Hercules Capital: Q2 Record Earnings, 9-10% Yield (NYSE:HTGC)

Looking for a high yield income vehicle that’ll benefit from rising interest rates? Business development companies, known as BDCs, offer retail investors high yield exposure to private companies, and some of them, like Hercules Capital (NYSE:HTGC), focus on companies which already are backed by venture capital firms.

These venture capital firms don’t want to lose their investments and will continue to support these companies. This has been crucial during the pandemic. HTGC invests a much smaller percentage of capital in these companies, compared to their VC backers, ranging from 0.7% – 1.9% – it was 1.2% as of 6/30/23:

95.5% of HTGC’s debt investments were on floating rates, as of 6/30/23. The portfolio is primarily in Senior Secured Loans: 78.4% 1st Lien, and 14% 2nd Lien, 4.5% Equity, ~2% each in Warrants and Unsecured positions:

As of 6/30/23, Drug Discovery & Development was HTGC’s biggest industry exposure, at 36.5%, followed by Software, at 28.6%, and Consumer Business & Services, at 14.8%. The 10 largest portfolio companies represented 30.3% of the portfolio.

HTGC’s management estimates that EPS will rise $0.12 for every 75 point increase in the prime rate:

Company Profile:

HTGC focuses primarily on pre-IPO and M&A, innovative high-growth venture capital backed companies at their expansion (venture growth) and established stages in a broadly diversified variety of technology, life sciences and sustainable and renewable technology industries. It has a $2.94B debt portfolio, and also holds warrants for 108 companies, which add more upside potential to its investment portfolio.

Portfolio Ratings:

A key factor in analyzing BDCs is the health of the underlying companies that they’ve invested in. The market’s misgivings about the ability of those companies to survive the pandemic led to deep price reductions in BDCs’ price/share in 2020.As of 6/30/23, HTGC’s holdings’ lowest two rating tiers, 4 and 5, comprised 2.3% of its portfolio, up from 0.6% a year earlier in Q2 ’22.

The top two tiers, 1 and 2, totaled 59.4%, vs. 70.4% in Q2 ’22. As of 6/30/23, the overall rating was 2.24, vs. 2.13 in Q2 ’22. The number of loans on non-accrual decreased by one loan quarter-over-quarter. As of June 30,2023, HTGC had one debt investment on non-accrual with an investment cost of $13.3M, or 0.4% of the portfolio value.

HTGC’s net cumulative realized loss, since its first origination activities in October 2004 through June 30, 2023, totaled $45.7M. That represents 28 basis points, or 0.28% of cumulative debt commitments, or an effective annualized loss rate of 1.5 bps, or 0.015%, one of the lowest BDC loss figures we’ve seen in the industry.

Record Earnings:

HTGC just reported Q2 ’23 earnings this week, on 8/3/23, and revealed record results.

Q2 ’23: HTGC had record total investment income of $116.2M, up 61.2% year-over-year; record NII of $75.7M, up 88.6% vs. Q2 ’23.

Unscheduled early principal repayments were $297M, up 46.7% vs. $202.4M in Q1 2023.

Q1-2 ’23: Record Total Investment Income of $221M, up 61% vs. one year ago, and record NII of $141M, up 86%. NII/share rose 63%, and NAV/share rose 5%, to $10.96, even with a 14.5% rise in the share count. Interest expense rose ~$9M, up 39%.

2023 results continued the positive trend from 2022, which saw lower but healthy growth in total and net investment income, and NII/share. Interestingly, interest expense was flat in 2022.

New Business:

After closing $541.5M in new debt and equity commitments in Q2 2023, Hercules has pending commitments of $305.5M in signed non-binding term sheets outstanding as of Aug. 2, 2023. Management closed $1.07B in new commitments in Q1-2 ’23.

Since the close of Q2 2023 and as of Aug. 2, 2023, Hercules has closed new gross debt and equity commitments of $209.6M and funded $142.9M .

Dividends:

Management raised the quarterly dividend from $.39 to $.40, and also declared an $.08 supplemental payout, both of which will go ex-dividend on 8/17/23, with an 8/25/23 pay date.

HTGC has an 11.19% five-year regular dividend growth rate, one of the better growth rates in the BDC industry. In addition, it also paid $1.04 in supplemental distributions from 2018-2022, including $.60 in 2022.

Q1-2 ’23 NII/share covered regular dividends by a strong 1.29X factor, up considerably vs. 2022’s .75X figure. However, HTGC also had $.94/share in UNII as of 12/31/22, and $1.02 as of 6/30/23.

Profitability and Leverage:

ROA and ROE continued to improve in Q2 ’23, as did EBIT margin, with all three metrics remaining far above BDC industry averages. Debt/NAV leverage also has become more conservative, and remains far below the BDC average.

Interest coverage also continued to improve in 2023, rising to over 5X, vs. 4.24X in Q2 ’22:

Debt and Liquidity:

HTGC had $670.7M of available liquidity, as of 6/30/23.

HTGC has no maturities until 2024, when $105M in SBA bonds comes due, followed by $170M in Notes coming due in 2025. 2026 is its biggest bump in maturities, at $425M. Moody’s rates HTGC’s debt at Baa3 Stable.

Performance:

Like our focus stock in Friday’s article, Capital Southwest (CSWC), Hercules has done very well for shareholders in recent times – it has outperformed the BDC industry, the financial sector, and the S&P 500 over the past month, quarter, year, and so far in 2023, all by wide margins. Its ~total 1-year return of 32% is also much higher.

Looking back further shows that HTGC also has much strong returns vs. its BDC peers over a 1-, 3-, 5-, and 7-year period. It has returned 92.4% over the past seven years:

Analysts’ Targets:

No surprise that, at $17.91, HTGC already is 10% above analysts’ average price target of $16.25, as these price targets often tend to lag earnings and performance.

Valuations:

With all of HTGC’s attractive attributes, Mr. Market has had no problem ponying up at premium prices for its shares. At $17.91, HTGC is getting a 63.4% premium to its NAV/Share of $10.96, vs. a -1% average premium for the BDC industry. It also has a premium earnings multiple, with its 10.6X P/NII, vs. the 9.16X industry average. HTGC’s base dividend yield is in line with the industry average, while its EV/EBIT is higher than average.

That premium pricing isn’t a fluke – HTGC routinely garners a premium valuation from investors:

Even in the Silicon Valley Bank crisis in March-April, HTGC’s Price/NAV didn’t come anywhere near 1X.

Parting Thoughts:

HTGC is a premier BDC worth waiting for. We rate it a Hold for now.

However, try to keep some dry powder, and wait for the next market crisis, and become a “vulture capitalist” – swoop in and grab some shares at a lower valuation when the market is panicking.

All tables furnished by Hidden Dividend Stocks Plus, unless otherwise noted.