Ares Capital: High Quality But Awaiting Better Entry (Downgrade)

seekingalpha04-27

Ares Capital has provided a total return slightly higher than the S&P 500 since December 2023. However, most of the returns are likely to come from the distribution only.The probability of rate cuts ...

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However, most of the returns are likely to come from the distribution only.The probability of rate cuts ...</p>\n\n<a href=\"https://seekingalpha.com/article/4686746-ares-capital-high-quality-but-awaiting-better-entry-downgrade\">Source Link</a>\n\n</div>\n","source":"seekingalpha","html":"<!DOCTYPE html>\n<html>\n<head>\n<meta http-equiv=\"Content-Type\" content=\"text/html; charset=utf-8\" />\n<meta name=\"viewport\" content=\"width=device-width,initial-scale=1.0,minimum-scale=1.0,maximum-scale=1.0,user-scalable=no\"/>\n<meta name=\"format-detection\" content=\"telephone=no,email=no,address=no\" />\n<title>Ares Capital: High Quality But Awaiting Better Entry (Downgrade)</title>\n<style type=\"text/css\">\na,abbr,acronym,address,applet,article,aside,audio,b,big,blockquote,body,canvas,caption,center,cite,code,dd,del,details,dfn,div,dl,dt,\nem,embed,fieldset,figcaption,figure,footer,form,h1,h2,h3,h4,h5,h6,header,hgroup,html,i,iframe,img,ins,kbd,label,legend,li,mark,menu,nav,\nobject,ol,output,p,pre,q,ruby,s,samp,section,small,span,strike,strong,sub,summary,sup,table,tbody,td,tfoot,th,thead,time,tr,tt,u,ul,var,video{ font:inherit;margin:0;padding:0;vertical-align:baseline;border:0 }\nbody{ font-size:16px; line-height:1.5; color:#999; background:transparent; }\n.wrapper{ overflow:hidden;word-break:break-all;padding:10px; }\nh1,h2{ font-weight:normal; line-height:1.35; margin-bottom:.6em; }\nh3,h4,h5,h6{ line-height:1.35; margin-bottom:1em; }\nh1{ font-size:24px; }\nh2{ font-size:20px; }\nh3{ font-size:18px; }\nh4{ font-size:16px; }\nh5{ font-size:14px; }\nh6{ font-size:12px; }\np,ul,ol,blockquote,dl,table{ margin:1.2em 0; }\nul,ol{ margin-left:2em; }\nul{ list-style:disc; }\nol{ list-style:decimal; }\nli,li p{ margin:10px 0;}\nimg{ max-width:100%;display:block;margin:0 auto 1em; }\nblockquote{ color:#B5B2B1; border-left:3px solid #aaa; padding:1em; }\nstrong,b{font-weight:bold;}\nem,i{font-style:italic;}\ntable{ width:100%;border-collapse:collapse;border-spacing:1px;margin:1em 0;font-size:.9em; }\nth,td{ padding:5px;text-align:left;border:1px solid #aaa; }\nth{ font-weight:bold;background:#5d5d5d; }\n.symbol-link{font-weight:bold;}\n/* header{ border-bottom:1px solid #494756; } */\n.title{ margin:0 0 8px;line-height:1.3;color:#ddd; }\n.meta {color:#5e5c6d;font-size:13px;margin:0 0 .5em; }\na{text-decoration:none; color:#2a4b87;}\n.meta .head { display: inline-block; overflow: hidden}\n.head .h-thumb { width: 30px; height: 30px; margin: 0; padding: 0; border-radius: 50%; float: left;}\n.head .h-content { margin: 0; padding: 0 0 0 9px; float: left;}\n.head .h-name {font-size: 13px; color: #eee; margin: 0;}\n.head .h-time {font-size: 11px; color: #7E829C; margin: 0;line-height: 11px;}\n.small {font-size: 12.5px; display: inline-block; transform: scale(0.9); -webkit-transform: scale(0.9); transform-origin: left; -webkit-transform-origin: left;}\n.smaller {font-size: 12.5px; display: inline-block; transform: scale(0.8); -webkit-transform: scale(0.8); transform-origin: left; -webkit-transform-origin: left;}\n.bt-text {font-size: 12px;margin: 1.5em 0 0 0}\n.bt-text p {margin: 0}\n</style>\n</head>\n<body>\n<div class=\"wrapper\">\n<header>\n<h2 class=\"title\">\nAres Capital: High Quality But Awaiting Better Entry (Downgrade)\n</h2>\n\n<h4 class=\"meta\">\n\n\n2024-04-27 01:31 GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4686746-ares-capital-high-quality-but-awaiting-better-entry-downgrade><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>Ares Capital has provided a total return slightly higher than the S&P 500 since December 2023. However, most of the returns are likely to come from the distribution only.The probability of rate cuts ...