GBDC - FS KKR Capital: I Am Doubling-Down On This Stellar 14.4% Yielding BDC

2023-10-19 07:51:11 ET

Summary

• FS KKR Capital Corp. is trading at a 21% discount to NAV, making it an attractive option for passive income investors.
• The BDC's portfolio quality improved in the second quarter of 2023, and it has a solid financial performance.
• Despite concerns about a potential decline in NII and portfolio quality, FS KKR Capital's dividend strength and excess dividend coverage make it a good investment.

I have been buying the dip in a number of real estate investment trusts and business development companies lately and one BDC that I particularly aggressively added to was FS KKR Capital Corp. (FSK) which for some reason is still trading at a 21% discount to NAV.

I have sold BDCs that have risen to or near NAV, like Golub Capital BDC, Inc. (GBDC) , and recycled proceeds into BDCs that trade, undeservedly, at much larger NAV discounts. FS KKR Capital is returning an obscene amount of capital to shareholders and the BDC’s portfolio quality also improved QoQ in 2Q-23.

With more cash flowing towards passive income investors, I think it makes sense to overweight FS KKR Capital over other BDCs.

My Rating History

FS KKR Capital is an unfairly treated BDC as the BDC’s financial results are solid and the BDC’s credit quality improved in 2Q-23. In January I wrote FS KKR Capital: Buy This 12.9% BDC Yield At A 26% Discount To BV . I am overweighting FSK due to improving portfolio quality, an excessive discount to NAV, and increasing dividends to shareholders.

Portfolio Overview, Peer Comparison, Credit Quality

FS KKR is the second-biggest BDC active in the sector, after Ares Capital Corp. (ARCC) . The large size of FS KKR Capital alone makes the BDC a compelling buy for passive income investors, particularly when taking into account that the stock is selling at what seems to me to be an excessive discount to NAV.

At the end of 2Q-23, FS KKR Capital had a total portfolio value (based on fair value) of $14.8 billion which consisted mostly of First and Second Lien Senior Secured Loans (67.4%). Based on FS KKR Capital’s second-quarter earnings release, 89% of the BDC’s investments were made in floating-rate loans, giving the company a significant NII upside in a rising-rate world.

In the second quarter, FS KKR Capital’s new originations have slowed for the same reason new origination activity dropped off for other BDCs as well: Higher interest costs have resulted in less demand for new loans.

FS KKR Capital originated just $363 million in new loans in 2Q-23 compared to $804 million in the year-ago quarter, reflecting a big decline of 55%.

FS KKR Capital had a non-accrual ratio of 2.5% in 2Q-23, showing a 0.2 percentage point decrease over 1Q-23, meaning the BDC’s portfolio quality marginally improved in the second quarter.

Dividend Coverage And Exceptional Special Dividend Potential

FS KKR Capital earned $0.82 per share in NII in the second quarter and a total of $3.19 per share in the last twelve months. The BDC paid out 87% in regular and variable dividends in the last year and 90% when including two $0.05 per share special dividends that were paid in the first and the second quarter.

I would rate the BDC’s excess dividend coverage as fairly good, particularly when taking into account that the stock pays a dividend yield of 14.4%. Since last year, FS KKR Capital’s total dividend has gone up by 12%.

That being said, I do expect lower NII and dividend growth moving forward as the central bank is unlikely to raise its rates as aggressively as it did last year.

Undeserved Discount To Net Asset Value

FS KKR Capital is trading at a 21% discount to NAV and I have recycled capital from the sale of some of my Golub Capital stock into FS KKR since I think that the margin of safety here is substantial.

Taking into account that FS KKR paid out just about 90% of NII (when including special dividends), I think the risk/reward ratio is very favorable for passive income investors. Present discounts to NAV for major BDCs range between 21% to small premiums to NAV.

Since FS KKR Capital is located at the lower end of this range and has considerable excess dividend coverage, I think FSK is attractive to passive income investors.

Why Is FS KKR Capital Selling For A Discount To NAV And Why It Might Sell At An Even Lower NAV Multiple

It could have something to do with investors generally anticipating a cyclical contraction in NII which may affect FS KKR Capital’s ability to grow its dividend, but this is true for all BDCs.

FS KKR had a non-accrual ratio of 2.5% in 2Q-23, so there are some credit issues in the portfolio, but they are not big enough, in my view, to justify such an excessive discount to NAV.

Furthermore, BDCs as a group have come a bit out of favor lately as investors worry about the earnings prospects for the sector once the present rate-hiking cycle ends. A decline in portfolio quality (uptick in non-accruals) would be a headwind for FSK as well.

My Conclusion

I doubled down on FS KKR Capital last week because the market continues to misjudge, in my view, the BDC’s dividend strength. Though the NAV discount has narrowed a bit since January, the dividend is growing and portfolio quality has improved in the second quarter and I think that investors misprice the BDC given its high degree of excess dividend coverage.

Presently, FS KKR Capital is selling for a 21% discount to NAV, but from a financial performance point of view, the BDC is doing not as bad as the size of the NAV discount indicates. It raised its total dividend by 12% YoY, is paying special dividends and the portfolio quality trend is improving.

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