(Published by Bob Ciura on July 21)
Business development companies, or BDCs, are a popular investment class among income investors. BDCs pay dividend yields that far exceed the yields available from other asset classes.
For example, the S&P 500 Index has a 2% dividend yield on average. High-quality bonds are not much better—the 10-year U.S. Treasury Bond yields just 2.3% right now.
Compare these puny yields with Harvest Capital Credit Corp. (HCAP, Financial), a BDC with a dividend yield nearing 10%.
Harvest is one of 405 stocks with a 5%-plus dividend yield.
Not only that, but Harvest pays its dividend each month rather than each quarter like most companies.
Of course, just because a stock has an attractive high dividend yield, does not automatically make it a good investment.
Investors must evaluate the sustainability of a dividend payout, especially for such extreme high-yielding stocks.
Business overview
As a BDC, Harvest makes investments in lower middle-market companies that are usually at an early stage in their growth cycles.
It has a very large and diversified investment portfolio across various industries.
Source: Investor Presentation, page 7
Harvest makes a variety of debt and equity investments, including senior secured debt, uni-tranche term loans, junior secured term loans, subordinated debt and minority equity co-investments.
It typically invests in companies with annual revenue of $10 million to $100 million.
The vast majority (96%) of the company’s investments are in secured debt:
Source: Investor Presentation, page 8
Harvest ended 2016 with 31 investments in the portfolio, 28 of which were debt investments.
The primary driver of Harvest’s profitability is investment income derived from its portfolio. Net investment income rose 3.9% last year to $1.60 per share.
This allows the company to make high levels of distributions to shareholders. Based on core net investment income, a non-GAAP measure which excludes certain non-recurring items, Harvest had a dividend coverage ratio of 119% last year.
This means the company generated approximately 19% more net investment income than it needed to pay dividends to shareholders in 2016.
Harvest’s other financial performance metrics were a mixed bag last year. Net asset value declined 2.8% to $13.86 due to lower portfolio assets and share issuances throughout the year.
Harvests’ debt investments generate high returns. The company ended 2016 with a weighted average yield of 15.2% in the debt investment portfolio.
Going forward, Harvest’s debt portfolio should continue to perform well as rising interest rates could be a growth catalyst.
Growth prospects
There are two major catalysts for Harvest’s future investment income growth. The first is growth in the portfolio. Increasing assets will allow the company to invest more, which would generate new income.
The second growth catalyst is higher yields from existing assets.
Harvest is off to a rough start in 2017, however. First-quarter new debt investment commitments declined 15% year over year.
In addition, the average yield of the company’s debt investments declined 40 basis points in the first quarter from the fourth quarter of 2016.
Because of higher shares outstanding, this drove a 15% decline in first-quarter net investment income per share.
Net investment income of 35 cents per share for the first quarter barely covered Harvest’s quarterly dividend of 34 cents per share.
The dividend coverage ratio sunk to 103%, which is now barely sufficient coverage. Investors should closely monitor the company’s results in future quarters as it does not have much room for error.
One advantage for Harvest is rising interest rates, which should boost investment income growth.
The company believes it has significant upside potential as interest rates rise. For example, management estimates net investment income stands to increase by more than $560,000, or nine cents per share, for every 100 basis-point move in LIBOR.
Dividend analysis
Harvest currently pays a monthly dividend of 11.25 cents per share. Annualized, the payout comes to $1.35 per share.
Based on Harvest’s July 19 closing share price of $13.99, the stock has a dividend yield of approximately 10%.
Fortunately, Harvest covered its dividend with net investment income last year. Additionally, the credit quality of the portfolio remains strong.
Harvest employs a proprietary ranking system to quantify its credit risk exposure. There are five levels of the system, based on how well the investments perform:
- Investment Rating 1: Investments that are performing above expectations, whose risks remain favorable.
- Investment Rating 2: Investments that are performing within expectations, whose risks remain neutral. All new loans are given an initial level 2 rating.
- Investment Rating 3: Investments that are performing below expectations and require closer evaluation. No losses are expected from this group.
- Investment Rating 4: Investments that are performing substantially below expectations, whose risks have increased substantially. Expectations are for some loss of return, but no loss of principal.
- Investment Rating 5: Investments that are performing substantially below expectations, whose risks have increased substantially. Some loss of both return and principal is expected.
This ranking system helps keep the company’s risks manageable. At the end of 2016, Harvest’s debt portfolio had a weighted average ranking of 2.01, up slightly from 1.97 the year before but still representing a strong overall portfolio.
To begin 2017, nine of Harvest’s 28 debt investments were ranked 1, 13 were ranked 2, three were ranked 3, two were ranked 4 and one was ranked 5.
The company seems to have an appropriate balance between risk and return in its debt portfolio, which is a positive for the dividend.
That said, there are a few potential red flags when it comes to Harvest’s dividend. First, it is a very small company. It has a market capitalization of just $90 million, which makes it a micro-cap.
Micro-caps tend to be more volatile and do not have the financial resources of larger companies. This often makes their dividends less reliable than more established large-caps, particularly if the economy enters recession.
Final thoughts
Stocks with double-digit yields are attractive, but are not for the faint of heart. With a nearly 10% dividend yield, Harvest has obvious appeal for income investors.
But Harvest is not a stock that can be a part of a “set-it-and-forget-it” portfolio. Investors cannot simply buy shares and assume the dividend will be sustainable.
The company is covering the dividend with sufficient investment income for now and has growth potential from higher interest rates, but none of this is a guarantee.
Harvest is an attractive dividend stock for its high dividend yield, but investors need to closely monitor the company’s results moving forward.
Disclosure: I am not long any of the stocks mentioned in this article.
