FSK - Better High Yield Buy: FS KKR Or Owl Rock Capital?

Summary

• Both Owl Rock Capital Corporation and FS KKR Capital Corp offer high dividend yields.
• Both also boast investment-grade credit ratings.
• We compare them side by side and share our take on which is the better buy today.

Both Owl Rock Capital Corporation ( ORCC ) and FS KKR Capital Corp ( FSK ) are high-yield business development companies (i.e., BDCs) ( BIZD ). Both also boast investment-grade credit ratings as well as the backing of world-class alternative asset managers in Blue Owl Capital ( OWL ) and KKR & Co. ( KKR ). We compare them side by side and share our take on which is the better buy today.

FS KKR Vs. Owl Rock - Balance Sheet

Both FSK and ORCC have some of the stronger balance sheets in the BDC sector, as evidenced by their investment grade credit ratings.

FSK's debt-to-equity ratio is currently 1.19x and its balance sheet has plenty of flexibility, with $2.75 billion of total available liquidity (19.8% of its enterprise value).

ORCC's debt-to-equity ratio is roughly equivalent to FSK's at 1.18x, and the company also has plentiful liquidity of $2.1 billion (18.3% of its enterprise value).

Both businesses have similarly constructed balance sheets with similar leverage ratios and liquidity pools relative to their enterprise values.

FS KKR Vs. Owl Rock - Business Models

An important item to keep in mind for FSK is that it previously had waived a meaningful portion of its management fees in order to help create value for shareholders. However, beginning this year, the manager will be reinstating its full incentive fee. While this is not a deal-breaker and should not come even close to threatening the base quarterly dividend, it will undoubtedly lead to lower special/extra dividends.

Both businesses have had pretty good underwriting performance of late. ORCC's non-accrual rate is currently 1.0% of total portfolio at cost, whereas FSK's non-accruals totaled 4.9% at cost. While ORCC's non-accrual rate is vastly superior to FSK's, it is important to point out that none of FSK's non-accruals are from loans underwritten since the new FS/KKR advisor took over in April 2018. As its legacy loans roll off its balance sheet, FSK's non-accrual rate is declining and should continue to improve moving forward.

When it comes to investment portfolio construction, FSK has 45% exposure to first lien senior secured loans, whereas ORCC has 72% exposure to first lien senior secured loans. FSK has 18% exposure to second lien senior secured loans and ORCC has 14% exposure to second lien senior secured loans. 73% of FSK's investments are in floating interest rate debt, while 86% of ORCC's investments are in floating interest rate debt.

FSK's sector exposure favors more defensive business models, including 23% exposure to software and 10% exposure to healthcare as its top two industries. Meanwhile, ORCC's largest sector exposure is 13% to software, 10% to financial services, 9% to insurance, and 7% to food and beverage businesses.

Overall, ORCC's investment portfolio looks to be much better suited to the current environment with its greater emphasis on conservatively positioned and floating interest rate loans, better underwriting track record, and equal to superior exposure to defensively positioned industries.

FS KKR Vs. Owl Rock - Dividend Outlook

In their latest earnings calls, both management teams have emphasized how rising interest rates have enabled them to grow earnings and dividends in the current environment.

For example, FSK's management announced :

The recent increases in interest rates have positively impacted our net investment income. And as Brian mentioned, we are well positioned to continue to benefit from the Fed's most recent action as 89% of our debt investments or floating rate. From a starting point of September 30, a 100-basis point move and higher and short-term rates ultimately will increase our net investment income by approximately $0.25 per share per year, which equates to approximately $0.06 per share per quarter.

As for ORCC :

we are increasing our regular quarterly dividend. Our Board has declared a fourth quarter dividend of $0.33 per share, up $0.02 from our third quarter dividend of $0.31 per share. We also want to ensure our shareholders benefit from the consistent earnings we expect in excess of our regular dividend going forward. And as such, we are introducing a new quarterly supplemental dividend in addition to our regular dividend. For the third quarter, our Board has declared a supplemental dividend of $0.03 per share...The increase in our regular dividend reflects our confidence in the earnings power of the portfolio and positions us to evaluate further increases in the future, while the supplemental dividend provides additional predictable cash flow to shareholders.

FS KKR Vs. Owl Rock - Valuation

Both BDCs appear to be deeply undervalued at the moment:

FSK continues to gradually buy back shares at a steep discount to NAV, but we have not seen them move aggressively on this front. That said, they are paying out hefty dividends and appear poised to continue doing so for the foreseeable future, so shareholders are definitely reaping the benefit of buying the stock at a steep discount to NAV.

As for ORCC, management is pursuing several options for trying to close its massive discount to NAV, and highlighted this on its last earnings call:

ORCC's Board authorized a new $150 million repurchase program, which replaces our previous program. Second, Blue Owl employees have opted to participate in an investment vehicle that intends to buy an additional $25 million of ORCC's stock. In the near term, the company plan and the investment vehicle intend to purchase $75 million of stock in aggregate, a portion of which will be executed under programmatic 10b5-1 plans so they are able to continue buying after the trading window closes. Our Board and the Blue Owl employees believe it is an attractive time to be buying ORCC shares, and we value this alignment between the company to allow our employees and our shareholders...

we're really frustrated by where the stock trades. Hopefully, that's clear in our action and what we're doing. And we have given visibility on earnings performance. And while there are attractive investment opportunities, we think it's important that we also address the stock price and the stock buyback is a way to do that. And so, we're not going to shy away from it either. I would also add that, as I've said, -- we've got employees of Blue Owl are also going to buy shares in the stock. And there's a lot of -- it was totally optional program that we got a very high participation rate in, and they obviously know the portfolio quite well. So hopefully, that's all read as a sign of confidence in what we're doing...

I will tell you the portfolio and the companies are doing, I think, meaningfully better than the way our stock is trading. Our stock is trading as if we're having lots of issues in the portfolio, and we are not.

Investor Takeaway

Overall, we think these two BDCs offer comparable risk-reward. FSK trades at a meaningfully larger discount to NAV than ORCC does, while also offering a significantly higher earnings and dividend yield. However, ORCC's investment portfolio is clearly more conservatively positioned, which is important in the current environment.

We think both are Strong Buys right now and are worth holding. However, given that we are very bullish on ORCC's parent OWL (which has significant indirect exposure to ORCC's loans as the fee-earning manager) and hold it in our portfolio already, we have elected to simply hold FSK over ORCC. You can read our full investment thesis for FSK here and our full investment thesis for OWL here .

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