OCSL - Ares Capital: Put New Money To Work

2023-12-03 09:07:58 ET

Summary

• Ares Capital is a solid pick for cash flow sanity in today's tech-fueled market, offering a 9.6% dividend yield.
• ARCC has a strong track record of value creation and a well-covered dividend payout.
• The company is well-positioned to take advantage of deal-making opportunities and grow its NAV/share organically.

With tech stocks like Salesforce ( CRM ) and Apple ( AAPL ) back in full-swing again, hitting their 52-week highs, there's plenty of new capital to be had should one wish to cash out of their positions.

While unrealized capital gains are nice to see on paper, paper gains alone are not a tangible early retirement strategy. After all, who wants to spend their retirement years fretting about having to match the timing of stock sales to fund their living expenses?

That's why I'm more of an advocate of a balanced approach between growth and income stocks, since the latter category is what pays the bills. Besides, income stocks like Ares Capital ( ARCC ) simply make sense from a payback period standpoint.

Should ARCC be able to maintain or grow its dividend rate (which it has for the past 10+ years), investors who buy today in a tax-advantaged retirement account would essentially be playing with "house money" after just over 10 years.

I last covered ARCC here with a 'Strong Buy' rating in April, noting its undervaluation and low leverage. The stock has risen by 10% since my last piece, and importantly, has given investors a near 16% total return thanks to dividends, surpassing the 12% rise in the S&P 500 ( SPY ) over the same time frame. In this article, I discuss why ARCC is a solid pick for cash flow sanity in today's tech-fueled market, so let's dive in!

Why ARCC?

Ares Capital is often recognized as the bellwether of BDCs due to its size, diversification, and track record of shareholder returns. Over the past 10 years, ARCC has done well for its shareholders, giving investors a 183% total return, far surpassing the 91% of the VanEck BDC Income ETF ( BIZD ) and sitting close to the 202% total return of the S&P 500, with the latter having taken off in recent weeks due to a rally in growth stocks.

The difference, of course, is that ARCC has given most of its shareholder returns in the form of cash dividends, whereas the return of the S&P 500 is largely locked into capital gains. Besides having a far quicker payback period from dividends, ARCC's shareholders also get to enjoy their returns now without having to sell shares. Applying the Rule of 72 , it would take 36 years for the 1.4% yield of the S&P 500 at its 10-year 6.7% growth rate to match the current 9.6% yield of ARCC.

As of the end of September, ARCC carried a sizable investment portfolio with a fair value of $21.9 billion, representing 2.8% YoY growth from the prior year period. Its investments are diversified across 490 portfolio companies. ARCC invests mostly in non-cyclical industries with software, healthcare, business services, and consumer durables representing its top 4 industries.

As shown below, the majority of ARCC's investments (82%) are in the form of senior secured loans or in Ivy Hill Asset Management, a related-party BDC that invests mostly in secured loans. It's worth noting that management has taken an even more conservative approach in recent times, as 97% of its investments in October were made to first lien senior secured loans.

Notably, ARCC's conservative portfolio management strategy has resulted in meaningful book value per share growth over the past 10 years, from $16.46 in 2013 to $18.99 as of the end of Q3. ARCC's NAV/share growth compares favorably to that of what I consider its direct peers, Blue Owl Capital Corp. ( OBDC ) and Oaktree Specialty Lending Corp. ( OCSL ).

For an apples-to-apples comparison, OBDC started in 2016, and grew its NAV/share by 3.7% since then, whereas ARCC grew its NAV/share by 15.4% over the same time period. Since Oaktree took over OCSL (from Fifth Street Asset Management) at the end of 2017, OCSL's NAV/share grew by 5.7%, sitting lower than the 10.8% growth in ARCC's NAV/share over the same timeframe.

Meanwhile, ARCC is benefitting from a favorable lending environment and higher interest rates, with NAV per share growing by 2.3% YoY and weighted average yield on debt investments growing by 170 bps YoY to 12.4% in the third quarter. It's also being conservative with debt, as debt-to-equity stands at 1.07x, sitting well below the 2.0x statutory limit and 1.27x from the prior year period.

Despite higher rates, ARCC's prudent underwriting resulted in portfolio weighted average EBITDA rising in each of the past 4 quarters. However, it's worth noting that rising interest rates are presenting a challenge as portfolio weighted average interest rate coverage has trended down from 2.0x last year to 1.6x in the last reported quarter, as shown below.

Nonetheless, ARCC's portfolio quality has remained steady, with investments in its lowest two grades (out of 4) rising by just 2 percentage points to 7% from 5% in the prior year period. Investments on non-accrual also remain at a 5-quarter low at 0.6% of the portfolio fair value, as shown below, and that's an encouraging sign.

Looking ahead, ARCC is well-positioned to opportunistically source deals with its strong balance sheet and $5.3 billion in available liquidity. Management sees potentially strong deal-making activity next year, due to pent-up private equity capital that sat on the sidelines this year, as noted during the last conference call :

We're optimistic about the outlook for new investment opportunities and we expect an uptick in M&A and additional sponsor-to-sponsor portfolio company sales to accelerate in 2024. Given the robust level of private equity dry powder that has largely gone unspent growing pressure from private equity LPs seeking returns of their capital and stronger sentiment amongst middle market companies to invest in the growth of their businesses, we expect stronger transaction volume in 2024.

Importantly for dividend investors, ARCC currently sports a 9.6% dividend yield, and the dividend is well-covered by an 81% payout ratio, leaving plenty of retained capital to grow investment and NAV/share organically.

I also see value in ARCC at the current price of $19.92 despite rise in price since when I last visited the stock. At the current price, ARCC trades at a slight 5% premium to NAV, which I find to be reasonable considering its aforementioned track record of value creation through dividends and NAV/share growth. While ARCC is slightly pricier than OBDC and OCSL, I view the premium as being deserved for the same aforementioned reason of better NAV/share growth.

Investor Takeaway

ARCC is an attractive investment for dividend investors, with a strong track record of value creation and a well-covered dividend payout. As the economy continues to recover and private equity activity picks up, ARCC is well-positioned to take advantage of deal-making opportunities and grow its NAV/share organically. With its conservative portfolio management strategy and strong balance sheet, I see ARCC as a solid long-term investment for dividend investors. As such, investors seeking to cash out on capital gains in search of income may want to consider ARCC at the current price and yield.

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