Co-produced with PendragonY
History of ARCC
Ares Capital Corp. (NASDAQ:ARCC) is a business development company that began trading publicly in 2004. Since that time it has generated very attractive annual returns for shareholders of an average of 13% (with dividends reinvested) over a 15-year period. While many companies, particularly BDCs, eliminated their dividend payments during the last recession, ARCC had only a small cut of just under 7 cents a quarter while it continued to pay $0.3447 a share each quarter. In 2019, it increased the dividend in two one-penny steps to the current $0.40 a share per quarter. Also in 2019, ARCC paid a special dividend of 2 cents a share each quarter. One item of note is that ARCC issues a 1099-DIV tax form and not a K-1.
The chart below shows the dividend history of ARCC since 2008, including multiple special dividend payments (not just in 2019).
net asset value ("NAV") or book value per share (as YCharts calls it) also is a very important metric for a BDC. That's the amount of money that's invested. If NAV is declining, income often follows. If income drops too much, dividends most likely will have to be reduced. ARCC generally has had increasing NAV since its IPO.
NAV is useful in determining the safety of the dividend because long-term declines in NAV tend to precede a fall in NII, or net investment income, which is what generates the cash to pay the dividend.
For a BDC, NAV per share is the metric to use. Total NAV can hide the fact that dividend coverage has been reduced by a big acquisition when share sales are used to help fund it. That in part happened to ARCC in 2016 when it acquired American Capital (ACAS). As can be seen in the chart above, that acquisition resulted in a drop in NAV per share that took ARCC awhile to recover. Since 2010, the value of NAV has trended upwards, with only short periods of decline (in the per-share value) in 2011 and 2016. Since July 1, 2010, ARCC has seen its per share NAV increase just over 20%.
Why the Business Model is Attractive
ARCC is a leader in middle-market direct lending with a $12.99 billion portfolio spread over 345 investments.
Source: November Investor Presentation
ARCC has positioned itself to fill the void created by the reduced lending by banks and the reduced funding raised by IPOs. BDCs like ARCC provide funding to small and medium-sized businesses in higher yield transactions. These companies, because banks have been exiting the market, would not otherwise have access to enough capital to continue to grow. Between bank consolidation, banks making fewer loans, banks focusing those loans on larger companies, and fewer IPOs, ARCC has a fairly wide market to operate without worrying about competition from banks.
Source: Q4 Earnings Report
The level of risk in its portfolio is low with 74% of its portfolio in either first or second lien senior secured loans. Over the last six months ARCC has increased their exposure to first-lien loans by 3%, thus increasing the overall safety of the portfolio.
The industries that ARCC invests in is relatively diverse. Energy has been a tough sector and many companies have seen lower share prices. ARCC's portfolio has only 2% exposure overall to that sector. Health Care Services, Software & Services, and Commercial & Professional Services combined are roughly one third of the portfolio. This diversification should help in the event any economic slowdown.
Source: Q4 Earnings Report
Since last we covered ARCC, back at the end of Q2 2019, the average EBITDA and credit statistics have improved for the companies within their portfolio. Leverage has stabilized over the last three quarters, ending a slight uptrend. Interest coverage also has improved slightly. For those companies within their portfolio included in the weighted average EBITDA has grown around 3% of the last year. While that's a slightly slower rate of growth than the companies were seeing six months ago, it's still a good growth rate.
Standing the Test of Time
Since inception in October of 2004, ARCC has stood the test of time. There have been boom years and years with significant headwinds for the companies in their portfolio. ARCC’s conservative portfolio focus on senior secured loans of 352 quality middle-market companies has generated approximately 430 bps of yield premium as compared to leveraged loans. Compared to other high yield loans, ARCC's portfolio companies have generated some 310 bps yield premium. While it did have to cut the dividend during the financial crisis, management worked to strengthen the company and it came through that period with only minor and soon repaired damage. In fairly short order, ARCC returned to its track record of outperforming the S&P500 index (SPY).
ARCC has paid a dividend for the last 15 years. During the last recession, when many companies were eliminating their dividend (or even going out of business), ARCC continued to pay a dividend. That dividend, while lower than the prior years, was still $1.40 a share. Today, the regular dividend has grown to $0.40 each quarter. From time to time, ARCC also has paid out a special dividend. Last year ARCC paid out 8 cents in special dividends (2 cents each quarter).
