 26 different companies in the first quarter, 10 of which were new borrowers.
Loan prepayments made amounted to $84.9 million, which together with the normal scheduled amortization of $11.3 million, resulted in total debt repayments of $96 million, which was well within below guidance by $150-250m, and down from $426m in Q4 2021. While this has hampered NII somewhat, it has led to a record increase in NII’s net debt investment portfolio $190.7 million.
HTGC has a history of making additional distributions, on top of its base payments. It paid $0.36 in those additional distributions in the last quarter, with the second quarter amount being $0.15.
HTGC’s regular dividends yield 9.82%, while its additional dividends yield an additional 4.46%, for a total return of 14.28%. It should be ex-dividend the next ~8/10/22. Management usually declares the August distribution at the end of July, so it will be some time before we know if they will pay another additional payment.
Regular dividend coverage of $0.33 was below 1X in Q1 22 at 0.91X, but has averaged 1X over the past 4 quarters. The shortfall of $0.03 and the additional payment of $0.15/share were covered by UNII. HTGC had retained earnings impacts of more than $171 million, or $1.39/share, as of 3/31/22.
Profitability and leverage:
ROA and ROA were relatively stable, but a bit below BDC averages, while Debt/NAV of 0.99X is slightly below average. HTGC’s EBIT margin of 75.78% was well above its industry average.
HTGC’s EBIT/interest coverage of 4.09X is among the highest ratios we’ve seen in the BDC industry, while its asset-to-debt ratio is in line.
Debt & Liquidity:
Management uses a wide range of debt sources to capitalize HTGC – ~50% equity, 37% institutional notes, 6.5% SBA loans, and ~5% credit facilities. Its debt is rated Baa3 by Moody’s.
Its debt looks well phased into the future, with its first installment of $105M in Notes, maturing in 2024:
HTGC had $430 million in cash as of 3/31/22.
It’s a mixed bag for performance – HTGC has outperformed BDC industry and the market over the past month, but trailed them over the past quarter and year. It has outperformed the market so far in 2022, but has lagged its industry, likely due to its higher concentration in tech – the tech sector is down around 30% in 2022.
At its closing price of $13.44 on 6/29/22, HTGC was trading at a 24.2% premium to its Q1 net asset value/share of $10.82, versus the US average. BDC industry by -3%. However, since NAV is affected by dividends and does not always tell the whole story, price/NII should also be researched.
HTGC is actually selling at a much lower P/NII of 10.42X, compared to the BDC industry average of 13.17X. Its additional dividends also give it a higher dividend yield:
HTGC has a history of selling at a premium to NAV over the past few years – its average premium to NAV from 2017 to 2021 is around 1.30X, ranging from 1.11 to 1.47X.
Analyst price targets:
At its 6/29/22 closing price of $13.44, HTGC was 18.5% below analysts’ low price target of $16.50 and 27% below the average price target of $18.44.
We view HTGC as a long-term BUY – it’s around 6% above its 52-week low and, of course, could go lower from here, but its relative undervaluation of the P/ NII and its UNII cushion for its dividends give us confidence in its long-term prospects as a worthy high-yielding investment vehicle.
If you’re interested in other high-performance vehicles, we’ve got them covered every weekend in our items. All charts are provided by Hidden Dividend Stocks Plus unless otherwise stated.