2023-12-15 04:05:13 ET
Summary
- Sixth Street Lending's stock price has risen 20% in 2023, leading to a classification change to Hold.
- The company has a well-managed portfolio and a dividend that is well-covered by adjusted net investment income.
- However, the stock has a high NAV multiple and passive income investors receive a lower dividend yield compared to the yield on its debt investments.
Taking into account that the price for the stock of business development company Sixth Street Specialty Lending Inc. ( TSLX ) has risen 20% in 2023, I am modifying my stock classification to Hold.
I think that the business development company is well-managed, has a strong portfolio and the dividend is well-covered by adjusted net investment income.
With that being said, though, Sixth Street Specialty Lending has a high NAV multiple and passive income investors only get a dividend yield of 8.6% from a portfolio that produces a 14.2% yield on its debt investments.
Thus, I view Sixth Street Specialty Lending as probably fair valued and I would advise to not chase the stock price at this point.
My Rating History
My last stock classification from May 2023 was a BUY and my rating was influenced by Sixth Street Specialty Lending's First Lien-focus and aggressive floating-rate exposure in a rising-rate environment. I still view Sixth Street Specialty Lending as a high quality BDC with substantial dividend coverage and a very well-positioned First Lien portfolio, but the sharp upwards re-rating is making the BDC only a Hold right now.
What Has Happened To Sixth Street Specialty Lending's Portfolio Since May?
Since May 2023, Sixth Street Specialty Lending has chugged along and originated new loans, predominantly in the First Lien Category.
In 2Q and 3Q, the business development company originated 87% and 99% of its total quarterly origination volume in the First Lien category, solidifying its strong senior secured lending focus. At the end of the third quarter, Sixth Street Specialty Lending was to 91% invested in First Liens, making it one of the most senior loan-focused business development companies in the market.
What is a positive trend in Sixth Street Specialty Lending's portfolio is that its value has increased whereas the asset trend has pointed downwards for many other BDCs in the last year. The reason for this was the high-rate environment which has suppressed new loan originations. Sixth Street Specialty Lending's portfolio value at the end of 3Q-23 was $3.1 billion, reflecting 11% YoY growth.
Portfolio Highlights - Asset Mix (Sixth Street Specialty Lending)
In terms of diversification, I don't see either an advantage or a disadvantage with Sixth Street Specialty Lending compared to other business development companies. As a First Lien-focused BDC, Sixth Street Specialty Lending prioritizes lending to those middle market companies that have predictable revenues, cash flow and EBITDA and this tends to be the case for Internet, Business and Financial Services companies.
As far as the borrower diversification goes, the largest borrower accounted for just 2.5% of investments while the top ten investments amounted to only 23%.
Borrower And Industry Diversification (Sixth Street Specialty Lending)
Sixth Street Specialty Lending's weighted-average total yield of debt and income-producing securities (at amortized cost) has risen sharply in the last year, thanks to the central bank lifting key interest rates up.
However, the 14.3% yield that the BDC's debt investments produce translate into a mere 8.6% yield that passive income investors receive from the common stock.
This, in my view, makes an investment in Sixth Street Specialty Lending uninteresting for passive income investors, particularly because the central bank's rate-hiking cycle, by all odds, is expected to end in the short-term, thereby lowering the appeal of Sixth Street Specialty Lending's 100% floating-rate debt investment portfolio. In short, Sixth Street Specialty Lending's debt yields are set to fall moving forward.
The Dividend Is Well-Covered, But Not A Bargain Anymore
Sixth Street Specialty Lending offers passive income investors a well-covered dividend and the dividend pay-out ratio has fallen in the last two quarters, relative to 1Q-23, implying a higher margin of safety.
Besides covering its main $0.46 per share per quarter dividend pay-out, by the end of the year the business development company will have paid $0.23 per share in total variable dividends as well which helped Sixth Street Specialty Lending distribute excess portfolio income.
With a pay-out ratio of 85%, I consider the dividend to have a reasonable margin of safety for passive income investors, though that does not mean that investors should buy it presently, due to valuation concerns.
Growth In Net Asset Value, But Aggressive NAV Multiple
Sixth Street Specialty Lending's net asset value is growing which is obviously good for intrinsic value development. The business development company covered its dividend with adjusted net investment income in 2Q-23 and 3Q-23, paid special dividends and then still added to its net asset value.
Sixth Street Specialty Lending ended the third quarter with a net asset value of $16.90 per share, reflecting $0.16 per share NAV growth compared to the second quarter.
Be that as it may, the 2023 re-rating has made the BDC expensive and the stock unappealing from a return perspective. Sixth Street Specialty Lending's common stock is selling for a 26% premium to net asset value, one of the highest premiums in the sector. The stocks of Blue Owl Capital Corp. ( OBDC ) and Ares Capital ( ARCC ) can be had for substantially lower valuation multiples while offering similar or better pay-out ratios.
Valuation Headwinds, The Central Bank And Other Risks To Consider
Sixth Street Specialty Lending's pay-out ratio is comparable to that of Blue Owl Capital, a highly-rated BDC with a twelve months pay-out ratio of round about 80% . With that being said, I don't view Sixth Street Specialty Lending's valuation multiple as competitive right now which is why I am changing my stock classification from Buy to Hold.
Other potential headaches include the central bank bringing to end the present rate-hiking cycle which makes aggressively floating-rate positioned BDC like Sixth Street Specialty Lending less appealing for passive income investors.
My Conclusion
Sixth Street Specialty Lending is a solid business developing company with a growing portfolio, a growing net asset value and improving dividend coverage since May 2023.
The company covered its dividend with adjusted net investment income in 2Q and 3Q and continued to distribute portfolio excess income. Sixth Street Specialty Lending, for better or worse, has enjoyed a rather substantial valuation re-rating this year which has had the effect of reducing the dividend yield to less than 9%, well below the portfolio debt yield.
The BDC's stock is now also selling at an excessive 1.26x NAV multiple, suggesting that passive income investors are overpaying for Sixth Street Specialty Lending's investment portfolio and related yield potential. Hold.
For further details see:
Sixth Street Specialty Lending: A Top BDC Selling At A Fair Price (Rating Downgrade)