FSK - Ares Capital: Higher Rates Make This 10% BDC Yield A No-Brainer (Upgrade)

2023-10-27 11:55:13 ET

Summary

• Ares Capital Corporation covered its dividend payout with net investment income and achieved a dividend coverage ratio above 100% in 3Q-23.
• The BDC's credit quality improved, with a low percentage of non-accruals in the third quarter.
• ARCC is positioned for higher interest rates and has large floating-rate exposure, making it a compelling investment option for passive income investors.

Ares Capital Corporation (ARCC) made a strong case for itself with the release of third quarter earnings which showed that the business development company once again covered its dividend pay-out with net investment income and achieved a dividend coverage ratio well above 100% in 3Q-23.

The BDC's credit quality improved, with Ares Capital showing just 0.6% in non-accruals in the third-quarter. Since Ares Capital continues to be positioned for higher interest rates and has large floating-rate exposure, the recent uptick in inflation as well as lower non-accruals make ARCC a compelling investment option for passive income investors. Buy.

My Rating History

Recently, I scaled back my investment in Ares Capital, due to the BDC trading at a premium to net asset value. Before that, my stock classification for Ares Capital was Buy due to strong long-term returns and impressive overall credit quality going back more than a decade.

I have, however, doubled down on BDCs that have higher discounts to net asset value, such as FS KKR Capital Corp ( FSK ) which I view as a compelling re-rating investment .

I am re-classifying ARCC after 3Q-23 as a Buy due to the fact that the BDC is seeing improved credit quality. With more rate hikes moving forward likely due to rising inflation, ARCC is set for net investment income tailwinds, too.

Minor Change To Portfolio Composition

Ares Capital's investment portfolio profited from higher interest rates as the BDC remained overly invested in floating-rate loans. The portfolio itself hardly changed in the last quarter as Ares Capital's main investments (60%) were First and Second Senior Secured Loans. Floating-rate loans totaled 69% of all debt investments, giving the BDC a strong net investment income tailwinds if the central bank pushes rates higher.

The BDC strengthened its position in First Liens with new commitments going overwhelmingly to this investment category. In total, Ares Capital made $1.6 billion in gross commitments in the third quarter. Subtracting investment exits of $1.3 billion, Ares Capital's net commitments were $318 million. In the second quarter, net commitments rose $80 million.

Ares Capital's credit quality improved substantially in the third quarter which is key to my stock reclassification as a Buy. The BDC's non-accrual ratio fell from 1.1% in 2Q-23 (based on fair value) to 0.6% in 3Q-23. The improvement in credit quality has removed uncertainty and, together with a NAV valuation, the stock looks compelling again as a Buy for passive income investors.

Dividend Coverage

Ares Capital earned $0.52 per share in net investment income in the third quarter which translates into a dividend coverage ratio of 108%. Even though the pay-out ratio has deteriorated in the last three quarters, the $0.48 per share per quarter dividend has been solidly covered by net investment income.

The dividend pay-out ratio in the last year, including Ares Capital's just released third quarter earnings, was 123%. The dividend has a high margin of safety, in my view, as well.

Tiny NAV Multiple, Updated Investment Plan

Ares Capital's NAV in 3Q-23 was $18.99 per share, up 2.2% QoQ. Now, with results reported, the BDC is selling at just about NAV. Given the quality of an investment in Ares Capital and improving credit quality, the NAV multiple presents a good entry level in my view. Other BDCs sell for discounts to NAV, but neither have the size nor the performance record of Ares Capital .

Because of that, I would think that Ares Capital deserves a higher NAV multiple than other First Lien-centric BDCs.

I planned on exiting ARCC stock at 1.10-1.15x NAV which would have led to a potential sell range of $20.44-21.37. This sell range has not been reached yet. Quite the opposite, ARCC has fallen back towards NAV.

Passive income investors can find a decent entry at this price/valuation level. A drop below NAV would make an investment in ARCC even more compelling than it already is.

What About Ares Capital's Risks?

Ares Capital improved its credit quality in the third quarter, but a rise in non-accruals might change my outlook on the BDC as would an approaching end to the rate-hiking cycle.

The risk of the rate-hiking cycle ending in the near term, however, has decreased lately, in my view, since inflation is going up again ( 3.7% YoY in September).

My Conclusion

Ares Capital is not a Strong Buy, but a solid Buy with a decent risk/reward ratio for passive income investors that don't want to wait until a premier BDC like ARCC becomes available at a discount to NAV.

A 10% decline in market valuation (implied 0.9x NAV) would result in me changing my stock classification from Buy to Strong Buy. But even without a discount to NAV available to passive income investors, Ares Capital is a solid, no-headache, put-passive-income-on-autopilot dividend investment.

With a 108% dividend coverage ratio in the third quarter and credit quality improving, owning BDC for an income-focused passive income portfolio is a no-brainer.

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