Hercules Capital: An excellent company, but it is better to wait until interest rates fall

summary

I analyze Hercules Capital (New York Stock Exchange: HTGC), a financial company that provides loans to private companies in the technology and life sciences industries. This company is attractive to investors because of its high dividend yield, which makes it a good fit Portfolios that need liquidity. However, we should not only take into account liquidity, but also evaluate all sources of value and determine whether they are overvalued. Otherwise we may end up with a poor investment despite high profits.

Financial performance

Hercules Capital demonstrated favorable operating performance and significant financing activity, contributing to a strong balance sheet with ample liquidity. The performance of its portfolio was positive, and the company continued to distribute dividends to shareholders, including a special distribution supported by high net investment income.

In the first quarter, Hercules Capital performed well with record total debt and equity Commitments and total financing. The company has provided $605.2 million in total funding, the highest amount to date. Total investment income was $121.6 million, reflecting a significant year-over-year increase of approximately 16%. Net investment income reached US$79.2 million, with a growth rate of 21%, equivalent to US$0.5 per share, covering 125% of the basic distribution of US$0.4 per share.

Hercules Capital has maintained a conservative balance sheet management strategy, with GAAP leverage of 93.6%. This wise approach enables the company to seize future opportunities. The company’s credit quality also showed improvement, with the highest credit scores (Grade 1 and 2) increasing from 62.6% to 68%, and the weakest credit score (Grade 3) falling from 34.0% to 29.2%. This is reflected in the small proportion of outstanding loans as a percentage of the company’s investment portfolio, which amounts to 1.2% and 0.1% on a cost basis and on a fair value basis, respectively.

At the end of the first quarter, Hercules Capital had a strong balance sheet and liquidity position of $498.1 million. It has maintained a base dividend of $0.4 per share, representing an annual dividend yield of 8.7%. Its good cash position allowed it to offer an additional dividend of $0.08 per share. I appreciate the company’s commitment to shareholders. Net asset value per share increased 1.7% sequentially, to $11.63 per share, indicating financial strength.

Competitive advantages

Hercules Capital is a business development company (BDC). It is one of the largest players in the industry, as shown in Figure 1. With a capitalization of $3.17 billion, it is the second largest company, after Ares Capital (ARCC), with a capitalization of $13.26 billion.

Hercules Capital operates a lending platform with $3.6 billion in assets. This platform allows them to lead in the technology and life sciences industry, provide quick financial solutions and be a trusted player. Its portfolio includes 127 companies. This focused strategy has allowed the company to have deep experience in complex industries that present a barrier to entry for new players trying to enter the market. There are investments in warrants in 104 companies and equity positions in 76 companies, for a total value of $183 million. The platform also has net debt obligations of $18 billion across 650 companies.

To assess its competitive position, I compare it with its peers. Hercules Capital has some advantages in yield yield and credit quality, but not a clear advantage on leverage. Its competitive position is strong, but it’s not a clear winner.

The yield is higher than that of Ares Capital (ARCC), a larger competitor with better negotiating power. Hercules Capital has a yield of 14.3%, and Ares Capital has a yield of 12.4%. Horizon Technology Finance Corporation (HRZN) has one of the largest returns at 15.6%.

Areas Capital has 95% leverage, which is in line with Hercules Capital. Capital Southwest (CSWC) is 82% less risky; However, you can find companies like Horizon Technology with leverage up to 137%, which is much worse.

Hercules Capital’s accrual ratio is better than Ares Capital’s, at 1.7% on a cost basis, and much better than Capital Southwest’s, at 2.3%.

The company has strong financial performance and dividends due to its strategic focus on the technology and life sciences sector, its large and specialized lending platform, and its many years of experience in the industry. The company’s return on equity was 18.8% in the first quarter of 2024.

I conclude that Hercules Capital’s strategy has some advantages that justify the market-placed premium over its competitors, as shown in Figure 2.

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Risks

The primary risk in Hercules Capital’s business is market risk, which refers to how changes in interest rates will affect investment income. The investment portfolio is based on fixed income assets with variable interest rate investments (97%) and a smaller percentage of fixed income investments with fixed interest rates. On the other hand, financing is 80% fixed and 20% variable. This structure makes investing risky in a scenario where interest rates could fall. I expect that when the Fed lowers interest rates, Hercules Capital will reduce net investment income because income is mostly variable and will decline. Income expense, which is what a company pays for its debts, is mostly flat so it declines less.

In a Reuters poll, most economists surveyed estimated that interest rates would be cut in September, and half of them said there would be two cuts. There is a lot of discussion in the market about when interest rates will be cut. My conclusion is that interest rates will likely be cut this year, and investment income will decline when that happens.

Another risk is credit risk, which refers to companies delinquent on loans or not paying the full amount. I believe the company manages credit risk effectively. Most loans are senior debt that is at least 83% secured. As I mentioned, the non-accrual percentage of the company’s total investment portfolio is very low. However, the company operates in a highly concentrated industry and geography. Specifically, 89% of its operations are located in the United States, and 65% of the company’s funding is allocated to the life sciences industry. Although this focus poses inherent risks, it is part of the company’s strategy. Therefore, the only way to mitigate this risk is through diversification.

The final risk I identify for Hercules Capital is competition. This type of risk is very limited given Hercules Capital’s strong market position in this industry. As I mentioned earlier when discussing competitive advantage, the company has a strong position on its lending platform.

evaluation

When evaluating this type of financial company, I estimate price to net asset value, which is equivalent to the book value of the price. This helps determine whether it is expensive or cheap.

At the end of the first quarter of 2014, Hercules Capital’s P/NAV ratio was 1.59. As you can see in Figure 4, this is the highest over the past four years, and I believe it is unsustainable. One of the main reasons for this multiplicity is the development of interest rates. As shown in Figure 5, interest rates are higher in 2023 and 2024. Hercules Capital’s business model is favored when interest rates are higher because its short-term loans benefit from higher interest rates and higher yields.

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As shown in Figure 6, I simulated the effect of an increase in interest rates on net investment income. I experienced increases of 0.5 percentage points, 1.0 percentage points, and 1.5 percentage points. The current investment income is 121.6, with a return of 14.3%. Investment expenses refer to the interest paid on the loans that finance Hercules. Net income is $101.6 million with a net yield of 12.6%. If interest rates fell by 0.5 percentage points, net income would decrease by 26%. If interest rates fell by 1.5 percentage points, net income would fall by 33%. This impact on net income is directly related to the distribution of profits, and is one of the reasons for investors’ confidence in the company. I therefore expect the stock price to fall significantly if the dividend is at risk.

Conclusion

The Hercules Capital premium has a price cap in a high interest rate environment and a high probability of those rates being reduced. As long as rates fall, the stock price will fall. So, I recommend waiting until interest rates come down, and in a low interest rate environment, investing in this company with good fundamentals. My recommendation is to wait.