BIZD - Better High Yield Buy After Quarterly Results: Ares Capital Vs. Capital Southwest

2023-08-09 09:56:06 ET

Summary

• Ares Capital Corp and Capital Southwest are both high yield Business Development Companies with strong track records of delivering attractive total returns.
• Both companies recently reported quarterly results.
• We compare ARCC and CSWC stocks side by side and offer our take on which is the better buy today.

Ares Capital Corp ( ARCC ) and Capital Southwest ( CSWC ) are both blue chip high yield Business Development Companies ( BIZD ) that have strong track records of delivering attractive total returns to shareholders over the long-term:

In this article, we share our opinion on which one is the better buy after reporting their quarterly results.

Capital Southwest Vs. Ares Capital: Quarterly Results Recap

ARCC reported solid Q2 results. NAV per share increased by $0.13 (0.7%) sequentially, due to a combination of unrealized gains in the portfolio as well as some retained earnings after paying out dividends. Weighted average yields on income producing securities and total investments increased by 20 basis points sequentially to 12.2% and 11.0%, respectively. The net interest and dividend margin also increased by 40 basis points sequentially to 7.9%. Meanwhile, non-accruals also improved sequentially, from 2.3% to 2.1% on an amortized cost basis and from 1.3% to 1.1% on a fair value basis.

CSWC's quarterly results were quite strong, highlighted by a 3.7% dividend hike on top of a $0.06 per share special dividend (up from $0.05 in the previous quarter and constituting 11.1% of the previous quarterly dividend). One negative from the quarter was that non-accruals at fair value did increase significantly during the quarter from 0.3% to 1.7%, though this still remains at a modest level.

CSWC Stock Vs. ARCC Stock: Balance Sheet

ARCC's leverage ratio declined from 1.09x to 1.07x, sequentially, in its most recent quarter. With investment grade credit ratings from several leading agencies, substantial liquidity, and a well-laddered debt maturity ladder (see below), ARCC's balance sheet remains in excellent shape.

Moreover, 68% of its outstanding debt is fixed rate at a weighted average interest rate of 3.37% with a weighted average term to maturity of 3.19 years and its blended overall weighted average interest rate is 4.56%. As a result, it appears well positioned to maintain an attractive cost of debt for the foreseeable future, especially if the Federal Reserve begins to taper back interest rates in 2024.

Meanwhile, CSWC obtained a BBB- investment grade credit rating from Fitch during the quarter and took other measures to fortify its balance sheet, including extending debt maturities, reducing its regulatory leverage ratio from 0.88x to 0.87x, and issuing equity at a 10% premium to NAV. As a result of these efforts and resilient performance in the underlying investment portfolio, the NAV per share edged higher sequentially by $0.01 per share despite the dividend and special dividend paid during the quarter.

CSWC has a very flexible balance sheet with no debt maturities until 2026 and plenty of liquidity, putting it in a strong financial position.

Comparing ARCC and CSWC overall, according to cefdata.com they have near identical leverage ratios, and both enjoy investment grade credit ratings from at least one credit rating agency. Both also have substantial liquidity with well-laddered debt maturity schedules. As a result, we rate them as being roughly equal in this category.

Capital Southwest Stock Vs. Ares Capital Stock: Investment Portfolio

When it comes to investment portfolios, CSWC has a lower expense ratio given that ARCC pays a rather hefty external management fee to Ares Management ( ARES ) for the considerable benefits that its vaunted direct lending and private credit platform provides to ARCC.

Moreover, CSWC's portfolio is significantly more defensively positioned than ARCC's is, with 81.6% of its portfolio invested in 1st lien/senior secured loans and 4.3% invested in 2nd lien/senior secured loans. In comparison, ARCC has 41.7% of its portfolio invested in 1st lien/senior secured loans and 23% invested in 2nd lien/senior secured loans.

That said, despite CSWC's more conservative posturing of its portfolio, ARCC has less of its portfolio on non-accrual status than CSWC does on a fair value basis, implying that ARCC's underwriting is quite excellent and can afford to go out further on the risk spectrum in the capital stack in order to generate better risk-adjusted returns relative to CSWC.

CSWC Stock Vs. ARCC Stock: Dividend Outlook

Both companies have lengthy track records of sustaining and/or growing their dividends. Moving forward, this appears likely to remain the case as both companies are covering their current dividends quite well.

In ARCC's most recent quarter, its quarterly dividend of $0.48 was well-covered by net investment income per share of $0.57 during Q2, leading to healthy 1.19x coverage. CSCW, meanwhile, easily outearned its quarterly dividend with $0.67 per share in net investment income, up 3% sequentially and providing 1.24x coverage of the dividend paid out during the quarter.

On the outlook for their respective dividends moving forward, the management teams had the following to say on their latest earnings calls:

• ARCC:

earnings are well in excess of the [current] dividend level. That's prudent...If we pull a couple of the different levers that could allow us to have a higher dividend or a lower dividend, the one that's the most impactful would be a significant decrease in base rates. You'd have to model non-accruals up a lot to have it to have any real impact on how we thought about the dividend today.

• CSWC:

While future dividend declarations are at the discretion of our Board of Directors it is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future, while base rates are above historical averages, and we have meaningful UTI generated by earnings in excess of our dividends and realized gains from our equity co-investment portfolio.

What both companies seem to be signaling is that they feel very confident in being able to sustain their current base dividend payouts and may be able to continue growing them/distributing supplemental dividends as long as interest rates remain elevated. However, ARCC in particular is being conservative about further increases to the base dividend and is also trying to sustain a considerable amount of spillback income in order to provide a strong cushion for the base dividend should a scenario arise where interest rates fall, and underwriting quality deteriorates.

CSWC Stock Vs. ARCC Stock: Valuation

The final consideration is valuation. ARCC's NTM yield of 9.9% is slightly lower than CSWC's NTM yield of 10.2%, though its NTM P/E ratio is lower at 8.44x compared to CSWC's NTM P/E ratio of 8.70x. Last, but not least, ARCC's price to NAV is more attractive as well at a 5.60% premium compared to CSWC's incredibly high price to NAV premium of 32.30%.

ARCC Vs CSWC: Which Stock Is The Better Buy?

Overall, ARCC continues to be a steady-as-she-goes dividend payer and wealth compounder with an excellent track record, top-notch management, and a solid investment grade balance sheet. The current dividend looks very sustainable for the foreseeable future as well when you combine the spillback income, the solid earnings coverage, and the modest leverage ratio and significant liquidity.

Meanwhile, CSWC also continues to be an excellent wealth compounder for investors with its conservative balance sheet, well-covered, growing, and attractive dividend, and high performing, conservatively positioned investment portfolio.

Given that both ARCC and CSWC have strong track records and are performing quite well at the moment, which is the better buy today?

While both BDCs offer investors strong underwriting, solid balance sheets, attractive and sustainable dividends, and impressive track records, ARCC is overall a better value at the moment in our view. This stems from the following two major factors:

1. ARCC trades at a significantly cheaper value
2. ARCC has slightly better underwriting performance at the moment

While CSWC gets more value for shareholders on a per dollar of NAV basis, ARCC's stock price is significantly cheaper, so in our view investors in ARCC get more value on a per dollar invested basis than they would by purchasing shares of CSWC. As a result, we hold ARCC alongside several other attractively priced, high quality BDCs in our portfolio.

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