</p>\n\n<a href=\"https://seekingalpha.com/article/4686746-ares-capital-high-quality-but-awaiting-better-entry-downgrade\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"IE00BKVL7J92.USD","symbol_name":"Legg Mason ClearBridge - US Equity Sustainability Leaders A Acc USD","start_time":0,"source_url":"https://seekingalpha.com/article/4686746-ares-capital-high-quality-but-awaiting-better-entry-downgrade","article_id":"2430366789","we_media_id":null,"thumbnails":["https://static.seekingalpha.com/cdn/s3/uploads/getty_images/157506557/image_157506557.jpg"],"rights":null,"url":"https://stock-news.laohu8.com/highlight/detail?id=2430366789","pubTimestamp":1714152691,"sourceInfo":{"source_id":"seekingalpha","name":"Seeking Alpha"},"weMediaInfo":null,"summary":"Ares Capital has provided a total return slightly higher than the S&P 500 since December 2023. 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However, most of the returns are likely to come from the distribution only.The probability of rate cuts has decreased due to high inflation and a strong labor market, which is beneficial for BDCs like ARCC.ARCC's diversified portfolio and strong financials make it an attractive option for investors seeking high dividend yields.However, ARCC currently trades near all-time highs. In addition, the premium to NAV is higher than the average.   LockieCurrieOverview I previously covered Ares Capital (NASDAQ:ARCC) in December 2023 with a Buy when there was an expectation that interest rates would come down soon. However, with the latest CPI report reinforcing the idea that the Fed will likely not begin cutting rates any time soon, I wanted to revisit one of my favorite Business Development Companies to provide an update outlook. Since my initial coverage back in December, ARCC has provided a total return that's slightly higher than the S&P 500 (SPY). Data by YChartsThe latest CPI report indicated that inflation remained higher than anticipated. A combination of high inflation but a strong labor market means that the probability of rates cuts were decreased significantly. Bank of America (BAC) analysts don't expect a rate cut util March 2025. If this is the case, then we have another year of elevated interest rates, which happens to be a prime environment for BDCs like ARCC. Higher interest rates directly translates to higher interest income that can be generated from portfolio companies within. Having exposure to BDCs in this environment is great because the higher interest levels can support the high distribution that BDCs typically have. For example, ARCC's current dividend yield is about 9.2% and there are very few places you can safely collect a high yield such as this. ARCC is also the largest BDC in the sector and has an excellent management team that has provided consistent returns for shareholders. Strategy & Portfolio For some quick background, Ares Capital is a business development company that focuses on upper middle market lending, acquisitions, recapitalizations, and leveraged buyouts. They generate their income through the debt investments they make to the middle market companies that need capital. ARCC has about $419B in assets under management and their segments can be broken down to a few sectors including credit, private equity, real estate & infrastructure, and secondaries. ARCC focuses on upper-middle market companies and, as a result, the weighted average EBITDA of their holdings is now $322M. We can see that the majority of their investment exposure is through first lien senior secured loans, with a total senior secured exposure making up 60% of their portfolio. This allocation provides a layer of safety, as senior secured debt sits at the top of the capital structure. This means that this sort of debt is prioritized and first in line for repayment in cases of defaults and liquidations.   ARCC Q4 PresentationIn comparison, I recently analyzed FS KKR Capital (FSK) where the senior secured portion accounted for 66% of their portfolio. While this can be a good gauge for how risky a BDC is, it doesn't paint the entire picture. Even though FSK has a higher exposure to senior secured debt, their performance lacks in comparison to ARCC. There are different factors like the portfolio makeup by industry, sector allocation, credit quality, and management. Data by YChartsWhen looking at ARCC by industry allocation, there is a lot to like here, as the BDC remains highly diversified in nature. The portfolio is spread across many different industries with a very balanced weighting. The largest industry exposure is to software & services, which make up 23% of the portfolio. The second-largest industry within the portfolio is health care services, which makes up 12% of the portfolio. This is then followed by commercial & professional services at 10%. ARCC is so diversified that the top ten investments here at fair value only make up 12.4% of the portfolio. For comparison, the average top ten holdings at fair value make up 23.8% of the peer BDC average.   