FSK - FS KKR: 2023 Odds Explained

Summary

• FSK's management has a poor track record of maintaining capital and value during economic downturns.
• FSK will almost certainly lose capital, NAV per share, and subsequently, investment income and dividends, in the long run, given its structural challenges exacerbated by high management fees and leverage.
• FSK'S long-term decline is buried under short-term price volatility, influenced by credit spreads, equity-risk premiums, and valuation multiples.

Investment Thesis

After my last article , " FS KKR ( FSK ): You Don't Want to Hold This One During a Recession ," shares of the Philadelphia-based Business Development Company "BDC" dropped 12%, underperforming the S&P index by more than 10%. Since the article's publication, FSK's shareholders have lost more than one year's worth of dividends and won't break even until July (assuming dividend and share price remain at current levels.) These dynamics support our contrarian view that, at this stage, investing in the S&P 500 ( SPY ) offers a better risk/reward profile than high-yield dividend stocks. For income investors, the market volatility in the bond market also opened an opportunity in debt and preferred equity assets. For example, Prospect's ( PSEC ) cumulative convertible preferred stock now yields 9%, supported by an investment-grade portfolio.

I believe that the stock market offers a better risk-adjusted price level compared to the BDC sector- Bashar Issa, June 2022

We remain alienated from FSK for five reasons, 1) Leveraged SMEs underperform during economic downturns, 2) Rising interest rates put pressure on NAV, despite their favorable impact on revenue in the short run, 3) Management's dim track record and 4) Availability of better investment alternatives, 5) Structural shortcomings making it almost inevitable for FSK to lose NAV per share in the long run.

Short-Term Forecast:

It's reasonable to say dividends will continue to be paid out for the foreseeable future (6 - 12 months horizon). On the other hand, we have less confidence in FSK's ticker price trajectory in 2023, as we expect widening credit spreads, high equity-risk premiums, and lower valuation multiples, impacting risk appetite and, subsequently, FSK's NAV and share price. Even if we assume that these dynamics don't affect FSK's underlying portfolio companies, we remain uncertain that total returns will be adequate to compensate for potential capital declines in 2023.

In the worst-case scenario, market disruptions will spill over FSK's portfolio. Abrupt changes in unemployment and economic activity will have a catastrophic impact on FSK, as explained in more detail in the following paragraphs.

Long-Term Forecast:

In the long run, FSK will almost certainly cut its distributions, lose NAV, and see its price fall, as discussed in the following paragraphs. Given these dynamics, long-term investment in FSK is a bet that annual capital losses will be less than dividend yield (currently standing at 14%.) This could be the case during economic stability. However, 2023 will be critical for FSK's long-term investors, given the dire consequences of a hard economic landing.

Is FSK's Dividend Safe?

In its short history, FSK has lowered its dividend payments multiple times primarily due to two reasons 1) asset write-offs and 2) dilutive capital-raising initiatives. In the years FSK increased dividends, it did so in conjunction with an increased asset base through acquisition or higher debt, and most often both, including KKR and FSK Capital Corp II mergers. For this reason, investors should not necessarily view the recent dividend increase as a sign of exceptional management talent. FSK's external advisor, called FS/KKR, has been managing its portfolio since before the FS-CCP merger, casting doubt on the argument that its dire performance is attributed to legacy investment from previous managers. Moreover, it is common for an acquirer to ask an acquired company to clean its portfolio before the acquisition, disposing of weaker assets before the purchase. Picking quality assets, whether individual securities or whole portfolios, is management's responsibility and is why shareholders pay nearly half of the investment income as management and incentive fees.

Below is a chart showing FSK's outstanding shares and liabilities progression in the past few years, along with dividends per share.

Nonetheless, one should note that there is no immediate pressure for the company to lower dividends at this point, given that dividend is fully covered by net investment income; Q3 net investment income of $217 million weighed against $193 million quarterly shareholder distribution.

On the other hand, FSK will almost certainly lose capital, NAV per share, and subsequently, investment income and dividends, in the long run, given its structural challenges exacerbated by high management fees and leverage (more about this below). Buying FSK for the long term is essentially a bet that management will manage this value destruction in an orderly manner that ensures that total returns remain positive. Below we shed more light on NAV and price dynamics.

Long-Term Price Trajectory

As mentioned above, in the long run, it is almost certain that FSK will lose capital, NAV per share, and subsequently, investment income and dividends. This is the easiest prediction one can give for FSK for the following reasons:

First and second-lien debt classifications are not reliable indicators of asset quality. First-lien debt, often touted as a secure investment, accounted for a large share of the assets that were written off in the BDC sector. Only a few BDCs publish the Loan-To-Value "LTV" ratio, which is more critical in determining the probability of recovering the loan value in case of default.

Beyond asset quality, structural issues make it almost impossible to retain NAV per share value. These issues are manifested in minimum distribution requirements and high management fees. Typically, when a financial institution realizes losses on bad debt, it lowers dividends to maintain financial health and capital. In the case of FSK and all BDCs, this is not an option due to Federal minimum distribution requirements. FSK has to pay at least 90% of its income regardless of losses. Given it is inevitable that FSK will realize loan losses, it is also unavoidable that its NAV and Net Investment Income will fall. This is why about 80% of the BDC companies (including FSK) lost NAV per share value since inception, and the longer they operate, the deeper they fall. In the long run, your bet on FSK is essentially a bet that the stock will fall at a lesser pace than the current 14% dividend yield.

Short-Term Price Trajectory

Predicting FSK price in 2023 is trickier, influenced by factors such as market multiples, equity risk premiums, and credit spreads. Thus, the mega-downward trend mentioned above could be buried by these factors. Any price decline absent from a fundamental change in portfolio credit performance is a buying opportunity, in my view. Investors should note that, unlike what the dividend suggests, FSK is not a scam but a high-risk investment fund operating on an unsustainable business model destined to leak value over time.

The problem is that the results of a recession, or as many call "hard landing," will be catastrophic for FSK. The company trades near its asset coverage regulatory requirement. A recession will likely lead to a significant loss in NAV, making it necessary to raise equity to maintain asset coverage. Raising capital when your back is against the wall could be pretty dilutive to shareholders and will likely entail an abrupt cut in dividends and further deterioration in NAV.

Summary

In the long run, your bet on FSK is essentially a bet that your annual dividend distribution will offset the stock price's inevitable decline. In the short and medium terms, changing macroeconomic conditions drive stock volatility, opening another venue for macroeconomic analysis. Shares could rise if macroeconomic conditions improve and equity price multiples appreciate and vice versa. However, sleeping on this ticker as an income source is not ideal, as manifested in the stock's total return performance since our last publication. BDCs, in general, and FSK in particular, are a risky investment, and while they might seem like a safe income-paying bet, being active in the market by buying the dips and selling the highs as one would typically do as a stock trader, is the best chance to navigate through these turbulent markets. For income investors seeking peace of mind, a better alternative is investment grade bonds and preferred, currently yielding +9% dividend, a few percentage points below FSK's 14% yield, but at a much more favorable risk/reward profile.

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