SAR - Saratoga Investment Corp: 12% Yield Strong Growth Undervalued Buy Rating

2023-10-13 09:15:00 ET

Summary

• Saratoga reported robust earnings this week - NII rose 81%, NII/Share rose 80%.
• It yields 12% with strong 1.49X dividend coverage.
• Saratoga is undervalued: 17% NAV discount, forward P/E is ~27% cheaper than the 7.6X BDC average, trailing P/NII is 32% cheaper than the industry's average.

With interest rates now projected to be higher for longer, investors are looking for ways to benefit from this trend. Business development companies are a good way to reap the rewards of higher rates, as most of them have mainly floating rate investments, but a majority of fixed rate debt.

Saratoga Investment Corp (SAR) is a good example of this profitable mix - over 95% of its debt is at fixed rates, while 99% of its interest earning assets are at a floating rate.

Company Profile:

Saratoga Investment Corp is a business development company ((BDC)) 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 investments are comprised of ~85% 1st Lien, 1.4% 2nd Lien and 1.6% Unsecured loans, in addition to 9.2% common Equity and 3.2% Structured Finance Securities.

Examples of Structured Finance Securities are Collateralized Debt Obligations, CDO's, Collateralized Bond, Obligations, CBOs, Collateralized Mortgage Obligations (CMOs), and Credit Default Swaps (CDSs).

Management has expanded the asset base by over 10X, from $95M to ~$1.1B, since SAR's fiscal year 2012. SAR's fiscal year ends on Feb. 28. The average weighted portfolio yield was 11.3%, as of 8/31/23.

1st Lien investments average yield is 12.8%, Unsecured Loans are at 10%, Structured Finance Securities are at 8.9%, and 2nd Lien are at 5.6%.

SAR is invested in 43 different industries - its biggest exposure is Healthcare Software, at ~11%, followed by IT Services, at 7.7%, HVAC Services and Sales, at 6.3%, and Consumer Services, at 5.8%.

Ratings:

Like other BDCs, SAR's management rates its invested companies each quarter. As of the period ending 8/31/23, (SAR's second fiscal quarter), 98.2% of SAR's loan investments had its highest internal rating, up slightly from the previous quarter and fiscal year-end. Two investments were non-accrual, representing 1.6% of fair value and 4.5% of cost.

Earnings:

SAR just reported earnings this week for its most recent fiscal quarter, the period ending 8/31/23. It had strong revenue growth of 62.5% and even stronger NII growth of 81.3%, with NII/Share rising 79.7%. NAV was $28.44, up 0.6% vs. a year ago. NAV has increased in 16 of the past 22 quarters.

As with other BDCs, interest expense soared. SAR's was up ~57% in the quarter but was outstripped by NII growth. Originations in the quarter totaled $28M with $6M in repayments and amortization.

The latest quarter followed the trend for fiscal 2023, the period ending 2/28/23, which had 40% total investment income growth, 76.5% NII growth, and 69% NII/share growth.

Dividends:

SAR's most recent quarterly distribution was $.71, which gives it a forward dividend yield of ~12%, based on its 10/11/23 closing price of $23.62. Management has raised the quarterly payout 11 times since October 2020.

However, they decreased it from $.56 to $.40 in July 2020, during the COVID lockdowns, hence the five-year dividend growth rate of -0.21%. Its trailing 12 month, ttm, coverage factor is a strong 1.49X.

SAR's distribution coverage was robust in the most recent two fiscal quarters, (period ending 8/31/23), rising to 1.53X, vs. 1.17X for fiscal 2023, (period ending 2/28/23).

Management shows the BDC industry average coverage factor as 1.31X:

Looking at the dividend growth during a two-year period shows 37% over the past two years, and 211% since fiscal Q2 2016, a 23.4% average annual growth rate.

Profitability and Leverage:

SAR's trailing ROA and ROE, particularly its ROE, were both above average, as was its EBIT margin. Its debt leverage of 2.20X was much higher than the 1.33X BDC industry average.

With the higher debt, SAR's asset/debt ratio and its interest coverage are less robust than that of other BDCs we've covered recently. For example, Horizon Technology Finance's asset/debt ratio is 1.77X, and its EBIT/interest coverage ratio is 2.93X.

Debt and Liquidity:

As of 8/31/23, SAR had $571M in long-term, covenant-free, non-SBIC debt, $189M in long-term, covenant-free SBIC debentures, and $35M in long-term revolving debt. It had ~$239M in liquidity, comprised of $48.4M in cash and cash equivalents, and $191M in available credit. More than 95% of its debt is at fixed rates. Its debt maturity schedule ranges mainly from 2 -10 years.

Management estimates that SAR's liquidity gives them the ability to grow Assets Under Management by 22% without any new external financing, as of Aug. 31, 2023.

Performance:

In spite of its strong financial performance, SAR has trailed the BDC industry, the financial sector, and the S&P 500 so far in 2023. However, its 1-year ~24% total return has beaten the financial sector and the S&P, while slightly trailing the BDC industry's 27% total return.

Management shows a 66% five-year return for SAR, vs. 34% for the BDC index:

Analyst Price Targets:

At its 10/11/23 closing price of $23.62, SAR is 5.5% below analysts' lowest price target of $25.00 and 14.5% below the average price target of $27.61.

SAR just received a downgrade on 10/12/23 from HOVDE group to Market Perform, with a target of $27.00.

Valuations:

SAR looks very undervalued vs. BDC industry averages on several bases , including price/NAV - it has a 17% discount. Its earnings multiples also are much cheaper than industry averages: Its P/NII of 5.7X is 32% cheaper than the industry's 8.43X average, and its 5.5X Forward P/E is ~27% cheaper than the 7.6X average valuation.

Parting Thoughts:

We rate SAR as a Buy based upon its strong earnings, its undervaluation and its attractive, well-covered dividend. In addition to higher interest rates, the BDC industry has an additional tailwind from the trend of banks backing off of lending to businesses, which forces those businesses to seek alternative financing.

All tables are furnished by Hidden Dividend Stocks Plus, unless otherwise note

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