FSK - FS KKR: This Steep Discount Wouldn't Last For Long

2023-11-12 15:00:00 ET

Summary

• FS KKR Capital is a leading business development company with a market cap of $5.6B.
• The company delivered a solid third-quarter performance with a highly attractive NII per share multiple of 6.4x.
• Despite potential headwinds, the company's focus on upper-middle market companies and extended special distribution should strengthen investor sentiment.
• I assessed that significant pessimism has been priced in, with a best-in-class "A+" valuation grade. Given its market leadership, the steep discount is appealing.
• Dip buyers also aggressively bought its recent October lows, lending confidence to a further upward recovery. Investors should buy while it's still cheap.

FS KKR Capital ( FSK ) is one of the largest business development companies or BDC by market cap. It last traded at a market cap of about $5.6B, recovering significantly from the October 2023 pullback. The BDC also delivered a solid third-quarter or FQ3 earnings release on November 6, benefiting from the market's confidence in the leading private credit providers.

Despite that, FSK still trades at a highly attractive NII per share multiple of 6.4x. Its forward dividend yield of more than 14% offers investors a substantial margin of safety, corroborated by Seeking Alpha Quant's "A+" valuation grade. In other words, the market seems to be baking in significant execution risks, even as management stressed its confidence in its operating performance. Accordingly, investors " can expect the base and supplemental distributions to continue in the coming quarters." FSK also extended its special distribution by another two quarters. The dividends will be "paid in two equal installments of $0.05 per share in the first and second quarters of 2024."

Therefore, it seems surprising that the market has not considered lifting its valuation further. Moreover, FSK's focus on upper-middle market companies should assure investors about the resilience of its portfolio companies, notwithstanding the increasing macroeconomic uncertainties in 2024. Furthermore, management's decision to extend its special distribution by another two quarters through H1'23 should strengthen investors' sentiments, helping mitigate near-term peak interest rates headwinds.

Some FSK bears could point out that the company's NII growth could slow over the next two years as the Fed potentially reaches the end of its hiking cadence. That's a reasonable assumption, as the FOMC's hawkish pause was extended for two consecutive meetings.

Furthermore, management highlighted that it saw spreads tightened recently, which could increase its near-term execution risks. Accordingly, the company indicated that "spreads have tightened by 25 to 50 basis points during the quarter, which could impact investment strategies."

Despite that, management is confident that the deal environment has stabilized, leading to an uptick in underlying demand for private credit solutions. Notwithstanding FSK's market leadership and scale, the tightening of spreads could suggest more intense competitive headwinds as capital competes to fund senior secured debt opportunities. While the company boasts a liquidity of $3.6B, it could hurt its ability to continue growing its NII per share in the near- to medium term, putting a lid on its dividend payouts.

Analysts' estimates indicate that FSK's NII per share could fall QoQ to $0.75 in Q4, in line with management's Q4 guidance of $0.74 per share. In addition, analysts also expect FSK's NII per share performance could have peaked in Q3 at $0.84. The estimated quarterly NII per share in 2024 is anticipated to fall below $0.8, suggesting that growth normalization is expected to be sustained.

Despite that, a higher-for-longer Fed should help to maintain robust NII performance for FSK, even though growth could slow or even decline. Also, a resilient US economy should underpin confidence in BDCs, bolstered by the lending headwinds in the banking industry. Worsened by potential regulatory changes requiring markedly higher capital ratios for banks, FSK is primed to benefit from external investors and private equity funds looking to partner with the leading BDCs to fund their deals.

As seen above, FSK dip buyers bought its recent October selloff with conviction, as it recovered its October losses confidently over the past two weeks. I assessed that FSK's attractive valuation should continue to underpin buying sentiments, even though NII per share growth headwinds could weigh on its momentum.

Despite that, FSK remains markedly below its critical resistance zone at the $21 level, suggesting relatively attractive risk/reward opportunities, notwithstanding the recent recovery.

I anticipate near-term volatility, given the extent of the recent surge. However, I have confidence that FSK's $18-$19 support level should hold robustly.

Rating: Maintain Buy.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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