2023-05-01 13:13:08 ET
Summary
- Ares Capital’s key metrics remained largely intact in 1Q-23.
- Origination activity remained solid, but slowed QoQ.
- Higher net investment income is the result of higher interest rates.
In the first quarter, Ares Capital ( ARCC ) benefited from higher net investment income related to the company's floating rate investment portfolio. In 1Q-23, the business development company maintained excellent dividend coverage while experiencing an increase in non-accruals.
Though Ares Capital no longer pays a supplemental dividend of $0.03 per share in Q1'23, the stock remains very appealing to passive income investors due to the BDC's solid portfolio quality and robust originations despite headwinds.
Given its key metrics and a rock of stability in a market that may see higher levels of volatility in the future, I believe Ares Capital is a core stock holding for passive income investors.
Rock Solid Portfolio With Decent Portfolio Quality
The central bank's attempt to control inflation by raising interest rates has harmed Ares Capital's originations in the second half of 2022 and the first quarter of 2023. In the first quarter, the business development company received gross commitments of $766 million, a significant decrease from the year-ago origination volume (gross commitments) of $2.0 billion.
Due to higher interest rates and softer demand for new investment capital, the number of new portfolio transactions decreased from 49 in 1Q-22 to 32 in 1Q-23. Having said that, the majority of Ares Capital's new originations in the first quarter remained First Lien Senior Secured Loans.
Portfolio Activity (Ares Capital Corp)
Even though Ares Capital's net investment income increased due to higher interest rates and a slight increase in net asset value, QoQ, the company's non-accrual ratio increased. Non-accruals are the amount of loans for which the borrower is unable to make contractual payments. Ares Capital's non-accrual ratio rose from 1.1% in 4Q-22 to 1.3% in 1Q-23, reflecting a $277 million total investment value at risk (based on fair value).
Given Ares Capital's large portfolio value of $21.1 billion, I am not concerned about a decline in the non-accrual ratio, but I would be concerned if the non-accrual ratio reached 2.0%.
Oaktree Specialty Lending Corporation ( OCSL ) , which I am currently overweighting, is a company that provides much better credit quality .
Loans On Non-Accrual Status (Ares Capital Corp)
The Dividend Remained Well-Covered With NII
Ares Capital did not pay a supplemental dividend of $0.03 per share in the first quarter, but the company's base dividend was increased to $0.48 per share in the fourth quarter. Ares Capital had a pay-out ratio of 80% in 1Q-23, taking into account the new base dividend pay-out of $0.48 per share per quarter, making the current dividend well-covered by net investment income.
Ares Capital had a dividend pay-out ratio of 76% over the last 12 months, indicating that the BDC's NII is more than enough to cover the dividend.
Dividend (Author Created Table Using BDC Earnings Information)
Furthermore, Ares Capital has seen a strong increase in net investment income YoY (+60%) to $318 million (+46% on a per share basis). The rise in interest rates was an important factor because the business development company had approximately 69% of its investments invested in floating rate debt.
Quarterly Operating Results (Ares Capital Corp)
Ares Capital Is A Bargain
The business development company sector has been under pressure in recent quarters as the central bank has raised interest rates, increasing the cost of borrowing for portfolio companies and limiting demand for new originations.
Ares Capital, on the other hand, is now only valued at net asset value, as opposed to a premium valuation last year. Ares Capital's net asset value increased $0.05 per share to $18.90 in the most recent quarter.
I believe that the current valuation is appealing to passive income investors with a medium risk tolerance and a long-term time horizon.
Why Ares Capital Could See A Lower/Higher Valuation
Ares Capital's dividend coverage and credit quality do not concern me. What concerns me the most is that the business development company has positioned itself to profit from the central bank's interest rate hikes by investing in floating rate debt securities.
The end of the current rate-hiking cycle could result in slower net investment income growth and a future deterioration of Ares Capital's dividend pay-out ratio.
My Conclusion
Even though originations fell in a rising-rate environment, Ares Capital demonstrated its fundamental value to passive income investors in the first quarter.
The BDC's net investment income trajectory and dividend coverage remained promising, and while non-accruals increased slightly, Ares Capital's overall package is compelling.
Ares Capital, the country's largest business development firm with a portfolio worth more than $21 billion, strikes me as a rock of stability that has value, particularly in times of increasing market uncertainty.
For further details see:
Ares Capital: A Rock Of Stability With An 11% Yield