Time To Buy This 12.5% Dividend Yield?

Companies that pay extraordinarily high dividends should be met with skepticism as a general rule, but does Hercules Capital (NYSE:HTGC) fall into that camp?

After all, this is a company that survived the 2008 financial crisis and managed to increase its dividend by more than 30% over the interim period.

Now paying an astonishing 12.5% dividend, Hercules is leaving the yields of Treasury bills and bonds in the dust, but is its dividend sustainable?

What Sets Hercules Apart

Hercules isn’t your run of the mill venture capital firm, but rather it’s a specialty finance company that offers debt financing to venture-backed and high growth firms, generally in the life sciences, technology and renewable energy sectors.

Where banks shy away from such companies because of the higher perceived risks, Hercules has carved out a niche, and can command higher yields as a result, in part because its deals often included equity kickers.

In its most recent earnings report, management claimed the annualized yield on debt investments was approximately 13.2% while its non-performing asset ratio was a paltry 0.9%, highlighting management’s expertise in risk assessment.

Clearly, management is not only skilled at issuing loans to start-ups but it’s got a keen eye for spotting winners too.

Hercules Is Not Your Average Lender

There is a reason Hercules Capital is up 17% year-to-date, outshining the 10.4% return posted by the S&P 500 so far.

Hercules has a business model that would be the envy of most lenders with 87% of loans secured by assets or revenue streams and a weighted average credit rating of 2.1, implying low default risk in spite of its rather unconventional portfolio.

Other key metrics that speak to the quality of the management team in assessing opportunities include the reported 11.7% net interest margin as of Q2 2023, up 9.2% since the turn of the decade. Add to that an operating efficiency ratio of 32.5% last quarter and you can see Hercules generates more income per dollar of expense than most of its rivals.

So far the numbers seem to play in favor of Hercules but what about its lofty 12.5% dividend? 

Is Hercules Dividend Safe?

No doubt, Hercules has shown a definitive commitment to shareholders who are seeking income by increasing its dividend for the past decade or so.

Now sitting at 12.56%, it is sky high relative to even the elevated yields offered by Treasury bills at the moment.

For shareholders, some concern may arise from the payout ratio, which sits at 89.75%, when 50% or below is a good rule of thumb threshold for sustainability.

So, is Hercules Capital dividend safe? In the near-term, the dividend is likely safe and will continue to be paid out but a rising payout ratio will almost certainly lead to a reduction over the medium to long-term.

Hercules Isn’t Just a Play On Debt

While most investors view Hercules as a pure play on debt investing, the company, in fact, specializes in structured senior secured loans, meaning its debt investments include added features such as warrants and convertible debt options. By so doing, Hercules Capital enjoys some equity upside beyond the interest income.

It also has exposure to the IPO market by lending to companies that may later go public. This is generally achieved through warrants that allow it to purchase stock down the line at pre-determined prices. It effectively results in a call option where a successful IPO leads to a windfall.

As of last quarter, Hercules had exposure to 17 companies that had either recently gone public or were in the process of filing for an IPO. 

It’s also worth noting that Hercules is very picky in selecting companies to back thanks to its stringent underwriting standards. Indeed, the majority of the loan applications it receives are rejected, so only perceived high-quality opportunities are approved. Of the 1,000+ potential investment opportunities per year it can choose, only about 5% meet the firm’s approval standards.

Beyond interest payments and equity upside, management is also skilled at monetizing the exit of investments by structuring exit fees, which essentially are additional payments made when the loan is fully repaid or the borrower exits through an IPO or acquisition. Typically, these contribute to approximately 1-2% in additional annualized yield on loans.

Is Hercules Capital a Good Investment?

Beyond the attributes already described, a noteworthy point is that Hercules Capital management clearly has skin in the game. Approximately 6% of shares outstanding are owned by insiders, a high enough figure to suggest the top brass is well-aligned with shareholders’ interests.

Analysts are generally in agreement that Hercules is a good investment, too, with the consensus price target sitting at $17.69 per share, above present levels.

With revenue growth accelerating and the income statement showing good profitability over the past year, investors have a lot to like in addition to the lofty dividend yield.

So too can investors revel in the history of providing billions in funding to around 600 companies, while currently overseeing over $4 billion in assets under management.

Analysts sentiment is generally bullish, too with JMP Securities in particular lauding the firm’s dominance in venture lending and forecasting higher demand for its services as traditional capital sources dry up. According to the research firm, the stock could rise by as much as 25% from a combination of share price appreciation and dividend yield.

Wrap-Up

Hercules Capital has a whole lot of factors in its favor, not least a 12%+ average return on equity over the past 5 years, a 12.5% dividend yield, bullish forecasts from top-rated analysts, a consensus price target meaningfully higher, and a proven management team with a strong track record of outperforming the market this year.

Hercules enjoys four ‘Buy’ and two ‘Hold’ recommendations. The stock has a potential upside of just above 10%, given its average target price of $17.42 over the next year.

With a high dividend yield that appears safe right now, Hercules checks a lot of boxes.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.