2023-12-01 10:29:43 ET
Summary
- Capital Southwest Corporation (CSWC) consistently delivers high distributions and has outperformed the S&P 500 in total return.
- CSWC's strategic approach focuses on middle-market companies and a diversified portfolio, with an emphasis on floating rate first lien debt.
- The company's ability to cover dividends through solid pre-tax net investment income.
- The current dividend yield sits at 9.7% and a supplemental payment has been declared for December.
Overview
When it comes to BDCs (Business Development Companies) and double-digit dividend yields, people often assume these companies sacrifice growth in exchange for distribution. In the case of Capital Southwest ( CSWC ), you'd be highly mistaken with that assumption. Since inception, CSWC has managed to deliver exceptionally consistent high distributions as well as provide investors with a total return that outperforms the S&P 500 ( SPY ). The only regret I have with CSWC is not starting a larger position size in 2020.
Capital Southwest Corporation is a business development company that specializes in investing in middle-market companies through credit, private equity, and venture capital. The company has a strategy that typically avoids startups, publicly traded companies, real estate, or troubled businesses. The firm prefers industries such as industrial manufacturing, healthcare, business services, specialty chemicals, and tech-enabled services.
This BDC seeks investments primarily in the United States. The typical investment ranges from $5 to $25 million, with a focus on companies with revenues above $10 million and profitable operations. I really like this CSWC because the structure and risk profile here that has been implemented allows the position to be a stress-free holding that continues to generate high levels of income.
Structure
CSWC employs a two-tiered investment strategy to enhance shareholder value. In the core aspect, focused on the lower middle market companies, CSWC creates deals involving companies with EBITDA ranging from $3 million to $20 million. The typical leverage is between 2.0x and 4.0x Debt to EBITDA, facilitated through CSWC's debt position. Commitments can go up to $50 million, with hold sizes typically ranging from $5 million to $35 million. CSWC engages primarily in floating rate first lien debt securities, which adds a layer of reassurance for me. As we can see, on their latest earnings report, their credit portfolio heavily leans toward first lien loans making up 97% of exposure.
Floating rate debt has helped CSWC maintain high levels of profitability throughout the rising interest rate environment. Additionally, these floating rates are first lien debt, which is normally considered "safer". Floating rate first lien debt is deemed safer for several reasons. Its interest rates adjust periodically, providing protection against interest rate fluctuations like we've seen over the last 12 months. This type of debt holds a senior position in a company's capital structure, offering higher priority for repayment in case of financial distress. Lastly, it often comes with collateral, providing an extra layer of security for investors.
In the other part of CSWC's structure, they target the upper middle market. CSWC invests in both first and second lien positions in this space. Companies in this category generally have EBITDA exceeding $20 million, with typical leverage ranging from 3.5x to 5.0x Debt to EBITDA through CSWC's debt position. Hold sizes in this category are usually between $5 million and $20 million, focusing on floating rate first and second lien debt securities.
CSWC has 94 companies in their portfolio and the total cost of the portfolio increased from $1,206,225 to $1,280,155. The weighted average yield on debt investments increased to 13.5%, and the weighted average yield on total investments ranged from 12.6% to 13.0%. The portfolio diversity also stands out to me, with no specific sector accounting for more than 13% of their total exposure. Similar to my previous analysis on Welltower ( WELL ), I believe the large exposure to healthcare will be beneficial as we have a growing aging population that will continue to have longer average life spans. This structure has a lot to like and has proven successful over time.
CSWC Earnings Presentation
Earnings
Capital Southwest reported a strong performance in their most recent earnings report. Management procured $110 million in originations across five new and six existing portfolio companies. Notably, the firm's total investment income reached $42.78 million, surpassing consensus by $0.82 million and marking a $2.38 million increase from the previous quarter.
In my opinion, loan originations for a BDC is always a good signal for several reasons. Increased loan originations tend to contribute to further income generation by helping the company expand the investment portfolio and diversify risk across more sectors. By structuring competitive deals, BDCs can enhance overall portfolio yield, leading to increased returns similar to what we've seen with all of the recent supplemental payments from CSWC.
