SAR - 12%-Yielding Saratoga Investment: Pullback In Regional Banks Spells Opportunity

2023-04-17 08:05:00 ET

Summary

• Saratoga Investment has demonstrated strong NII growth and maintains strong portfolio quality.
• Stubbornly high rates and weakness in the regional bank sector may create continued opportunities for Saratoga Investment.
• Its dividend is well-covered by NII and the recent share price weakness has created an attractively high yield.

Some may believe that it's better to put a lump sum of money into stocks all at once rather than putting money to work in tranches when the opportunity is right. I don't subscribe to the former notion, as individual stocks go in and out of their own bear markets all the time, and hence that's why savvy investors like Warren Buffett keeps plenty of dry powder on hand to take advantage of mispriced assets.

Such I find the case to be with Saratoga Investment ( SAR ) which I last covered in January here , highlighting the strength of its underlying portfolio metrics. The stock has since fallen from $26.75 to $23.31 at present, pushing the dividend yield up to 11.8%. In this article, I highlight recent developments and provide an updated valuation.

Why SAR?

Saratoga Investment is an externally-managed BDC that provides loans to middle-market companies across the U.S. At present, it has a portfolio fair value of $982 million with 82% first lien secured loans, and was one of the few BDCs to opportunistically grow its portfolio during 2020. SAR's portfolio has grown every year since FY 2012 and is well-diversified across 39 different industries. As shown below, SAR's largest industries are mostly defensive in nature, with Healthcare, IT, HVAC, and Education representing its top 4 segments comprising 30% of the portfolio total.

Meanwhile, SAR has demonstrated continued strong underlying performance, as adjusted net investment income per share grew by 33% sequentially in the latest reported quarter, driven primarily by rising interest rates. This has given management the confidence to grow the dividend by 28% over the past 6 months. Importantly, SAR's portfolio credit quality remains strong, with 96% of investments being at its highest internal rating (on a scale from 1 to 3), with just 1 investment being on non-accrual status (representing 1.0% of portfolio fair value).

Plus, has seen a continued decent flow of opportunities, as it closed $88 million of follow-on investments in the first half of the most recently closed quarter, partially offset by $57 million worth of repayments. It also has been to secure $100 million worth of additional funding through two baby bond offerings and obtained an important third SBIC license all while maintaining a BBB+ investment grade credit rating. This is especially important for growth in the current credit cycle.

Looking ahead, I see potential for slower NII growth, considering that interest rate hikes have taken somewhat of a breather. This is considering the Fed's 25 basis point hike in March as opposed to the previously expected 50 basis point hike.

However, the demand environment should remain strong, considering the troubles around the regional banking segment after the failure of Silicon Valley Bank, among others. A pullback in lending from regional banks could further drive demand for commercial loans from BDCs like Saratoga Investment. That's because unlike regional banks, BDCs have a permanent equity base rather than a depositor base that can pull money out at any time.

Plus, I would expect to see continued sequential improvement at least in the upcoming Q4 FY2023 results as the portfolio is 98% floating rate, and management noted that the higher LIBOR rate at the end of if Q3 FY2023 was not fully reflected during the third quarter during the last conference call :

The average LIBOR base rate utilized for our portfolio for interest rate receipts and accruals during the quarter was 3.59%. Quarter-end LIBOR was 33% higher and 4.78%, implying that the entire impact of the current rising rate environment is not yet fully reflected in our reported earnings.

Notably, SAR's balance sheet is in good shape with a 137% debt to equity ratio ( 173% asset coverage ratio as reported by management), sitting well below the 200% statutory limit. Its forward dividend rate is also protected by an 89.6% payout ratio and I would expect the payout ratio to be lower in the Q4 FY 2024 results due to the aforementioned full-quarter's earnings contribution from the higher LIBOR rate.

Lastly, SAR is trading in value territory at present, with a price to NAV ratio of 83%. As shown below, this sits at the low end of SAR's valuation range over the past 5 years outside of the 2020 timeframe. Analysts have a consensus Buy rating with an average price target of $28.36 , implying a potential 33% total return over the next 12 months.

Investor Takeaway

Saratoga Investment is an attractive opportunity for investors seeking a high yield and dividend growth potential in the BDC space. Its portfolio is well-diversified across defensive industries with strong credit quality, and its balance sheet remains in good shape to support continued investment opportunities. While NII growth may slow going forward, it could see a demand boost from borrowers due to a pullback in regional banks. Lastly, I see the recent material pullback in the share price as presenting an attractive opportunity for income investors.

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