Ares Capital: One Of The Safest High-Yielders Your Money Can Buy (Rating Upgrade)

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Although higher interest rates serve as catalysts for BDCs, 2024 has been somewhat difficult for the sector due to decreased investment activity.With higher for longer rates, this has not only placed ...

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Ares Capital (NASDAQ:ARCC) recently reported their Q3 earnings and continued to prove why they're one of the safest, higher-yielding investments your money can buy. Although the BDC sector (BIZD) as a whole is considered riskier due to their business models, (acting as banks for sometimes distressed borrowers), ARCC has consistently proven why they're at the top of the sector in terms of quality. Moreover, since the 50-basis points rate cut by the Fed in September, BDC share prices have held up well, better than I anticipated. But with rates expected to continue trending lower in the coming months, ARCC offers little upside. But due to their NAV growth that is likely to continue moving forward and cheaper valuation in comparison to peers, I am upgrading the BDC to a buy. If you're looking for reliable income, then their high-yield may be worth considering here. In this article, I delve into the company's latest earnings, fundamentals, and discuss why they remain the top BDC. Previous Hold I covered Ares Capital this past August assigning the BDC a hold rating due to limited upside. This is because interest rates were expected to be cut the next month, in which they were. But as previously mentioned, the sector has held up well with ARCC even up since then by 7.53%. For comparison, the S&P is up 11.21% over the same period. During Q2, ARCC saw strong growth in their net investment income and deal flow, resulting in growth in their portfolio fair value. This grew from $21.5 billion to $25 billion on an annualized basis. Seeking Alpha They also saw higher NAV growth year-over-year than some of its externally managed peers like Blackstone Secured Lending (BXSL), Blue Owl Capital (OBDC), and Golub Capital BDC (GBDC) with 5.54% growth. This was in comparison to an 2.57% average for the other three BDCs. Size & Scale Advantages Apparent Although higher interest rates serve as catalysts for BDCs, 2024 has been somewhat difficult for the sector due to decreased investment activity. With higher for longer rates, this has not only placed downward pressure on their borrowers, it has also led to less M&A activity. During ARCC's Q3 earnings, the company continued showing why they're at the top of the sector in terms of quality. They're size, experience, relationships with sponsors and scale advantages gives them an edge in terms of deal flow. I also like that they tend to focus more on growth than awarding shareholders with special and supplemental dividends. Gross commitments were $3.9 billion, up slightly from the previous quarter that saw commitments of $3.86 billion. Year-over-year these were more than double Q3'23 that saw gross commitments of $1.6 billion. ARCC IR This was in comparison to the second largest BDC by portfolio value, Blue Owl Capital who saw originations of just $3.3 billion during their Q2. These could increase during the upcoming Q3 earnings; however, I suspect they will be less than ARCC's $3.9 billion. This was also higher than peer FSK KKR Capital's (FSK) entire investments through the first half which stood at $2.7 billion. Despite ARCC's robust investment activity, they still managed to miss analysts' expectations on their bottom line, with net investment income of $361 million missing the $375 million mark. But these grew from the previous year that saw NII of $289 million and was $3 million higher than the previous quarter. In total, ARCC added 23 new companies to bring their count to 530. Additionally, borrowers saw LTM EBITDA growth of double-digits for the third consecutive quarter and saw their non-accruals decrease quarter-over-quarter to 1.3% at fair value and 0.6% at cost. This positions the BDC well for unexpected economic volatility as larger borrowers tend to do better in times of uncertainty. Balance Sheet Already sporting investment-grade credit ratings from all three major agencies, ARCC received an upgrade from Moody's from Baa2 to Baa3. This should lead to cost efficiency and additional funding capacity in the future. As a result, the BDC is likely to see strong investment activity and commitments in the foreseeable future, likely offsetting the negative impact lower interest rates are expected to have on their financials. They also bolstered their liquidity which stood at $5.8 billion, up from $5 billion in Q2 as well as deleverage to 1.06x, down from 1.10x the previous quarter. This is well-below the sector median's 1.16x and peers like BXSL and Capital Southwest (CSWC) who had leverages of 1.13x and 0.80x respectively. They also increased their revolver capacity to $1.3 billion and reduced the weighted-average spread on their floating debt. So, from a balance sheet standpoint, ARCC is ready to pounce on increased investment activity deal flow in the future. They do have a significant amount of debt due next year, but as seen by their ample liquidity, ARCC's debt is manageable. ARCC IR NAV & Dividend ARCC's net asset value also saw solid growth from $19.61 to $19.77 during the quarter, a company record. This was $18.99 in the previous year's quarter. The one knock investors may have for ARCC is the company's conservatism regarding the dividend. They declared an additional $0.48 dividend, which they've held steady since 2022, giving them a yield of 9.1%. But as previously mentioned, ARCC's dividend is one of the safest around due to their conservatism. ARCC has seemingly been more focused on growth, which I'm perfectly fine with. Even when interest rates decline, likely over the coming years, ARCC's dividend will likely remain safe as they had 2x the base dividend payment in spillover income. ARCC came into this year with $631 million, or $1.04 in extra capital that they could use to offset declining financials during the FED's rate cutting cycle. ARCC Investor Presentation Valuation Comparison At the time of writing, Ares Capital has a P/NAV ratio of 1.06x. While I like ARCC in the high teens where I bought most of my shares, the BDC is cheaper than some of their peers like Blackstone Secured Lending, Capital Southwest, and Main Street Capital (MAIN). I also realized I was a bit too conservative, and their valuation is actually reasonable for the tier of quality regarding the BDC. And as previously mentioned, ARCC's fundamentals remain top-tier as seen by their strong portfolio growth, growth in net asset value, and decline in non-accruals, making them worthy of dollar-cost averaging in at current levels.   BDC Share Price NAV Price P/NAV Ratio   ARCC $21 $19.77 1.06x   BXSL $30.59 $27.19 1.12x   MAIN $50.67 $29.54 1.71x   CSWC $24 $16.59 1.45x   Click to enlarge Risks & Bottom Line Although it seems we've managed to achieve a soft landing, ARCC's borrowers still face risks from higher for longer interest rates. Moreover, these are expected to decline in the coming months/years, but these will likely have a lagging effect, putting their loans at an elevated risk default for the near to medium term.  But as mentioned in the article, I suspect ARCC's management team will successfully navigate any economic uncertainty should this rise unexpectedly due to their strong liquidity position and conservatism. In an expensive market and sector currently, Ares Capital is one of the safest, high-yielding companies your money can buy.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":1,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2481557525"}