Hercules Upgraded to Neutral

We are upgrading our recommendation on Hercules Technology Growth Capital Inc. (HTGC - Analyst Report) to Neutral from Underperform, based on better-than-expected fourth quarter 2010 results and a dividend hike.

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’ fourth quarter distributable net operating income (DNOI) came to 26 cents per share, marginally up from the Zacks Consensus Estimate of 22 cents. This compares favorably with DNOI of 25 cents in the prior quarter, but missed the prior-year quarter’s DNOI of 28 cents.

Better-than-expected results in the quarter were attributable to a rise in total investment income and a lower net realized loss 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. Because of its RIC status, the company will always pay out the majority of its earnings each year as dividends. The dividend growth story has been fairly decent.

Also, effective 2009, the Board of Directors adopted a policy to distribute quarterly dividends approximating 90–95% of the company’s taxable income. The company increased its first quarter 2011 dividend by 10%. This represents the twenty-second consecutive dividend payment since its inception.

Additionally, Hercules is currently a small participant 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.

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 #3 Rank, which translates into a short-term ‘Hold’ rating. Triangle Capital Corporation (TCAP - Snapshot Report), one of Hercules’ closest competitors, also retains a Zacks #3 Rank (short-term ‘Hold’ rating).

Read the full analyst report on HTGC

Read the full analyst report on TCAP