Published on March 26th, 2019 by Josh Arnold
Business Development Companies, or BDCs, are a popular investment class among income investors. The reason is that 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 aren’t much better—the 10-year U.S. Treasury Bond yields just 2.5% right now.
Compare these diminutive yields with Harvest Capital Credit Corporation (HCAP), a BDC with a dividend yield of 9.4%.
Harvest is one of about 400 stocks with a 5% or better dividend yield. You can see the full list of established 5%+ yielding stocks here.
Not only that, but Harvest pays its dividend each month, rather than each quarter like most companies. This is very rare – there are currently only 41 stocks that pay monthly dividends. You can access the full database below:
Of course, just because a stock has an attractive high dividend yield, that does not automatically make it a good investment.
Investors must evaluate the sustainability of a dividend payout, especially for such extreme high-yielding stocks. Indeed, very high yields can often signal unsustainability of the payout.
This article will discuss Harvest’s business model, and whether the dividend appears to be sustainable going forward.
Business Overview
Harvest Capital is a Business Development Company, or BDC, that provides financing to small and midsized businesses located primarily in the U.S.
The company uses senior secured debt, term loans, junior secured loans, subordinated debt, and minority equity investments. This flexibility allows it to offer financing solutions to a wide variety of companies.
Harvest targets companies that are either cash-flow positive and can support its repayments, or companies with attractive and valuable assets that can be used as collateral. Target companies generally generate $10 million to $100 million in annual revenue, and most deals are directly originated instead of syndicated.
Deal size is generally in the $2 million to $5 million range for debt investments. For equity investments, the typical size is up to $1 million.
Source: Investor Relations
The above is a sampling of the companies current investments, which span across multiple industries.
Harvest ensures its portfolio is always diversified in geographical and sector terms, so that a downturn in an individual sector will likely not have an outsized impact on its results.
Harvest ended 2018 with 24 investments in the portfolio, 17 of which were debt investments. These numbers are down from 31 and 24, respectively, from the end of 2017.
Source: Q4 earnings press release
The company made $19.2 million of new debt investments in 2018, in addition to $1.6 million in new equity investments. However, it exited $37.5 million of debt positions and a further $1.6 million in equity.
In total, the company’s portfolio of investments shrank by $20.6 million in 2018.
In 2018, these drivers pushed the weighted average yield of the portfolio down from 13.7% to 12.7%, thanks to lower payment-in-kind and fee amortization yields, partially offset by a higher cash yield on its investments. This also helped drive net asset value down from $12.66 to $12.30 year-over-year.
The primary driver of Harvest’s profitability is investment income derived from its portfolio. Core net investment income fell markedly from 2017, declining from $1.40 to $0.93 per share. The decline was entirely attributable to the smaller investment portfolio, not poor performance of the company’s assets.
Subsequent to the end of the fourth quarter, the company received several million dollars in early repayments, but has already spent $21 million on new investments. Therefore, its portfolio could expand back to a more normalized size following the significant drop off in 2018.
Growth Prospects
There are two major catalysts for Harvest’s future investment income growth. The first is growth of the portfolio itself. Increasing assets will allow the company to invest more, which would generate new income. It appears Harvest is well on its way to accomplishing this in 2019.
The second growth catalyst is expanding yields from existing assets. Harvest’s debt portfolio is largely floating rate securities. This means that when rates move up or down, so does the yield on the assets it owns.
During a time of rising rates, Harvest can do very well. Of course, that leverage works both ways, and declining rates can be painful to a BDC.
The company’s investment portfolio has decreased in recent quarters. Management has been picky about new investments, which is a good thing, but it is delaying progress in reflating the investment book.
Overall, the growth outlook is fairly murky for Harvest, given that its investment portfolio is in a state of transition. This has sent its average yield lower, and as a result, net investment income has taken a significant hit.
Dividend Analysis
Harvest currently pays a monthly dividend of $0.08 per share. Annualized, the payout comes to $0.96 per share. Harvest does not have a strong dividend history. The dividend was cut in February of 2018 from $0.1125 per share, to $0.095 per share.
The dividend was reduced again for 2019, this time to the current value $0.08 per month. This highlights the nature of investing in BDCs. There always exists a meaningful risk that the payout is unsustainable.
Based on Harvest’s current share price near $10, the stock has a dividend yield of 9.4%.
Another bad sign is that Harvest’s payout ratio is alarmingly high, at over 100% in terms of net investment income. Last year, Harvest generated net investment income of $0.93, which would not sufficiently cover the new reduced dividend of $0.96 per share.
The company’s new investments should help grow the portfolio and net investment income, but Harvest still appears to have meaningful risk in its payout after two recent cuts.
Harvest’s credit quality remains strong, which reduces its repayment risk. But with falling yields and a smaller portfolio, it doesn’t appear the dividend is out of the woods just yet.
Harvest is one of the smaller BDCs on the market with a total market capitalization of just $64 million. This means it lacks the size and scale of some of the larger BDCs, and a downturn could be more harmful to Harvest than larger competitors.
Overall, we are quite cautious on Harvest’s ability to continue to pay its distribution, and think investors should carefully examine the company’s results before buying the stock.
Final Thoughts
Stocks with near 10% yields are attractive, but are not for risk-averse investors. With a 9.4% dividend yield, Harvest has obvious appeal for income.
But Harvest is not a stock that can be a part of a “set-it-and-forget-it” portfolio. Investors cannot simply buy Harvest shares and assume the dividend will be sustainable, as the company has cut the payout twice in just the past 15 months.
The lack of dividend sustainability means investors need to closely monitor the company’s results moving forward. We recommend investors avoid the shares.
