Despite the sluggish economic recovery, a steady pace of new investments by venture capitalists is palpable. Consequently, new investment opportunities are expected, though we remain cautious about the company’s investment and credit management strategies.
Hercules’ first-quarter 2011 distributable net operating income (:DNOI) came in at 25 cents per share, marginally up from the Zacks Consensus Estimate of 22 cents. This compared favorably with DNOI of 17 cents per share in the prior-year quarter.
Better-than-expected results in the reported quarter were attributable to a rise in total investment income and higher net realized gain on investments, partially offset by higher operating expenses. Additionally, Hercules ended the quarter with a strong balance sheet and a high level of liquidity.
We view Hercules as a sound asset for yield-oriented investors. Moreover, the company is expected to pay the majority of its earnings each year as dividends due to its RIC status. The dividend growth story has been fairly decent.
Also, effective 2009, the board of directors adopted a policy to distribute quarterly dividends approximating 90–100% of the company’s taxable income. The company increased its first-quarter 2011 dividend by 10% to $0.22 per share and maintained the same level in the second quarter.
Additionally, Hercules is currently a small player in a market with huge growth prospects. Though the recession has resulted in the current contraction within the venture capital community and volatility in general, 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 persist in the near future.
On the flip side, 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 would be at risk.
In addition, concentration risk is also fairly high. One bad credit could have a substantial negative impact at this stage of the business. There is a risk 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.
Hercules currently retains a Zacks #4 Rank, which translates into a short-term ‘Sell’ rating. However, Triangle Capital Corporation (NYSE:TCAP - News), one of Hercules’ closest competitors, retains a Zacks #2 Rank (a short-term ‘Buy’ rating).
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