We have downgraded our recommendation on Hercules Technology Growth Capital Inc. (HTGC) to Underperform from Neutral based on its rising expenses and weak fundamentals.
Hercules Technology’s third quarter 2010 distributable net operating income (DNOI) came in at 25 cents per share, up from the Zacks Consensus Estimate of 23 cents. However, this compares unfavorably with the DNOI of 31 cents in the prior-year quarter.
Increased operating expenses and higher net realized loss on investments primarily pulled back the results. However,a strong balance sheet and high liquidity level were among the positives.
As Hercules is more of an asset-based lender, its focus on early-stage venture companies could become a headwind. If products of any of its investment companies do not succeed or if it is unable to manage additional funding from outside, it will be at risk.
Concentration risk is also fairly high in both the portfolios. One bad credit could have a sizable negative impactat this stage of the business. The odds are that management will stretch the investment size in order to grow more quickly and fully leverage on its equity. Although making fewer larger investments will clearly maximize revenues, greater diversification would be desirable from a risk-management perspective.
To comply with regulatory requirements, Hercules invests primarily in U.S. based companies and to a lesser extent in foreign companies. As of December 31, 2009, the company had 93.1% of its investment in U.S. companies and the remaining 6.9% were in Canada, Israel and the Netherlands. Since late 2007, the U.S. market has been experiencing illiquidity in debt capital markets. The U.S. economy has been reviving since the past few quarters albeit at a slow pace. This might increase the cost of funding and limit the access to capital market. Its foreign investment will be too limited to support its overall financials.
On the other hand, Hercules is currently a small participant in a market with huge growth prospects. Though the recession has contributed to the current contraction within the venture capital community and resulted in general volatility, we are encouraged by the company’s focus on its credit performance. The company continues to experience an increase in new investment origination activities and expects the trend to prevail in the near future.
Also, we view Hercules as a sound asset for yield-oriented investors. Because of its RIC status, the company will always pay out the majority of its earnings each year as dividends. The dividend growth story has been fairly decent. Also, effective 2009, the board of directors adopted a policy to distribute four quarterly dividends in an amount that approximates 90–95% of the company’s taxable income. In December 2010, the company paid its twenty-first consecutive dividend since its inception.
Hercules typically invests in high growth venture-capital-backed companies and receives warrants in conjunction with debt investments. As a result, the company’s investment portfolio will benefit from the recently improving M&A environment as there could be material appreciation in its warrant positions.
Despite the capital market disruption and sluggish economic recovery, a steady pace of new investments by venture capitalists is being viewed. As a result of this, new investment opportunities are expected, though we remain cautious about the company’s investment and credit management strategies.
Herculescurrently retains a Zacks #5 Rank, which translates into a short-term ‘Strong Sell’ rating.
We are, however, maintaining our Neutral recommendation on Hercules Technology’s peer Marlin Business Services Corp. (MRLN).