This growth was attributed to a rise in average debt investments outstanding and an increase in the weighted average yield on debt investments, climbing to 13.5%. The Net Asset Value per share also exhibited positive movement, reaching $16.46 as of September 30, compared to $16.38 at June 30.
The cash flow produced also reinforces the company's strong portfolio performance, generating $0.67 of pre-tax net investment income for the quarter. This income comfortably covered both the $0.56 per share regular dividend and the $0.06 per share supplemental dividend paid during the period.
Dividend
As of the latest declared dividend of $0.57/share, the current dividend yield sits around 9.7%. This declared dividend also represents a raise of 1.8% from the prior payout of $0.56/share. In addition to the raise, CSWC also declared a supplemental dividend of $0.06/share to be paid out in December.
As you can see, the dividend has grown 37% over the last 5 years and I think that we will continue seeing this grown as profitability remains strong. We can ignore the two large spikes in the data above, as those were special dividends paid out. According to Portfolio Visualizer , if you invested $10,000 in 2016, didn't reinvest any dividends, and just held, your income would have gone from a measly $274 to an impressive $1,300 annually in 2023.
As previously stated, we can see that the net investment income per share of $0.67 fully covers the regular dividend of $0.56/share as well as the supplemental dividend of $0.06/share. In this high interest rate environment, I do think we will continue to see slight raises of the dividend since CSWC has been benefitting from the floating rate loans. It seems that managed confirms that they will continue to also distribute quarterly supplemental dividends into the future as rates remain above historical averages. The CEO confirmed this on the last earnings call :
In addition, due to the excess earnings being generated by our floating rate debt investment portfolio in this high interest rate environment, our board has again declared a supplemental dividend of $0.06 per share from the December '23 quarter, bringing total dividends declared for the December '23 quarter to $0.63 per share, which in total represent 11% growth over total dividends paid out a year ago quarter. - Bowen Diehl, CEO
Valuation
The price to NAV (net asset value) relationship of CSWC is a bit tricky to get down. To one end, the price remains to trade at a significant premium valuation over its NAV of 36.21%. Although, trading at a premium doesn't necessarily mean you should avoid buying in right now. Especially when this premium seems to be for good reason, given the index beating total returns. At the same time, however, the P/E of 8.35x currently sits below the 5-year average of 11.3x, which could indicate undervaluation. However, I think the main thing here would be to focus on the sustainability and future growth of the dividend.
I was lucky enough to pick up shares of CSWC in May 2020 when the discount to NAV was roughly -20%. At these levels, however, I am hesitant to add to my position because of the news that rates have a possibility to be cut as soon as Q1 of 2024. I don't have a magic crystal ball, but I do think there is a possibility that BDCs like CSWC drop in price following any future rate cuts. I am sure they will still be profitable in the long term and continue to deliver exceptional returns, but I would like to wait for a better entry.
Since CSWC is comprised of floating rate loans, I think there is a likelihood that this BDC would react much more dramatically in price movement. Once again, though, I do believe that CSWC will continue to grow their business and offer long term value.
Takeaway
Capital Southwest Corporation ((CSWC)) stands out as a resilient and high-performing business development company that defies the common misconception of sacrificing growth for dividends. CSWC has consistently delivered substantial distributions and outperformed the S&P 500 since its inception.
The company's strategic approach, with a focus on middle-market companies, a diversified portfolio, and a meticulous investment structure, has proven successful over time. Notably, CSWC's emphasis on floating rate first lien debt has enhanced profitability. The company's ability to cover dividends through solid pre-tax net investment income reinforces its financial strength.
While CSWC's premium valuation may raise eyebrows, the P/E ratio below the 5-year average and the focus on sustainable dividend growth provide reassurance. Despite potential challenges with future interest rate cuts, CSWC's unique position with floating rate loans and a history of exceptional returns make it a compelling long-term investment.
For further details see:
Capital Southwest: Strong Cash Flow To Support Future Dividend Growth