FSK - FS KKR: 19% Discount To NAV Growing Payouts 12.7% Base Yield

2023-08-17 10:47:35 ET

Summary

• FSK is paying its common shareholders a 12.7% base dividend yield that was 122% covered by its fiscal 2023 second quarter adjusted net investment income.
• The BDC is currently swapping hands at a 19% discount to its net asset value.
• NAV per share of $24.69 did decline sequentially on the back of special distributions and adjusted NII that was flat versus the first quarter.

The sustained rise in the Fed funds rate to a 22-year high at 5.25% to 5.50% has been a bittersweet event for many diversified income investors who have seen the valuations of their REITs pull back, but income from their business development companies ramp up going into the fastest pace of monetary tightening in decades. The current elevated interest rate backdrop has catalyzed record investment income for BDCs whose credit portfolios are mostly structured around floating rate loans that track interest rates up and down. FS KKR (FSK) provides debt to private middle market US companies and just declared a fiscal 2023 third quarter base cash dividend of $0.64 per share , in line with the prior base payment and for a 12.7% annualized forward dividend yield.

Critically, FSK's net asset value at $6.95 billion, around $24.69 per share , means the BDC is currently swapping hands at a 19% discount to NAV. This is important against a wider BDC universe where persistent premiums to NAV have become the status quo. The discount embeds new purchases of the ticker, which are essentially being made for 81 cents on the dollar, with a healthy margin of safety and is set against a double-digit yield that is set to be bolstered by supplemental and special payouts. FSK also declared a $0.06 per share supplemental payment for the third quarter for what would be an incremental 1.2% annualized forward yield. The BDC had previously declared special distributions totaling $0.15 per share to be paid in three equal installments by the end of 2023.

Investment Income Surges As Floating Rate Loans Spark Financial Nirvana

FSK reported a total investment income of $462 million , up 21.9% over its year-ago comp and a beat by $12.8 million on consensus estimates. This growth was driven by a $14.8 billion investment portfolio at fair value spread across 195 portfolio companies and 23 industries. This was down $513 million sequentially from the first quarter with the decline being due to the sale of lower yielding assets during the recent quarter. Management spoke about the sale in some detail during the second quarter earnings call with $500 million of lower-yielding investments sold during the period to a third party. This was set against $363 million of new investments, mostly add-on financing to existing portfolio companies.

In total, there were $845 million of opportunistic portfolio sales and repayments to drive a net portfolio decrease of $482 million. The weighting towards first lien senior secured credit was just under 60% with 68% of the portfolio invested in senior secured loans. Further, the weighted average annual yield on all debt investments at 11.8% as of the end of the second quarter was up 40 basis points from 11.4% in the first quarter. This was on the back of variable rate debt investment forming just under 70% of FSK's portfolio as of the end of the second quarter.

NAV per share of $24.69 dropped 24 cents from the first quarter to continue a trend of NAV declining on a nominal and a per share basis. This forms one of the reasons the BDC has been unable to close its discount to NAV despite being the second-largest publicly traded BDC. FSK is not unique in trading at this discount with a top 5 BDC Blue Owl Capital ( OBDC ) also swapping hands at a discount. Protecting NAV would mean investors would be more likely to close out the discount in my view.

Conservative Leverage And Strong Dividend Coverage Infer Continued Supplementals And Specials

FSK had a net debt-to-equity ratio of 1.13x as of the end of the second quarter, a decrease from 1.18x in the first quarter. This came as investments on non-accrual status at 2.5% of its portfolio at fair value fell from 2.7% in the first quarter. The BDC's second quarter adjusted net investment income was $0.78 per share, roughly flat from the first quarter but beating consensus estimates by 2 cents. This meant 122% coverage of the base dividend declared for the third quarter.

The BDC has shifted to a more conservative footing going into 2023 with new investments for its recent second quarter at 40% of its year-ago level. The BDC has also ramped up its allocation to first-lien senior secured loans to 83% of new investments from 49% in its year-ago quarter. This defensive positioning against the currently high interest rate environment is important against the specter of a US recession. However, recession expectations have been dialed back in recent weeks in response to strong employment figures and retail sales. J.P. Morgan no longer sees a US recession in 2023 and Goldman Sachs has cut the probability of a recession next year to 20% from a prior 25% chance. Essentially, an elevated Fed funds rate appears to be great for BDCs to the extent that it does not spark a marked deterioration of the economy that drives up loans on non-accrual status. FSK is a buy against this improved backdrop.

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