FDUS - Fidus: Q2 Update - Another Dividend Hike

2023-09-01 13:52:24 ET

Summary

• We discuss quarterly results from the BDC Fidus Investment and highlight key income dynamics of the portfolio.
• Net income rose over the quarter, driving a dividend hike.
• FDUS continues to have a very low level of interest expense, giving it a material competitive advantage in the current environment.
• We recently upgraded the stock to Buy.

In this article, we catch up on Q2 results from the Business Development Company Fidus Investment ( FDUS ). FDUS trades at a total dividend yield of 14.9% and a 101% valuation.

The company is focused on the lower middle-market segment with EBITDA in the range of $5-$30m, in contrast to the larger BDCs like BXSL, OCSL and ARCC that allocate primarily to the upper middle-market segment and above.

Its primary sector exposures are in Tech, Healthcare, and Business Services - fairly typical of the BDC space.

Quarter Update

Adjusted net investment income rose by 3%.

For Q3, FDUS declared dividends of $0.72, a rise of almost 3% from the previous quarter. The company's dividends have been growing sharply over the last couple of years (left chart), significantly outpacing the broader BDC sector (right chart).

As FDUS investors may know, the company's dividend is composed of three parts. The base dividend targets the floor the company expects to generate in net income. The supplemental covers the gap between net income and the base dividend. The special dividend is there to gradually push the spillover lower, so it is closer to its target of three-quarters of the base dividend.

Although the company's total dividend coverage is below 100%, this is because of a pre-announced series of $0.10 quarterly special dividends for each quarter in 2023. The sum of the base dividend and the supplemental are by definition 100% of adjusted net investment income.

The NAV fell by 1.2% for the quarter however the company still managed to deliver a more than respectable 2.4% return for the quarter - in line with the average of the 14 other BDCs we have processed so far on the service and slightly below the median level.

Income Dynamics

Net new investments remained positive.

This resulted in an uptick in leverage to 1x - fairly low in the sector.

Portfolio asset yield rose to 14.5% while cost of debt rose to 4.3%.

FDUS has the highest level of yield differential between its assets and liabilities at 10.2% - well above the 6.8% sector average. This is due to a combination of both high asset yields as well as very low cost of debt.

FDUS boasts one of the very lowest interest cost profiles, even below the highest-rated BDCs, due to its opportunistic bond issuance, almost entirely fixed-rate profile and significant SBIC issuance. For instance, ARCC and BXSL - both investment grade and among the best rated BDCs have interest expenses of 4.6% and 4.8% - above the FDUS level - respectively despite the fact that FDUS does not carry an investment-grade rating.

Its earliest unsecured debt maturity is in 2026 and the first SBIC debenture maturity is in 2025 (latest is in 2033). The company recently tapped a line of credit which represents its highest interest expense, however, it is only about 6% of its total debt versus around 50% for the broader sector.

Credit facility interest expense across the sector is very elevated due to the high level of short-term rates so having nearly all of its debt in fixed-rate format is a huge competitive advantage for FDUS.

Portfolio Quality

FDUS wrote off an $11.5m investment in one holding. This is the first realized loss for the company for over two years.

There was a bit of reshuffling in non-accruals with a company removed and others added. Overall, there are two companies on non-accruals with a total figure falling to 1.6% - near the sector average level. Both non-accruals are owned by a sponsor which is supportive of their companies.

Portfolio quality as gauged by internal metrics worsened slightly.

PIK has increased off a low level however remains below the sector average.

Weighted-average net leverage of the lower middle-market portfolio fell on the quarter to 3.9x while loan-to-value is 40% - both very good portfolio stats.

FDUS aims to reduce its allocation to equity securities in favor of first-lien holdings. It has made some progress on this front over the last year though this has stalled somewhat over the last few quarters.

Return And Valuation Profile

Despite being somewhat under the radar, FDUS remains one of the strongest-performing BDCs.

FDUS has consistently outperformed the sector on a twelve-month trailing basis (yellow line staying above zero).

The company's valuation has been volatile. It is currently above its historical average and median levels.

Prior to 2022, FDUS has tended to trade at a discount to the sector. However, as investors have caught on to its strong performance, it has remained at a premium valuation over the last couple of years.

Stance And Takeaways

FDUS remains one of the best performers but continues to trade at a fairly middling valuation - only a 3% premium to the sector average. Its two key risks are that it is not as well diversified (using the number of holdings as the criterion) as the rest of the sector (79 portfolio companies vs. 127 median) and its equity allocation is relatively high.

FDUS is an attractive BDC on its own merits as well as a diversifier to the larger BDCs that allocate to upper middle-market companies. It is also attractive for investors who want to see a higher level of dividends from their BDCs due to its dividend formula.

We originally added the stock to our portfolios in 2021 when it traded at a large discount to the sector valuation and pared it down when this discount turned to a premium. We have recently moved our rating from Hold to Buy, and we expect it to outperform the sector.

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