ARCC Q4 Presentation Updated Financials & Interest Rates Their reported Q4 earnings came in strong, with total investment income growing by 10.5% year over year. This can likely be attributed to the higher interest rate environment that we are in. Looking at the historical relationship between ARCC's price and the effective federal funds rate, we can see that there has been a slight inverse relationship between the two. When rates were cut in 2020 to near zero levels, the price ultimately ended up towards the $22 per share mark. When rates started to rapidly rise, the price cooled down and retracted towards the $18 per share mark. Ultimately, ARCC's performance has stayed consistent through these rate changes and I anticipate this to continue being the case due to their strong portfolio make up and capital management. Data by YChartsA higher interest rate directly translates to a higher net investment income, as BDCs like ARCC can use this to generate additional income on their floating rate debt investments. As of the last earnings call, we received confirmation that their portfolio contains about 70% in floating rate debt. We are still in a higher rate environment for fixed rate debt issuances. If you think about our portfolio, we have about 70% of our portfolio being in floating rate. So there is a benefit to kind of match funding the interest rate and looking at that opportunity to have that more aligned with the rate on the portfolio being floating - Penni Roll, Chief Financial Officer    ARCC Form 8-KLooking at their operating results, we can actually see how this plays out in real time. The NII (net investment income) total for the full year 2023 totaled out to $1,266M in comparison to the prior year's $1,092M. NII per share grew up to $2.28 over the prior year's $2.19 as well. NII for the quarter came in at $0.60 per share, which fully covers the distribution of $0.48 for the quarter. In addition, NII rose from $289M in Q3 up to $345M in Q4. While NII rose, expenses simultaneously decreased. Expenses in Q4 came in at $353M, which was a slight drop of $363M from the prior quarter. Lastly, it's reassuring to see that gross commitments grew during the quarter because it means that there are active efforts to continue growth. Gross commitments totaled $2.38B for the quarter, which shows us that ARCC is deploying more capital towards new investments. In turn, these new investments can yield additional income generation through interest and fees. Dividend As of the latest declared quarterly dividend of $0.48 per share, the current dividend yield sits at 9.2%. Since NII for the quarter was $0.60, this fully covered the distribution of $0.48 with a wide margin of safety. This represents coverage of 125%. While the dividend remains safe, it has also provided a significant source of growing income for shareholders. With a BDC like ARCC, the consistent high distribution is what fuels the total return potential. Taking a look at the data over the last decade, we can see that the price has only appreciated by nearly 20% while the actual total return is closer to 214%. Data by YChartsThis is what makes ARCC and the BDC sector so attractive for investors that are nearing or at retirement age. These investors that depend on the income generated from their portfolio have a way to collect a high yield in any interest rate environment. While future drop in interest rates may lower NII amounts, BDCs still have the obligation to distribute most of their earnings out as a dividend. Even if rates are cut, however, I do not believe there is a reason for them to drop as low as they once were. There is no need for that kind of economic stimulus right now and, as a result, I believe that we will continue to see a higher average rate. Even with a starting dividend yield already nearing double digits, ARCC has been able to provide some dividend growth. Over the last decade, the dividend has increased at a CAGR (compound annual growth rate) of 2.36%. While this is small, it's still a nice bonus when the starting yield is already so high. On a smaller time frame of 5 years, the dividend has increased at a CAGR of 4.24%. We've seen several raises and supplemental dividends