Introduction
Many could also be questioning how effectively BDCs will fare in 2024, with charges nonetheless anticipated to say no. I’m a giant believer within the sector and assume they’re extra than simply excessive rate of interest setting investments. With the banking disaster roughly a 12 months in the past inflicting tighter lending requirements, I feel this can profit the sector for the long run.
And although many BDCs have rewarded shareholders these previous two years with further earnings due to their predominantly floating-rate portfolios, some have nonetheless confronted headwinds within the course of. One which has just lately is the fourth-largest BDC, FS KKR Capital (NYSE:FSK). On this article, we’ll focus on why the BDC has bought off just lately however why they’re nonetheless an ideal funding for income-focused traders.
Earlier Article
I final coated FS KKR Capital again in December: Is The Low cost To NAV Justified Or Is This BDC A Cut price? I rated the inventory a purchase however since then the inventory’s share value has declined almost 6% on the time of writing. In it, I mentioned how the corporate had been impressively rising its portfolio by making acquisitions.
Moreover, I mentioned the BDC’s robust steadiness sheet which had upcoming debt maturities, however these had been well-laddered and coated by their robust liquidity profile. That they had additionally outperformed widespread friends, Ares Capital (ARCC) and Predominant Avenue Capital (MAIN) in complete returns by means of 3 quarters, which I believed was extremely spectacular contemplating the 2 are extra widespread amongst traders. So, why has the BDC bought off whereas each ARCC & MAIN are each within the inexperienced?
Transient Overview
Earlier than we get into why the BDC bought off just lately, let’s speak concerning the firm. FSK is an externally-managed BDC, much like friends ARCC and Blackstone Secured Lending (BXSL) and is managed by FS/KKR Advisor.
They’re the 4th largest BDC with 204 portfolio corporations which have a complete truthful worth of $14.6 billion. They make investments primarily in senior-secured investments with these accounting for 66.4% and 58% in first-lien loans throughout 24 industries. Like a lot of its friends, additionally they have a large portion of their portfolio invested within the Software program & Providers sector at 16.9%.
So Why The Promote-Off?
Since my final article, FSK reported their This autumn earnings on the finish of February and the BDC upset some traders with the rise in non-accruals through the quarter. Though BDCs have loved the additional earnings from portfolio corporations, they’ve additionally confronted downward strain from increased rates of interest.
Via the primary 3 quarters, the corporate really managed to lower non-accruals with these declining quarter-over-quarter by means of the primary 9 months. However in This autumn these accounted for five.1% at price and a couple of.6% at truthful worth, up from 2.4% within the third quarter.
Non-accruals have plagued many BDCs, however the higher-quality ones like ARCC & BXSL have managed these prudently up to now 12 months. BXSL really managed to lower their non-accruals from 0.14% in Q1 to simply 0.1% of complete investments. ARCC additionally noticed a decline in non-accruals from 1.7% at price to 1.3% to shut out the 12 months.
This, together with a drop in NII additionally prompted FSK’s NAV share value to say no quarter-over-quarter as effectively. Additionally they had a couple of challenges with credit inserting two extra corporations, Miami Seashore Medical Group & Reliant Rehab, on non-accrual. In This autumn there have been a complete of 5 corporations positioned on non-accrual standing.
One other portfolio firm additionally confirmed materials deterioration of their ahead EPS projections. NII declined from $0.84 in Q3 to $0.75 whereas complete funding earnings fell 3.9% to $447 million over the identical interval. So, not an ideal quarter for the BDC to say the least.
With charges remaining increased for longer, non-accruals will proceed to be a headwind for BDCs. And although the FED nonetheless expects price cuts within the close to future, these will possible have a lagging impact and nonetheless place downward strain on BDC debtors. This additionally causes increased web bills, which impacts their NII. So, that is one thing traders within the sector ought to concentrate on when seeking to make investments. I will likely be holding a detailed eye to see how FSK’s administration handles portfolio corporations within the close to future.
Regardless of challenges, FSK did handle to speculate $680 million in new investments through the quarter, leading to portfolio progress of roughly $162 million. 58% of those had been add-on investments in present corporations. However seeing by the variety of corporations positioned on non-accrual and extra (corporations) with deteriorating projections, FSK traders must be actually cautious going ahead.
Dividend Security
As a BDC investor, most care concerning the security of the dividend. For the fourth quarter, the dividend payout of $0.75 was coated by NII. The great factor is that BDCs who pay supplementals and/or specials can simply reduce these at any time. The common dividend of $0.64 offers FSK dividend protection of 117% which is secure. And for the primary quarter, the BDC declared a further $0.75 complete payout payable in April.
That is compared to an absolute favourite of mine and present holding BSXL, who had dividend protection of 125% throughout This autumn. For the full-year FS KKR Capital paid out $2.95 in distributions and introduced in a complete of $3.18 in web funding earnings. So, for these nervous about their dividend security, that is greater than coated presently. Wanting ahead, if borrower credit score high quality continues to drop, the BDC will possible reduce the supplemental however nonetheless pay a pleasant common dividend.
Liquidity Profile
Whereas they do have $900 million in debt maturing this 12 months, FSK’s steadiness sheet stays in fine condition with complete liquidity of $3.9 billion and net-debt-to fairness of 1.13x, in comparison with 1.10x to finish the third quarter. That is compared to the most important BDC by market cap, Ares Capital’s 1.02x.
Nonetheless, they are going to possible need to refinance their upcoming debt at increased charges as these have weighted-average rates of interest of 4.625% and 1.650% respectively. However as beforehand talked about, their liquidity profile stays robust. They’re additionally investment-grade rated by Fitch and Moody’s.
Undervalued For A Cause
As seen by their borrower credit score high quality points, FSK presently trades at a P/NAV ratio of roughly 0.78x. That is compared to a lot of its friends who presently commerce at premiums above NAV due to their enticing yields and distributions due to increased rates of interest.
Moreover, the present low cost of almost 28% sits increased than the 3-year common of 20.94%. So, these in search of strictly earnings, now could also be an excellent time to pounce on FSK because the valuation is enticing in the intervening time. Nonetheless, as a result of their talked about credit score points leading to a drop in NAV and rise in non-accruals, I do not see the share value appreciating a lot from right here till these points are resolved. And it provides little upside to their value goal from the present value of roughly $19. However once more, nice earnings play for traders looking for increased yields.
Backside Line
Though FS KKR Capital has seen their borrower credit score high quality diminish quarter-over-quarter, the double-digit dividend yield stays enticing with dividend protection over 100%. Moreover, their steadiness sheet stays in good well being with manageable debt maturities within the coming months and ample liquidity.
At a P/NAV under its 3-year common and fewer than 1.0x presently, the BDC could also be too exhausting to move for these looking for increased yields. Particularly with rates of interest anticipated to say no within the close to future. And though I’m downgrading the BDC to a maintain as a result of present borrower credit score points, I nonetheless assume they continue to be an ideal earnings play.