With massive stock market volatility caused by the euro crisis and uncertain growth prospects in the U.S., how do you find investment ideas that provide steady income and upside potential but also let you sleep at night? Consider BlackRock Kelso Capital (BKCC) – a business development company (BDC) that is focused on lending to middle-market companies in the U.S. BKCC’s investments must be approved by a committee comprised of executives from BlackRock, Inc. (arguably the most respected asset management firm in the U.S.) and Kelso & Co., a leading blue-chip private equity firm with a long history and a stellar reputation.
At the closing price of $8.25 on November 28, the stock provided a 12.6% dividend yield. It’s comforting to know that you’re being paid quite well regardless of the market’s gyrations. But is the dividend safe? After all, the company did cut the payout earlier this year (from $0.32 to $0.26). Going forward, I believe it is - the company has generated enough adjusted Net Operating Income (NOI) to cover 71% of the 2011 dividend through the first three quarters of the year – modestly behind the 75% pace you'd like to see. They should come close to covering the full dividend for 2011, and NOI will most likely exceed the current dividend in 2012 based on the current pace of portfolio growth (see below).
I believe that BKCC will be able to grow NOI per share next year – through the first three quarters of 2011 BKCC has grown the fair market value (FMV) of its portfolio at a 15.4% annualized rate. The company added to their origination staff earlier this year and the results seemed to show in the third quarter, with new investments up sharply from the previous three quarters. In addition, the company is funding growth primarily with low-cost debt (it has plenty of capacity), which should help drive the return on equity higher. As the company demonstrates that they can cover the dividend (and potentially grow it), the stock is likely to trade more in line with Net Asset Value (NAV) per share (currently $9.75), representing nearly 20% upside from current levels - and this is in addition to the 12.6% dividend yield.
Lets You Sleep at Night
As of this writing, BKCC is trading at only 85% of Net Asset Value, despite a conservative, high quality portfolio (FMV = 95% of cost, senior debt comprises 71% of the portfolio) and a blue chip investment committee that carefully screens all new deals. The BDC group has been beaten down by global economic concerns, but BKCC is exposed primarily to the senior debt of established, profitable middle-market U.S. companies. NAV per share has been stable for the past two years despite extreme market volatility – ranging from $9.55 to $9.83. There is already significant downside risk baked into the stock price despite this consistent track record. Portfolio writedowns that take NAV per share below the current stock price seem highly unlikely.
The stock has been volatile in the past year (trading as high as $12.97 and as low as $6.30) but the underlying performance of the company has been steady. A total return of 30% over the next twelve months is entirely possible, with limited downside risk at current levels. The company is paying a hefty dividend while we ride out the economic storm, and the stock should appreciate nicely when the sun starts shining again.
Disclosure: I am long BKCC.