Hercules Upgraded to Outperform

We are upgrading our recommendation on Hercules Technology Growth Capital (HTGC - Analyst Report) to Outperform on its better-than-expected second quarter results and renewed credit facilities. Second quarter distributable net operating income (DNOI) came in at 26 cents per share, a nickel ahead of the Zacks Consensus Estimate.

Better-than-expected results were attributable to a substantial increase in total investment income and improved net realized and unrealized gain, partially offset by higher operating expenses. Additionally, Hercules ended the quarter with a strong balance sheet and a high level of liquidity.

Hercules is currently a small participant in a market with huge growth prospects. Though the recession has contributed to the contraction within the venture capital community and resulted in 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 continue in the near future.

Moreover, we are impressed to see that the company ended the June quarter with approximately $330.0 million in available liquidity and no outstanding borrowings under its renewed credit facilities.

Hercules typically invests in high growth venture-capital-backed companies and receives warrants in conjunction with debt investments. As a result, the company’s investment portfolio will benefit from the recently improving M&A environment as there could be material appreciation in its warrant positions.

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 will be at risk.

To comply with regulatory requirements, Hercules invests primarily in U.S. based companies and to a lesser extent in foreign names. Since late 2007, the U.S. market has been experiencing illiquidity in the debt capital markets.

Though the past few quarters saw a revival in the U.S. economy, the tardy rate and regulatory constraints may lead to increased cost of funding and thereby limit the access to capital market. Its foreign investment will be too limited to support its overall financials.

Despite the capital market disruption and sluggish economic recovery, we expect a steady pace of new investments by venture capitalists. This could lead to new investment opportunities, even though we remain cautious about Hercules’ investment and credit management strategies.

Hercules currently retains a Zacks #2 Rank (a short-term Buy rating). However, one of its competitors, MCG Capital Corporation (MCGC - Snapshot Report) retains a Zacks # 3 Rank (a short-term Hold’ rating).

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Read the full analyst report on MCGC