Introduction
I’m sure most of us are very familiar with those “Proceed with Caution” signs that are usually posted at businesses or work sites. When looking into any investment, especially those with higher yields, one should be very careful. Higher-yielding companies are great income generators, but investors should do their due diligence before placing their hard-earned money into a holding.
When it comes to Horizon Technology Finance (NASDAQ:HRZN), a BDC I haven’t covered here on Seeking Alpha, I urge investors to do the same. Although their attractive yield is enticing right now, let’s take a look at the company’s recent earnings, fundamentals, and why I think investors should proceed cautiously.
Brief Overview
Like many business development companies, Horizon Technology Finance lends to smaller and middle-market companies, providing funding for growth. Unlike peers Ares Capital (ARCC) or Capital Southwest (CSWC), however, HRZN focuses heavily on the Technology & Life Sciences industries.
This is similar to BDCs TriplePoint Venture Capital (TPVG) and Trinity Capital (TRIN), both I’ve covered and can read here and here. Horizon Technology Finance Corp specializes in investments for venture-backed companies. They are externally-managed by Horizon Technology Finance Management and IPO’d shortly after the GFC in 2010. Forty percent of their investments are on the Western Coast of the U.S.
Latest Earnings
Horizon Technology Finance Corp reported Q1 earnings at the beginning of the month with net investment income of $0.38, in-line with estimates. Total investment income of $26.1 million missed slightly. And while their Nll covers the current quarterly dividend amount of $0.33, this has declined 3 straight quarters and is down over annualized basis. Total investment income also declined from $28.2 million in the fourth quarter and $29.1 million in Q3.
This is something that investors should be worried about as declining financials on a sequential basis can happen, but multiple quarters with declines usually warrant caution, sometimes speaking to a BDC’s credit quality, especially in this macro environment. On an annualized basis, both Nll and Tll declined as well. Net investment income declined more than 17% from $0.46 in Q1 ’23; Tll also declined nearly 7% over the same period.
|
Q1 ‘23 |
Q1 ‘24 |
|---|---|
|
$0.46 |
$0.38 |
|
$28 |
$26.1 |
Deteriorating Risk Profile
Over the past two years, although some BDCs have enjoyed extra income and paid out specials and supplementals as a result of their floating rate debt investments, HRZN’s credit quality has seemed to deteriorate somewhat. Last year, the banking crisis impacted them with the failure of Silicon Valley bank. But management stated during earnings they are starting to see a recovery in the venture ecosystem.
Their total portfolio value also declined year-over-year from $715.3 million to $711.1 million. As a result, their NAV also experienced a decline to $9.64, or $332.1 million. This is something investors should be concerned about as a declining NAV can be multifactorial. BDCs typically grow their NAV by out-earning their dividend and making additional investments to grow their portfolio.
But an increased risk profile and/or unrealized losses are usually reasons for this. HRZN’s NAV declined from Q4’s $9.71, and on an annualized basis declined significantly by roughly 15%. Peer Trinity Capital (TRIN) also saw a decline in its NAV on a sequential and annualized basis. This fell to $12.88 in Q1 from $13.19 in Q4 and $13.07 in Q1 ’23.
Author creation
However, during the quarter, they did fund $33 million worth of investments to five existing portfolio companies. The company did not make any additional investments in new companies as they mentioned underwriting strategies for transactions are taking longer to develop as a result of the economic backdrop, exposing the lower quality of their borrowers.
But they did take advantage of the opportunity to make investments to existing companies that are performing strong. And they expect opportunities to pick up in the upcoming quarter and back half of 2024 which we should see the BDC make additional investments in new companies.
Dividend Safety
HRZN’s double-digit yield is currently covered by the BDC’s Nll of $0.38 as stated previously. Additionally, the company paid a few special dividends of $0.05 at the end of last month and the end of 2022 & 2023. But for the most part, they have been modest in paying out extra income. I think this is a smart move by management to prefer to retain capital as their borrowers have faced financial difficulties during the high interest rate environment.
Another reason the yield may be attractive is that HRZN pays a monthly dividend vs quarterly. Furthermore, they have already declared a monthly $0.11 dividend payment for the month of July, August, & September.
Although the BDC’s dividend coverage is not as strong as their monthly paying BDC peer MAIN Street Capital, who covered its dividend by 54% with Nll of $1.11 during their recent quarter.
However, HRZN’s spillover income puts them in a comfortable position if dividend coverage becomes tight as a result of declining Nll. During Q1, spillover income was $1.30. This gives them ample liquidity to make additional investments or help struggling borrowers.
Solid Balance Sheet & Liquidity
At quarter’s end, HRZN’s liquidity levels were solid with $90.7 million available. This included $71.3 million in cash. They also issued 1 million additional shares above NAV, which also boosted the company’s liquidity, and enhanced their opportunity to access equity markets should opportunities arise.
Their debt-to-equity and net leverage ratios were solid at 1.37x and 1.16x, respectively. This is in-line with TRIN’s 1.16x. Furthermore, they have no debt maturing until 2026 with $57.5 million due. This had a weighted-average interest rate of 4.875%, so there’s a good chance the BDC can refinance at a lower rate.
They also extended their share repurchase program until June of next year. And although they didn’t repurchase any shares, I suspect they will if the share price drops below NAV, especially if interest rates are lowered sometime in the near future.
HRZN investor presentation
Risks
With the economic backdrop still placing downward pressure on their borrowers, this puts HRZN’s credit profiles at further risk. During the quarter, Horizon added an additional company to non-accrual status, which caused management to write down the investment. The BDC has faced immense pressure from the high interest rate environment as seen by their declining financials and NAV.
Furthermore, additional companies added could cause more write-downs, ultimately impacting their earnings going forward. This could also lead to their dividend safety being at risk, although I think the BDC could cover this with their spillover income for a prolonged period. However, further unrealized losses is something investors should be aware of for the foreseeable future as it will impact the company down the line.
Valuation
As you can see in the chart below, Horizon Technology Finance has lagged its peers over the past year, down more than 8% in comparison. One reason for this is the BDC’s credit losses and deteriorating credit quality. The high interest rate environment has provided challenges for their borrowers, but others showed solid growth over the same period.
Moreover, they currently trade at a 20% premium to NAV, and although this is relative to their 3-year range, I think investors looking to buy should wait for any sort of pullback in price. And with interest rates expected to decline sometime in the near future, BDC prices could see somewhat of a share price retraction as their high-yields won’t be as attractive. Additionally, I think there are better, high-yielding BDCs to invest in at the moment if one is willing to pay a premium.
Takeaway
Horizon Technology Finance has faced challenges during the high interest rate environment. And although their credit quality is declining, the current dividend yield is safe, at least for the short term. Moreover, their balance sheet and liquidity levels put them in a strong position to execute on opportunistic investments in the back half of this year.
But the stock trades at a 20% premium to its NAV, giving investors little margin of safety in my opinion. Although I think Horizon Technology Finance’s dividend is safe, there are better options currently as a result of its premium and lower quality borrowers. This, along with their unrealized losses, I rate HRZN a hold.
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