SAR - Saratoga Investment: An Under-The-Radar 10.4% Dividend Yield

2023-07-02 22:56:45 ET

Summary

• Saratoga has returned around 24% on a total return basis over the last year.
• Its portfolio held a weighted average yield of 10.7% as of the end of its last reported fiscal 2023 fourth quarter.
• Saratoga's fourth-quarter earnings were strong, with total investment income growing by 70.3% year-over-year.
• Floating-rate loans made up 89% of Saratoga's AUM; with the Federal Reserve threatening more rate hikes in 2023, Saratoga is likely to realize more net investment income gains, which could lead to higher dividends.
• The BDC's net asset value (NAV) was $347 million as of the end of the fourth quarter, around $29.18 per share, with a $11.2 million sequential increase from the third quarter.

Saratoga Investment ( SAR ) has been a relatively under-the-radar business development company ("BDC") that's returned around 24% on a total return basis over the last 1 year. The New York-based externally managed BDC provides debt financing and equity capital to middle-market companies. Saratoga typically makes $5 million to $75 million investments in events from leveraged and management buyouts to growth, acquisition, and transactional financings. For example, the BDC provided a $55 million second lien term loan to private equity-owned plumbing and HVAC maintenance services company Granite Comfort. The BDC seeks to de-risk its overall originations by partnering with private equity companies for some of its investments.

Saratoga's portfolio as of the end of its last reported fiscal 2023 fourth quarter ending on the 28th of February was worth $972.6 million at fair value. This was around 82.1% constituted by first lien debt with common equity at 10%. forming the second largest allocation. Crucially, the portfolio held a weighted average yield of 10.7% and was principally invested in 49 portfolio companies , one collateralized loan obligation fund, and one joint venture fund. This drove a quarterly cash dividend of $0.70 per share , a 1.4% increase from the prior payout, and a 10.4% forward annualized yield.

Dividend Likely Set For Further Growth As Floating Rate Loans Boost Net Investment Income

BDCs were created by Congress back in 1980 and are structured as pass-through entities, regulated investment companies, for tax purposes. Hence, with banks under tighter regulatory restrictions ever since the 2008 financial crisis and with the recent March 2023 banking crisis in view, BDCs are set to become an ever more valuable source of capital for middle-market companies. They must generally distribute 90% of their income to shareholders.

Saratoga's fourth-quarter earnings were incredibly strong with the BDC reporting total investment income that grew by 70.3% year-over-year to $32.3 million . This growth was boosted by assets under management that was 89% comprised of floating-rate loans set against a Fed funds rate that had been hiked ten consecutive times up until the pause at the June FOMC meeting. It currently sits at its highest level since 2008 at 5% to 5.25%. The Fed has stated that they will conduct further hikes in 2023 and the market is currently pricing in an 86.8% chance of a 25 basis point hike at the July 26th FOMC meeting. This is up from a 71.9% chance just a week ago.

Critically, with the macro backdrop set to remain extremely favorable to Saratoga, the BDC is set to realize more net investment income gains to form the backdrop for further dividend hikes. The BDC reported a net investment income of $9.6 million with an adjusted net investment income ("ANII") per share of $0.98, up $0.45 from the year-ago comp and sequentially from ANII of $0.77 in the third quarter. This came on the back of a record net interest margin excluding CLO investments of $15.5 million.

Net Asset Value Moves Up

Saratoga's ANII covered its dividend payout by 140% with spillover income left at just under $20 million, around $1.65 per share, as of the end of the first quarter. The BDC flagged that it does not currently anticipate paying a supplemental until its spillover reconciliation date in November of 2024 with the focus now being on crystallizing undistributed income into its NAV and its overall liquidity structure.

NAV was $347 million as of the end of the fourth quarter, around $29.18 per share, with a $11.2 million sequential increase from the third quarter. Net realized gains of $10.5 million and net investment income minus dividends declared of $1.5 million drove most of the NAV gains during the fourth quarter. However, NAV did decline by $8.8 million from the year-ago comp. Nonaccrual was limited to a sole loan to Nolan which was around 1.1% of Saratoga's portfolio at fair value at the start of their fiscal 2023 but has likely declined to less than 1% as it remains the only loan on nonaccrual.

I like that NAV has actually grown over the long term and even through periods of significant macroeconomic volatility. Apart from fiscal 2011 to fiscal 2014 where NAV per share declined for three consecutive years, the trendline has been going up since then. NAV per share is one of the most important factors to consider when making a BDC investment. It tells you whether the BDC's current dividend is sustainable or essentially being paid out from a declining per-share asset base. I'm rating Saratoga as a buy against this with the outlook for NAV set to be positive on the back of the 140% dividend coverage.

For further details see: