2023-12-01 09:15:00 ET
Summary
- Management declared the 6th straight base dividend hike and the 5th straight supplemental dividend.
- CSWC saw significant growth in Q3 '23, with NII up 88%.
- CSWC yields over 11%.
While many businesses are finding their bottom lines strained by rising rates, it has been the opposite for Business Development Companies, BDCs. With a majority of their investments at floating rates, and a large amount of their borrowings at fixed rates, BDCs have been reaping the rewards of rising rates.
A case in point is Capital Southwest ( CSWC ), a BDC whose Q3 '23 earnings clearly illustrated this trend, with revenue growth of nearly 60%, NII growth of 88%, and NII/Share growth of nearly 33%, even with 38% rise in the share count. As elsewhere, interest expense had a big hike, up 38%, but was outstripped by NII. 97% of CSWC's debt investments are at floating rates, whereas 61% of its borrowings are at fixed rates.
CSWC's fiscal year ends on March 31st. Hence, the period ending 9/30/23 was its 2nd fiscal quarter.
Company Profile:
Capital Southwest Corporation is an internally managed business development company specializing in credit and private equity and venture capital investments in middle market companies, mezzanine, later stage, mature, late venture, emerging growth, buyouts, recapitalizations and growth capital investments. (CSWC site)
Portfolio Ratings:
On the flip side of rising rates, one must look at the health of the underlying companies that a BDC holds, especially in light of rising interest rates. This is done on a quarterly basis. CSWC uses a 4-tier system, with 1 being the top tier, and 4 being the lowest.
There were 3 downgrades, totaling $24.8M, and 3 upgrades, totaling $29.4M, in the quarter ending 9/30/23. CSWC had 4 portfolio companies with loans on non-accrual, representing 2%, ~$23.5M, of its investment portfolio at fair value, vs. $4M as of 3/31/23.
Equity Issuance Approval:
Subsequent to quarter-end, management received shareholder approval to increase the company's authorized shares of common stock to 75 million shares from 40 million shares. That would be a major dilution if undertaken in one action, but management has had a long track record of creating shareholder value.
CSWC's 9/30/15 NAV/Share was $17.68, while its 9/30/23 NAV/Share was $16.46. However, they've paid out $14.90 in dividends during that period.
Management favors periodic equity issuance vs. high debt leverage. CSWC raised $22.8M in gross proceeds through its Equity ATM Program during the quarter.
"During the past eight years of asset growth, Capital Southwest has raised approximately $450 million in gross equity proceeds at a weighted average premium of 24% to the prevailing net asset value per share. Funding a meaningful portion of our investment activity with accretive equity issuances is a crucial part of our business model, as it is important to maintain conservative fund leverage throughout the economic cycle.
Although the Company has no specific plans at this time for the use of the additional shares of common stock, having additional authorized shares of common stock available for issuance in the future would give the Company greater capital markets flexibility." (CSWC site)
Valuations:
CSWC's 11/29/23 price of $22.30 shows a big 35.48% premium over its 9/30/23 NAV/Share of $16.46, vs. the BDC industry's average 3% discount.
Over the past 3 years, CSWC has mostly sold at premiums above 1X, which ranged as high as ~1.7X in 2021, ~1.6X in 2022, and over 1.4X so far in 2023. There were dips to lower valuations in late 2022 and Q1 '23, but it has mostly climbed back to higher valuations after those dips.
In our most recent article on CSWC, in early September, it was also selling at a ~35% premium to NAV/Share. This was after reporting 97% NII growth and ~33% NII/Share growth for the quarter ending 6/30/23.
It's also important to take a look at BDCs' earnings multiples, i.e. Price/NII per share. We've noted in the past that some BDCs may be selling at a premium to NAV, but also have a hidden value, in that their earnings multiples are much lower than BDC industry averages.
Unfortunately for new investors, this currently isn't the case with CSWC - its 8.51X Price/NII is right in line with the BDC industry average, and its Forward P/E is a bit higher than average.
Holdings:
Management has more than doubled the % of 1st Lien investments over the past few years, from 43% to 97%. As the portfolio has expanded, the average hold size has decreased from 5.6% to 1.1% of the portfolio's value, which stood at $1.18B, as of 9/30/23.
CSWC's niche is lower middle market companies with EBITDA between $3M and $20M, and leverage of 2 - 4X Debt to EBITDA. It does both sponsored and non-sponsored deals. Its weighted average yield was 13.50%, with a 90/10% mix of Debt/Equity positions as of 9/30/23. (96% of its Investment Income is via cash, and 99% of that income is recurring.)
Its equity co-investment portfolio consists of 59 investments with a total fair value of $121.1M.
CWSC's JV, the I-45 Senior Loan Fund ("I-45 SLF"), is in partnership with Main Street Capital. It had a portfolio value of $132M, with 95% in 1st Lien investments, and 33 issuers, as of 9/30/23. That's down from $161M and 39 issuers, as of 12/31/22.
New Business:
While there have been rumblings about the Fed potentially dropping rates in 2024, CSWC's management is still seeing attractive loan pricing spreads on new portfolio loans that are 25 to 50 basis points higher than 12 to 18 months ago.
There was $110M in new commitments during the quarter ending 9/30/23, comprised of $81.7M in commitments to 5 new portfolio companies, and $28.3M in commitments to 6 existing portfolio companies.
Dividends:
CSWC raised its quarterly dividend by a penny, to $.57, and also declared another $.06 supplemental dividend of $.06, based upon its strong fiscal Q2 earnings. That's the 5th straight quarterly supplemental dividend declared, and the 6th straight regular dividend hike.
At its 11/29/23 intraday price of $22.30, CSWC's base dividend yield was 10.22%, and its supplemental dividend yield was 1.08%, for a total dividend yield of 11.30%.
Management said on the fiscal Q2 earnings call , that, "it is our expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future, while base rates are above historical averages, and we have a meaningful UTI, which is generated by earnings in excess of our dividend and realized gains from our equity investment portfolio."
Total dividend coverage improved to 1.06X over the past 2 fiscal quarters, vs. 1.01X in fiscal 2023. CSWC also had $.42/share in UNII, Undistributed NII, as of 9/30/23.
Profitability & Leverage:
ROA and ROE have both improved markedly in 2023, while Debt/NAV leverage has remained more conservative than the BDC average. EBIT/Interest coverage is down, but is in line with the BDC average. EBIT Margin declined, but remained higher than the BDC industry average.
Debt & Liquidity:
CSWC had $184M available on its credit facility and $23M in cash and cash equivalents as of 9/30/23. Its earliest maturity isn't until January 2026, when its $140M in 2026 Notes come due.
During the quarter ending 6/3023, CSWC received investment grade ratings from both Moody's and Fitch.
Performance:
CSWC has had quite a year so far in 2023, rising 31.7%, and outperforming the BDC industry, the Financial sector and the S&P 500 by wide margins. It's ~total 1 year return of 36% over 2X that of the S&P 500 and the BDC industry.
Analysts' Price Targets:
With that outperformance, it's not surprising that CSWC is only 2.2% below analysts' average price target of $22.81. Analysts' targets tend to lag earnings, so companies with increasing earnings can often find their share price near or above the targets.
The most recent ratings were in August, from Raymond James, and JMP Securities, both of whom rated CSWC Outperform.
Parting Thoughts:
In addition to rising interest rates, BDCs have also benefited from traditional banks pulling back from commercial lending.
In our previous article on CSWC, when it was priced at $22.03, we wrote, "CSWC is 3.75% off of its 52-week high of $22.92. We rate it a HOLD. It's a good long term income holding, if you can manage to buy it at a much lower premium."
We haven't changed our opinion - we still rate CSWC a Hold, due to its high premium/NAV. We advise waiting for the next market pullback before picking up new shares.
For further details see:
Capital Southwest: Strong Fiscal Q2 Earnings, 6 Straight Dividend Hikes