issued since interest rates began rising in 2022. Portfolio VisualizerUsing Portfolio Visualizer, we can see how the dividend growth of ARCC would have translated in real terms over the last decade. This graph assumes an initial investment of $10,000 with dividends being reinvested every quarter. No additional capital was deployed after the initial $10,000. In 2013, your initial investment would have netted you $928 in dividend income. Fast-forward to 2023, your total income from the initial $10,000 investment would now be generating you $2,940 annually in dividend income. Something to keep in mind here is that the dividends received from a BDC like ARCC are usually tax-classified as ordinary income. Therefore, this sort of high-yielding asset is most efficient in a tax advantaged account. Valuation In terms of valuation, ARCC is now trading above its usual historical price range. Prior to the pandemic in 2020, shares have never traded above the $20 mark. However, coming off the tail end of the pandemic, we saw shares rise as high as $22 per share for a brief moment in 2022. Since then, the price has retracted down to the $20 mark and casually flirts with this mark by frequently dipping below and above. To get a better reference point here, we can take a look at the price relationship to the NAV (net asset value). Over the last 3-year period, the price has traded at a premium to NAV of 5.63%. The price currently trades at a premium of over 8% to NAV. Therefore, I believe we should await a better entry point here for the long term. A lot of the value with BDCs comes from when you make your initial purchase. Ideally, we'd all like to pick up shares in that discount territory when possible. CEF DataWhile I do believe that ARCC will continue to provide consistent dividend income to shareholders with a decent margin of safety, I do feel a bit hesitant to add shares at this premium level and above the $20 per-share price mark. I believe that a future drop in interest rates, even if that's a year from now, has the potential to negatively impact the price and provide us with a better entry point for ARCC. Therefore, I rate ARCC a Hold for now. I currently own shares, but I was lucky enough to get them around the $18 mark. Risk Profile ARCC's risk profile seems to be pretty solid. We've already established this because of their diversity and track record, but we also have confirmation in their investment grade ratings. They received mostly positive investment grade ratings from S&P Global, Moody's, and Fitch. ARCC's current debt/equity ratio comes to 1.02x which is extremely healthy. This metric indicates what portion of their operations they are funding through debt. A higher rate would mean they are using more leverage and opening themselves up for more risk.   ARCC Q4 PresentationIn addition, the current non-accrual rate was 1.3% of total investments at amortized cost. While this rate doesn't raise any red flags, it is an important metric to keep an eye on in a high-interest rate environment. Higher rates may put additional strain on their portfolio companies and increase defaults or late payments, thereby increasing the non-accrual rate. For reference, here are the non-accrual rates for some peer BDCs to compare.  FS KKR Capital (FSK): 8.9% Main Street Capital (MAIN): 0.6% Crescent Capital (CCAP): 2%    ARCC Q4 PresentationLastly, ARCC pulls in enough cash to comfortable cover their fixed charges. For the year-end of 2023, the fixed charge coverage ratio was 3.4x, which means that their earnings were more than 3 times greater than the cost of their charges. Additionally, they also had an asset coverage ratio of 2.2x for their unsecured notes within. Takeaway  Ares Capital (ARCC) is one of the largest BDCs in the sector and has consistently provided shareholders with high levels of income. Their portfolio consisting of 70% floating rate debt investments has been a great way to capitalize on this higher interest rate environment that we are in. While rates are not expected to come down anytime soon, I believe ARCC is a great way to continue earnings a high level of income as their NII growth safely covers the dividend distribution by a wide margin. Their portfolio is diverse in nature and credit quality is solid. However, the price does trade close to an all-time high and at a higher premium to NAV than usual. 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