ARCC - FS KKR Has A Distribution Yield Of 12.51% And Is Undervalued

2023-09-07 11:00:00 ET

Summary

• FS KKR Capital Corp is the 2nd largest BDC by net assets and market cap, making it a popular choice among income investors.
• FSK delivered strong Q2 results, beating consensus estimates for net investment income and total investment income.
• FSK's portfolio and distribution yield make it an attractive investment, especially as the Fed considers easing rates.

At the close of business on 9/6, there were 14 Business Development Companies ((BDC)) whose net assets exceeded $1 billion and 13 BDCs with market caps that surpassed $1 billion. FS KKR Capital Corp ( FSK ) is the 2nd largest BDC by net assets with $6.91 billion and the 2nd largest BDC by market cap at $5.69 billion. BDCs have become increasingly popular among income investors as they are required to distribute over 90% of their profit to shareholders due to their regulated investment company ((RIC)) status. In many cases, this has caused their yields to rival real estate investment trusts ((REIT)) and master limited partnerships (MLPs). FSK has become one of my favorite BDCs as it has sequentially increased its total investment income and net investment income per share quarterly since Q2 of 2022. Today, shares of FSK trade at a deep discount to its net asset value ((NAV)) while generating a 12.53% distribution yield , excluding the supplemental distributions its board of directors has been approving. While we wait for the Fed's decision on rates, I believe it's a good time for income investors to consider FSK as it has built a portfolio that can deliver large amounts of income when the Fed eventually starts easing rates.

FSK delivered a solid Q2 and continues to reward shareholders through supplemental distributions in addition to the normal distribution

In their 2023 Q2 , FSK generated $0.78 of net investment income ((NII)) per share, a $0.02 beat from the consensus estimates, while producing $462 million in total investment income. FSK beat the consensus estimates by $12.8 million as its total investment income increased by 21.9% YoY. From an operating standpoint, I want to see that the BDCs I invest in generate a large amount of NII because this is the pool of capital from which the distributions are paid. This is also the determining factor as to whether management is making strong investments, as the results are reflected in the top-line total investment income.

In Q2, FSK generated $462 million in total investment income, which correlated to $0.82 per share of NII. This allowed FSK to pay shareholders $0.75 in distributions through its normal $0.64 distribution and a special and supplemental distribution amounting to $0.11. The strength of FSK's portfolio can be seen in its operating results and by the actions of its board. FSK's board has declared a quarterly distribution of $0.70 consisting of the $0.64 base distribution and a supplemental distribution of $0.06 per share. The board had previously declared an additional $0.15 per share in special distributions, where the last installment of $0.05 will be paid in November. In the pipeline, FSK has declared $0.75 of upcoming distributions before declaring the quarterly distribution for December. Shares of FSK started the year at $17.45 per share, and the board will declare and pay a minimum of $2.95 per share in distributions for 2023, which is a 16.91% yield on the initial share price at the beginning of 2023.

I would argue that investors who purchased shares at the beginning of 2023 got more than they bargained for as the base share is up 16.39%, and they will produce a minimum of 16.91% on invested capital in distributed income if they hold shares until the close of 2023. On the Q2 conference call , Michael Forman, who is FSK's CEO, stated that management believes FSK is positioned to continue producing strong financial results and have the ability to reward shareholders with an attractive dividend yield over the long term.

FSK's investment activity was lower than its historical averages in Q2, even though it picked up a bit from Q1. This is actually a great environment for BDCs and one of the reasons I am bullish on the sector. As traditional lending from banks has become tighter, it has created an opportunity for BDCs as private lenders to negotiate attractive pricing, enhanced call protection, and lower overall leverage levels. As the traditional banking sector remains restrictive, private credit from BDCs could continue to be a primary financing alternative for many lower-middle and middle-market companies, which is bullish for FSKs long-term portfolio and NII generation.

In Q2, FSK originated $363 million in new investments while selling off roughly $500 million in lower-yielding investments. FSK finished Q2 with a portfolio fair value of $14.8 billion, and the 10 largest portfolio companies represented approximately 19% of the portfolio. FSK has 68% of its portfolio invested in senior secured debt, with 59.5% in first-lien loans. The weighted average yield on accruing debt investments was 12.1%, and 89% of its debt investments are floating rate. I am excited about how the portfolio has been structured, and it should produce significant amounts of NII going forward, securing a large distribution yield on my investment.

FSK looks undervalued compared to its peers, and I am buying more

I am invested in several BDCs and track a large peer group. I will compare FSK's market cap to NII multiple, discount to NAV, and dividend yield to its peers.

• Prospect Capital Corporation ( PSEC ).
• Barings BDC (BBDC).
• Main Street Capital ( MAIN ).
• Blue Owl Capital Corporation (OBDC).
• MidCap Financial Investment Corporation ( MFIC ).
• Goldman Sachs BDC ( GSBD ).
• Oaktree Specialty Lending Corporation ( OCSL ).
• Golub Capital BDC (GBDC).
• Ares Capital ( ARCC ).
• Gladstone Investment ( GLAD ).
• Sixth Street Specialty Lending ( TSLX ).

FSK generates the 2nd largest amount of NII on a trailing twelve-month ((TTM)) basis. It's $877 million of NII over the TTM places its market cap to NII multiple at 6.49x, which is the 2nd lowest in the group and significantly lower than the peer group average of 8.31x.

I like to pay as close to a BDC's NAV as possible, and I am even happier paying a discount for strong BDCs. FSK is trading at a -17.74% discount to its NAV, while the peer group trades at an average discount of -2.74%. When I see this and the fact that FSK generates the 2nd largest amount of NII and has the 2nd largest amount of net assets, I see an opportunity.

FSK provides investors with a 12.51% yield on its base distribution of $2.56 per share prior to the supplemental distributions they have been paying. This is the 2nd largest yield in the peer group and more than 2% larger than the 10.31% peer group average.

Conclusion

FSK has become the 2nd largest BDC position in my Dividend Harvesting Portfolio series on Seeking Alpha ( can be read here ), and I believe FSK is one of the best opportunities in the BDC sector. Today, you can grab shares of FSK at a deep discount to its NAV and pay a low multiple on the NII it produces while generating a distribution yield that exceeds 12%. FSK has a proven track record of growing its total investment income and its NII per share, and management has rewarded shareholders with a flow of supplemental and special distributions in 2023. When the Fed starts to reduce rates, I believe that money will flow into the market when risk-free assets mature, and some of the capital will find its way into high-yielding assets such as BDCs. If you're an income investor looking for an investment vehicle that can continue generating large amounts of yield, I would research FSK further, as I think it is undervalued and will continue to do well for shareholders.

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