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TM Editors' note: This article discusses a penny stock and/or microcap. Such stocks are easily manipulated; do your own careful due diligence.

Like a partner who has burned you before but is trying to change, Prospect Capital (PSEC) is still hard to trust.

The business development company, or BDC, lends money to and invests in private companies. The stock is very popular with income investors because of its 13.2% yield, its low share price, and the fact that it pays a dividend monthly.

Let’s see whether the company can actually afford its dividend.

In Prospect Capital’s fiscal year that ended on June 30, 2023, it generated $421 million in net investment income (NII). NII is the measure of cash flow that we use for BDCs. It tells us how much money the company’s investments made after expenses.

That 2023 NII figure was up sharply from the previous two years.

When the company reports results from its most recent fiscal year next month, I estimate it will report $457 million in NII. We’re seeing solid growth over the past year and over the past three years, which is a great sign.

You can see from the chart above that NII has been steadily growing, as has the total amount of dividends paid – though it’s important to note that the total dividend payout has increased because the number of outstanding shares has risen, not because the dividend itself has risen. The company’s monthly dividend per share has remained at $0.06 for more than six years.

BDCs must pay out 90% of their profits in dividends, so I’m OK with them paying out up to 100% of their NII. (Profits and NII aren’t the same thing, but they are similar.) Prospect Capital’s 2023 payout ratio of 71% and its expected 79% payout ratio in 2024 are well within my comfort zone.

The only problem I have with Prospect Capital’s dividend safety is its history of reducing the payout to shareholders.

Granted, it hasn’t done so since 2017, but it slashed its dividend twice in the three years before that – and pretty dramatically. The dividend is 46% lower now than it was prior to the decline.

If Prospect Capital keeps its dividend stable over the next few years, the past cuts will start to age out of the Safety Net model, and its grade should improve. Until then, even though the company can afford the dividend right now, investors should be wary that another cut could be coming if times get tough.

Dividend Safety Rating: C

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