2023-08-04 09:15:00 ET
Summary
- Business Development Companies (BDCs) with high percentages of floating rate investments may benefit from rising interest rates.
- Capital Southwest Corp. (CSWC) has 98% of its credit portfolio in floating rates and expects to gain additional income with interest rate increases.
- CSWC has shown strong growth in its portfolio and earnings, and has a history of rewarding shareholders with dividends.
Looking for ways to benefit from rising rates? You may want to consider investing in business development companies, many of whom have high %'s of fixed rate debt, but also have higher percentages of floating rate investments.
Capital Southwest Corp. ( CSWC ) is one of those companies with that timely mix: 98% of its credit portfolio has floating rates. Management estimates that CSWC gains an extra $.12 in annual NII for each 50 basis point increase in interest rates:
CSWC site
You can see the upward trend over the past four quarters, with cash interest rising 76%, from $17.4M in the quarter ended 6/30/22, to $30.71 in the quarter ended 3/31/23:
CSWC site
Company Profile:
CSWC is an internally-managed BDC, specializing in credit and private equity and venture capital investments in lower and middle market companies with EBITDA between $3M and ~$20M; and leverage of 2X to 4X debt/EBITDA through CSWC's debt position. Being internally managed is a plus for CSWC - it avoids those often expensive management and incentive fees that externally managed BDCs must deal with.
96% of its $1.04B credit portfolio is in 1st Lien Secured Loans. The average holding size has decreased as the portfolio size has increased - it was 1.3% as of 3/31/23, vs. 5.6% in 2016:
CSWC site
The portfolio holds 85 companies, with an average EBITDA of $21M and 4X leverage. $13.3M is the average holding size. The average yield on debt is 12.8%.
CSWC site
Media and Marketing remained the largest industry exposure in the quarter ending 3/31/23, steady at 12%. Business Services and Healthcare Services were 11%. The 2 Consumer categories totaled 15%:
CSWC site
JV:
CSWC also manages a joint venture - its I-45 Senior Loan Fund (“I-45 SLF”), in partnership with Main Street Capital. As of 3/31/23, 95% of that portfolio's investments were in Senior Loans.
There were ~$144M in debt investments in 39 companies, with an average issuer EBITDA of ~$75M, and a 6.3% LIBOR spread, the same as in the two previous quarters.
The top five industries comprised 57% of this portfolio, led by Business Services at 15%, and Healthcare at 14%. The average investment size was 2.6% of the portfolio.
CSWC site
Portfolio Ratings:
Like other BDCs, CSWC reevaluates its portfolio companies each quarter. It uses a 4-tier system, with 1 being the top tier, and 4 being the lowest.
There were $83M in upgrades in the latest quarter, vs. $23M in downgrades. As of 3/31/23, CSWC had $4M worth of investments on non-accrual, representing 0.3% of its investment portfolio at fair value, with no new non-accruals added the quarter.
CSWC site
New Business:
During the quarter ending 3/31/22, portfolio growth was driven by $67M in new commitments, consisting of commitments to five new portfolio companies totaling $49.5M, and add-on commitments to nine existing portfolio companies totaling $17.8M. This was offset by $16.8M in proceeds from one debt prepayment during the quarter.
Earnings:
CSDWC's fiscal year ends on March 31.
Fiscal Q4 had robust growth, with total investment income up 77% and NII up 86%. NII/Share grew 30%, with the share count rising 31%, while interest expense rose ~80%, due to a larger portfolio, and higher rates. NAV/share was $16.37 as of 3/31/23.
Fiscal year ending 3/31/23 also had strong growth, total investment income up 45%, and NII up 61%. NII/share rose 22%, and interest expense rose 45% for the year.
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Fiscal Q1 2024 (Period Ending 6/30/23) Estimates:
Fiscal Q1 '24 earnings should continue this strong earnings trend, with NII in a range very similar to fiscal Q4 '23:
"Capital Southwest’s preliminary estimate of its first quarter 2024 pre-tax net investment income is in the range of $0.66 to $0.67/share. The preliminary estimate of its net investment income for the same period is in the range of $0.64 to $0.65/share. Additionally, Capital Southwest’s preliminary estimate of its NAV/share as of June 30, 2023 is in the range of $16.35 to $16.40. Finally, Capital Southwest’s preliminary estimate of its regulatory leverage as of June 30, 2023 is 0.86x to 0.88x debt to equity.
