SAR - Saratoga Investment Corp: 12% Yield 16% Discount Buy Rating

2024-01-21 09:15:00 ET

Summary

• SAR yields 12.5%, with strong dividend coverage, and a 10% 5-year dividend growth rate.
• SAR is undervalued vs, the BDC industry on a P/NII trailing and forward basis, and on a Price/NAV basis.
• We rate SAR a BUY.

While Wall Street has been betting that the Fed will start cutting rates in March 2024, Fed members have been pushing back on that theme.

One sub-sector that benefited greatly from rising rates is the BDC sector, due to many BDC's lending money at floating rates, but borrowing at fixed rates.

Company Profile:

Saratoga Investment Corp ( SAR ) is a business development company specializing in leveraged and management buyouts, acquisition financings, growth financings, recapitalization, debt refinancing, and transitional financing transactions at the lower end of middle market companies.

It structures its investments as debt and equity by investing through first and second lien loans, mezzanine debt, co-investments, select high yield bonds, senior secured bonds, unsecured bonds, and preferred and common equity. (SAR site)

Holdings:

SAR's fiscal year ends on February 28th. As of the end of its fiscal 3rd quarter, 11/30/23, it had $1.114B portfolio, an increase of 13.4% from $982M as of November 30, 2022. The portfolio is comprised of 86% 1st Lien, 1.3% 2nd Lien, 2.6% Structured Finance Securities, 1.6% Unsecured Loans, and 8.3% in Common Equity positions.

The portfolio has investments across 43 distinct industries. Healthcare is the largest exposure, at 10.8%, followed by IT, at 7%, HVAC, at 6.2%, and Consumer Services, at 5.7%.

Company Ratings: Like other BDC's, SAR's management rates its invested companies each quarter. As of the period ending 11/30/23, (SAR's 34d fiscal quarter), 97.1% of SAR's loan investments had its highest internal rating, down slightly from 98.2% in the previous quarter. 3 investments were on non-accrual at quarter-end, representing 2.6% of fair value/6.0% of cost.

Earnings:

Fiscal Q3 '24 (Period ending 11/30/24): Higher interest rates ramped up SAR's NII by over 43%, also aided by higher total Investment Income, which rose over 38%. NII/Share rose 31%, to $1.09, vs. $.83 in fiscal Q3 '23. As seen with other BDC's, Interest expense jumped, but NII outpaced it. Adjusted net investment income of $13.1M increased by $4M.

Originations for the quarter totaled $35.6M, with $2.1M in repayments and amortization.

Fiscal Q1-3 '24: So far in fiscal '24, topline growth has been very strong, at 59%. NII was up 72.5%, with NII/share rising ~68%. The share count rose 9.76%.

Overall portfolio interest was 12.5%, similar to the BDC industry median of 12.7%, whereas SAR's NII yield is 14.6%, much higher than the BDC median of 12%:

The flip side to rising rates is that BDC's may have invested in companies which will struggle to pay higher rates. That can result in higher Realized Losses. SAR is one of only 13 BDC's to have a positive Realized Gains average of over the past 3 years:

Dividends:

SAR has a 5-year dividend growth average of over 10%, mainly due to a jump from $1.81 to $2.81 in 2022. 2023 dividends totaled $2.82/share.

At its 1/19/24 closing price of $23.02, SAR yields 12.51%. Management has raised the quarterly payout for 6 straight quarters. SAR should go ex-dividend next on ~3/15/24, with a ~ 3/29/24 pay date.

Distribution coverage was 1.34X for fiscal Q1-3, a bit stronger than the 1.17X for the fiscal year ending 2/28/23:

Profitability & Leverage:

ROA and ROE both improved in fiscal Q3, and remained above BDC industry averages. Debt leverage moved higher - at 2.6X it's one of the higher leverage factors we've seen in the BDC space.

However, management shows a lower 1.69X leverage factor for Regulatory Debt/Equity.

SAR's Assets/Debt ratio was steady, at 1.48X this quarter, as was EBIT/Interest coverage, which was 2.14X:

Debt & Liquidity:

SAR had $222M in available liquidity, including $47M in cash, as of 11/30/23. It has a $65M Credit Revolver, which comes due in 2 years; and $52M in private notes coming due over the next 4 years.

Performance:

SAR rose as high as $28.87 in June '23, but then drifted down to ~$23.00 by November. It then had a good bounce up to ~$26.00, but is back down to ~$23.00, due to 2 analyst downgrades in early January '24.

SAR has one of the stronger 5-year total returns, at 100%, in the BDC industry - management's chart shows it in 11th place overall.

Analysts' Price Targets:

SAR received 2 analyst downgrades in early January, from Compass Point and B. Riley Securities, who both moved it from Buy to Neutral. B. Riley has a $28.00 price target on SAR.

At $23.02, SAR is 4% below analysts' $24.00 lowest price target, and 11.6% below the $26.00 average price target.

Valuations:

At $23.02, SAR is selling at a big 16% discount to its $27.42 NAV/share, vs. the BDC industry's average 1% premium to NAV.

More importantly, SAR is selling at a much cheaper trailing P/NII per share of 5.26X, vs. the BDC industry's 8.43X average valuation; and its forward P/E of 5.38X is also much cheaper than the 7.94X BDC average. Meanwhile, its 12.5% dividend yield is 160 basis points higher than average:

Parting Thoughts:

We rate SAR a Buy, based upon its attractive, well-covered 12.5% yield, and its undervaluations for NII and NAV.

All tables furnished by Hidden Dividend Stocks Plus, unless otherwise noted.

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