FS KKR: This fall, Large Low cost To NAV Justified; BDC Stays A Nice Earnings Play

Introduction

Many could also be questioning how properly BDCs will fare in 2024, with charges nonetheless anticipated to say no. I’m a giant believer within the sector and suppose 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 may profit the sector for the long run.

And although many BDCs have rewarded shareholders these previous two years with further revenue due to their predominantly floating-rate portfolios, some have nonetheless confronted headwinds within the course of. One which has lately is the fourth-largest BDC, FS KKR Capital (NYSE:FSK). On this article, we’ll focus on why the BDC has offered off lately however why they’re nonetheless an awesome funding for income-focused traders.

Earlier Article

I final lined FS KKR Capital again in December: Is The Discount To NAV Justified Or Is This BDC A Bargain? 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 sturdy stability sheet which had upcoming debt maturities, however these had been well-laddered and lined by their sturdy liquidity profile. That they had additionally outperformed common friends, Ares Capital (ARCC) and Most important Road Capital (MAIN) in whole returns by way of 3 quarters, which I assumed was extremely spectacular contemplating the 2 are extra common amongst traders. So, why has the BDC offered off whereas each ARCC & MAIN are each within the inexperienced?

Transient Overview

Earlier than we get into why the BDC offered off lately, let’s speak concerning the firm. FSK is an externally-managed BDC, just 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 honest 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 & Companies sector at 16.9%.

So Why The Promote-Off?

Since my final article, FSK reported their Q4 earnings on the finish of February and the BDC disenchanted some traders with the rise in non-accruals through the quarter. Though BDCs have loved the additional revenue from portfolio corporations, they’ve additionally confronted downward strain from greater rates of interest.

By means of the primary 3 quarters, the corporate really managed to lower non-accruals with these declining quarter-over-quarter by way of the primary 9 months. However in This fall these accounted for five.1% at value and a couple of.6% at honest 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 whole investments. ARCC additionally noticed a decline in non-accruals from 1.7% at value to 1.3% to shut out the 12 months.

This, together with a drop in NII additionally brought about FSK’s NAV share value to say no quarter-over-quarter as properly. In addition they had a couple of challenges with credit putting two extra corporations, Miami Seashore Medical Group & Reliant Rehab, on non-accrual. In This fall 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 whole funding revenue fell 3.9% to $447 million over the identical interval. So, not an awesome quarter for the BDC to say the least.

With charges remaining greater for longer, non-accruals will proceed to be a headwind for BDCs. And although the FED nonetheless expects fee cuts within the close to future, these will seemingly have a lagging impact and nonetheless place downward strain on BDC debtors. This additionally causes greater 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 shall be preserving a detailed eye to see how FSK’s administration handles portfolio corporations within the close to future.

Regardless of challenges, FSK did handle to take a position $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 lined by NII. The great factor is that BDCs who pay supplementals and/or specials can simply minimize these at any time. The common dividend of $0.64 offers FSK dividend protection of 117% which is protected. And for the primary quarter, the BDC declared a further $0.75 whole 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 fall. For the full-year FS KKR Capital paid out $2.95 in distributions and introduced in a complete of $3.18 in web funding revenue. So, for these apprehensive about their dividend security, that is greater than lined at the moment. Trying ahead, if borrower credit score high quality continues to drop, the BDC will seemingly minimize 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 stability sheet stays in good condition with whole 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 biggest BDC by market cap, Ares Capital’s 1.02x.

Nonetheless, they’ll seemingly should refinance their upcoming debt at greater 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 sturdy. They’re additionally investment-grade rated by Fitch and Moody’s.

Undervalued For A Motive

As seen by their borrower credit score high quality points, FSK at the moment trades at a P/NAV ratio of roughly 0.78x. That is compared to a lot of its friends who at the moment commerce at premiums above NAV due to their enticing yields and distributions because of greater rates of interest.

Moreover, the present low cost of almost 28% sits greater than the 3-year average of 20.94%. So, these on the lookout for strictly revenue, now could also be an excellent time to pounce on FSK because the valuation is enticing in the meanwhile. Nonetheless, on account 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 gives little upside to their value goal from the present value of roughly $19. However once more, nice revenue play for traders in quest of greater 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 stability sheet stays in good well being with manageable debt maturities within the coming months and ample liquidity.

At a P/NAV beneath its 3-year common and fewer than 1.0x at the moment, the BDC could also be too laborious to cross for these in quest of greater 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 on account of present borrower credit score points, I nonetheless suppose they continue to be an awesome revenue play.