Capital Southwest will release its finalized first quarter 2024 results on Monday, August 7, 2023, after the market closes. In conjunction with the release, Capital Southwest has scheduled a live webcast on Tuesday, August 8, 2023, at 11:00 a.m. Eastern time." (CSWC site)
Dividends:
CSWC's most recent quarterly base distribution was $.54, giving it a dividend yield of ~10%. Management also paid out another $.05 supplemental distribution, its 3rd in a row, which brings the total yield to ~11%.
CSWC should go ex-dividend next on ~9/14/23, with a ~9/29/23 pay date.
CSWC has one of the highest five-year dividend growth rates in the BDC industry, at 19.5%.
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NII/Share of $2.30 covered regular dividends by a 1.13X factor for the fiscal year ending 3/31/23. CSWC also paid $.25 in supplemental dividends, for a total payout/share of $2.28.
Adding realized earnings/share to the mix brings another $1.71 into play, for a total EPS of $4.01, which covered the $2.28/share in total dividends by a strong factor of 1.76X. CSWC also had $.45/share in UNII, as of 3/31/23:
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CSWC has a history of rewarding shareholders: Its total value (net asset value + cumulative dividends paid) increased by $12.38/share through 3/31/2023:
CSWC site
Profitability and Leverage:
ROA and ROE both had a healthy jump in fiscal Q4, and remained well above BDC industry averages. Debt/NAV was stable in the quarter, and is much more conservative than the BDC industry average, whereas EBIT/interest was down a bit. EBIT margin was also somewhat lower, but remained above the BDC industry average.
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Debt and Liquidity:
During the quarter, CSWC received $65M in additional commitments on its revolving credit facility, bringing total credit facility commitments to $400M; and also received approval for $50M in additional SBA debentures.
In June, CSWC did an offering of $71,875M in aggregate principal amount of its 7.75% Notes due 2028, and received $69.3M in net proceeds from the offering. The Notes bear interest at a rate of 7.75%/year, payable quarterly on February 1, May 1, August 1, and November 1, beginning August 1, 2023. The Notes will mature on August 1, 2028 and may be redeemed in whole or in part at Capital Southwest’s option on or after August 1, 2025. (CSWC site)
Also in June, Fitch ratings assigned Capital Southwest an investment grade long-term issuer rating of BBB- with a stable outlook.
CSWC has no debt maturities until 2026, when ~$611M comes due in Credit Facilities, Notes, and SBA Debentures.
CSWC site
Performance:
Like some other BDCs, CSWC has had quite a nice ride this year. It has outperformed the BDC industry, the financial sector, and the S&P 500 so far in 2023, and over the past month and quarter. It also outperformed all of them by a wide margin on a total return basis over the past year.
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Analysts' Targets:
With all of that outperformance, it's not surprising that CSWC is about even with Wall St. analysts' average price target of $21.56.
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Valuations:
CSWC appears to be a "get what you pay for" stock - it has generally sold at a premium to NAV over the past year, with Mr. Market paying up for quality:
Ycharts
At $21.43, CSWC is priced at a ~31% premium to its 3/31/23 NAV of $16.37, its highest premium over the past year, vs. the BDC industry average -1%.
Its earnings multiple, price/NII, of 8.78X, is a bit lower than the 9.16X industry average, whereas its base dividend yield is somewhat lower.
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Parting Thoughts:
CSWC will report fiscal Q1 (period ending 6/30/23), on Monday, Aug. 7, 2023, after the market closes. It should be another good quarter. It's certainly one of the stronger BDCs , and worth owning, especially if you're an income investor.
However, with CSWC near a 52-week high price/share and price/NAV, we advise waiting for a market pullback before buying new shares. Gloomy September isn't that far off.
All tables furnished by Hidden Dividend Stocks Plus, unless otherwise noted.
For further details see:
Capital Southwest: 10% Yield, Upcoming Earnings Look Good