Published on August 31st, 2020 📆 | 5762 Views ⚑0
Horizon Technology Finance: Small But With High Returns (NASDAQ:HRZN)
Business development companies or BDCs provide financing to smaller companies that are under-served by banks. This often includes “mezzanine loans” that pay high interest rates.
One such BDC, Horizon Technology Finance’s (NASDAQ: HRZN) portfolio is expanding in asset size, which is leading to more client diversification and this, despite specializing in just two industries which are technology and life sciences.
Moreover, in terms of management model, Horizon is classified as an externally managed BDC compared to those which are internally managed like Hercules Capital (HTGC).
Now, there are many arguments in favor of the internally managed BDCs which are seen as having lesser management fees and operating costs.
Therefore, I verified whether there has been an increase in operating expenses as a percentage of total revenues but this was not the case and it was stable around the 32% mark for the last five quarters.
Figure 1: Quarterly income statement with all figures in millions of dollars.
Moreover, limiting oneself to classification based on management model would amount to pure shortsightedness and there are other metrics to consider like total returns.
In this respect, Horizon has outperformed Hercules by 10% over a one-year period.
Figure 2: Comparing the returns
Now, for most of us who are already aware about the lending capacity of the banks, big and small, it comes as a surprise how a tiny play like Horizon with a market cap of just $200 million can deliver higher returns than Bank of America (BAC).
To understand this, we must first understand the strength of BDCs’ underlying assets.
Looking back in 1940, the US Congress passed the Investment Companies Act, which prompted the emergence of a new form of lending with tax advantages. The aim was to help unaccredited investors to be able to pool funds in order to lend them to promising small businesses.
A BDC can therefore be considered as a fund which brings together a diverse panel of small valuation shares. This financial product can concentrate a dozen as well as expand to a few hundred companies.
As for Horizon, it has debt investments in 35 companies representing about $343 million and a portfolio of warrant, equity and other investments in 72 companies with an aggregate value of $13 million.
While venture capitalists or other structures like Blackstone (BX) invest in startups through the purchase of shares, Horizon takes a somewhat different approach, as it mainly lends money to these startups together with minor equity positions.
Looking further, since this is a competitive market, there is a chase for better yields which can be derived out of the amount invested in debtors.
Competition for yields
I noticed that the company has seen a decrease in onboarding yields of 11.1% compared to 11.2% achieved in the first quarter. According to the executives, the reason is because of strong competition especially in the life sciences sector with several financing options available to debtors.
Now, it may seem awkward that in a market impacted by the coronavirus, there would be competition in the first place, as normally corporations would be on the defensive, give preference to cash conservation and avoid being further indebted.
Looking deeper, this is far from the case, with Horizon being able to provide more capital to life sciences companies, many of which are witnessing growth due to the coronavirus itself. Additionally, it has to compete with other lenders as well.
Here, what I like about Horizon is that it is being choosy, thus showing a “preference for high quality deals with good investor support and lots of liquidity”.
This makes a lot of sense in the current environment of volatility where this “more conservative” strategy aimed at maintaining quality rather than chasing yields is more appropriate.
Finally, despite actions to maintain the company’s creditworthiness in the face of uncertainty, there are other risks of a macroeconomic nature and it is important to analyse these in detail and how Horizon is undertaking mitigation steps.
Risks and mitigation
To mitigate risks, Horizon has prioritized on regular communications and discussions with portfolio companies about employing a realistic and achievable outlook when making business plans.
In this case, the approach is based on past experience gained in the 2008-2009 financial crisis.
Figure 3: Horizon’s three pronged approach to counter risks
Source: Table built from Q2-2020 earnings call transcript.
This approach is providing useful in aligning Horizon’s interests with portfolio company’s growth aims.
I now consider two metrics normally used in times of economic hardship.
1. Cash runway. This refers to the length of time in which a company will remain solvent, assuming that they are unable to raise more money.
As for Horizon’s debtors, the majority (75-80%) have cash to operate till 2021. The other 20-25% make up for “six or seven” companies according to the executives and some are in the process of raising cash.
2. Non-accrual status. Non-accrual status is given to a debt investment which has become due for 90 or more days representing a risk that the company may not receive interest and principal repayments.
I checked and found that two companies have been put under non-accrual status.
However, on further checking in the quarterly statements, I saw that the value of loan and equity (common and preferred) issued to these companies totaled about $8 million which is only about 2% of Horizon’s total debt issuance and equity investments combined.
Normally to counter cases of cash runway and non-accrual, companies rely on diversification to minimize possible bankruptcy impacting some companies.
Here, Horizon’s strategy is to focus on just technology and healthcare sectors but by lending money to companies at various development stages.
Figure 4: Reducing risks through diversification.
This enables decrease in potential concentration risk while at the same time ensuring specialization in a few sectors which the loan issuers already know inside out. Emphasis is also laid on strong relationships with debtors and avoid the business-as-usual higher yield chasing mindset.
Talking yields, high dividends which BDCs are so famous for come to mind, more so in an environment characterized by low interest rates (by the FED) where bond investors (like myself) aren’t doing much better.
Coming back to the law on investment companies, it requires BDCs to pay at least 90% of the income generated also called the Net Investment Income or NII to shareholders.
Horizon’s payout ratio is 94% for a dividend yield of 10%.
For that matter, most BDCs provide dividends, which is also a contributing factor explaining why their total returns are relatively high.
Interestingly, Horizon has declared monthly distributions of $0.10 per share for 48 consecutive months and dividends paid being covered by NII as a matter of policy.
During the quarter, NII of $0.40 per share was generated, up from $0.26/share in Q1-2020 and $0.37/share for Q2-2019.
Finally, the company intends to maintain the monthly distribution level at $0.10 per share through December.
Valuations and key takeaways
In the company’s second quarter investors presentation, it is mentioned that Horizon has outperformed the Wells Fargo BDC index over past 60 months by more than 48%.
This justifies the fact that at $12, Horizon is selling at a 3% premium to its 6/30/20 NAV/share of $11.64.
Moreover, at the end of the second quarter NAV/share rose $0.16 from March 31, 2020 levels.
Figure 5 : NAV per share and Price/NAV
Moreover, in terms of book value, the stock hit a high in early August, following its strong Q2-2020 earnings report. But it is now past this point and it is currently at a discount to book value taking into consideration metric evolution in the last one year (excluding the March lows) which was due to a generalized stock market slump.
Therefore, I find a price of $12.5-13, which would put the stock at the lower end of the $12 to $16 range as appropriate for the short term till further visibility is obtained in the third quarter as to NII.
Figure 6: Stock price and P/B variation.
This said, I do not have a preference for internally or externally managed BDCs but find it better to select one which opts for quality of asset instead of chasing yield in the current economic climate.
In this respect, Horizon with its experienced management team having proven expertise navigating the 2008-2009 recession fits the bill.
Also, dividend yields may fluctuate due to Net Investment Income being lower as a result of less onboarding yields but investors will note that in the second quarter there were four loan prepayments totaling $30 million, which significantly contributed to NII and this, despite an adverse economic environment.
At a debt to equity ratio of 0.97 and potential debt capacity of $204 million (including the revolver) as of June 30 plus operating expenses under control, Horizon is a stable company.
Also, its balanced risk loans generate high returns.
Therefore, Horizon is a buy.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HRZN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.