Since its inception as a public company in 2004, ARCC has outperformed SPY. Due to a good 2019 second half for the S&P 500 index, ARCC has only outperformed SPY by 1.8 times (as opposed to the 1.9 times better it was doing back at the end of July 2019).
Outperformance Compared To Other BDCs
Source: November Investor Presentation
Since 2012 ARCC has paid more than $1.51 in annual dividends, often boosted by special dividends. Last year ARCC paid out a total of $1.6798 in dividends, helped out by 8 cents of special dividend payments. For Q1 of 2020, ARCC has announced a $0.40 payment for the quarter (annual rate is $1.60). While we were disappointed that no special dividend (or dividend increase) was declared, we think the dividend is safe and that some boost to dividend payments is likely. BDCs have legal requirements to distribute their income to the shareholders. Last year they had some $0.76 in what is called spillover. This is a per-share amount of payments that the company is required to make to shareholders but has not yet done so. This provides a cushion for when the quarterly NII isn’t enough to cover the dividend payment and can be the source of special dividends and dividend increases. ARCC paid out a special dividend in order to reduce that number last year but starts this year with $0.95 a share (a total of $408 million). This bodes well for both dividend safety and some increase in the dividend payment. We expect a special dividend or a regular dividend hike before the year is out.
Value of Assets on Non-Accrual Status Remains Low
Source: Q4 Earnings Report
An important metric in evaluating management performance is how much of the total portfolio is on non-accrual status. This both tells us how efficient the underwriting process is because it gives us an indication of how likely management spots a borrower who will get in trouble, and how effective management is in guiding its portfolio companies away from trouble.
While there was some improvement in the rate of non-accrual in Q3, there was a definite uptick in Q4. From a cost standpoint, the increase was fairly small, and mostly just erased the improvement that happened in Q3. However, in Q4, the rate based on fair value went up quite a lot. While still below 1%, it's somewhat worrisome that the change was so much bigger than cost. If this disparity continues, that might be a reason to dig more into whether or not management is underestimating the value of some assets that are having trouble.
A High Dividend Is Great, But Only If It's Safe
Source: Q4 Earnings Report
NII is the safest source for cash to pay the dividend. In the chart above, we can see that ARCC has had NII that exceeded the dividend paid (including the special dividend) every quarter for the last five quarters (according to older data presented in past articles, that streak extends to two additional quarters prior to the ones shown here). Further evidence that the dividend is well covered is that the spillover income (which is income ARCC is required to distribute to shareholders) increased to $0.95 per share from the $0.76 value it had at the start of 2019.
Having looked at why ARCC is a company we want as an investment partner, our next task is to determine if ARCC shares are selling at a good value. First, let’s look at the history of the ratio of the NAV to the share price.
In the chart above we can see the ratio of the NAV to the share price since 2010 (about 10 years). This ratio is close to its lowest level trading close to NAV. This fairly modest premium to NAV contrasts with Main Street Capital (MAIN) which often trades above a 70% premium.
Given the consistent NII and NAV growth, it would not be unreasonable for ARCC to trade at a 12% to 15% premium to NAV, or +10% higher from here. That would set a price of about $19.40 on the low end to $19.90 on the high end. That would mean an 8% yield with the current $0.40 dividend.
Source: WSJ Markets
According to a survey of analysts queried by the Wall Street Journal, the average price target is $19.70, with a median value of $20. That matches up well with our target NAV premium (12%-15%) and target yield of 8%. Analysts target price is at 12% higher from here.
What about the dividends?
Source: ARCC Q4 Earnings Presentation
As we can see, ARCC has been paying a generous dividend that has had some modest growth. Last year they also paid out a total of 8 cents per share in special dividends. At this time, they did not announce another special dividend for this year. Two things have made management cautious about committing to a special dividend (or a dividend raise).
- First, LIBOR is down and projected to decline during the year. That will impact how much cash they have to pay a dividend.
- Also, in January ARCC issued $715 million of unsecured notes with a 3.25% coupon that will mature in the middle of 2025. While the cost of this debt was very good, it has to be deployed effectively. So any special dividend announcement (or dividend increase) will likely wait for a bit until management has seen clarity on where interest rates are going and what the new assets will produce. The good news is that with $0.95 a share (which is over $400 million) in spillover revenue management has a huge buffer to cover the current dividend payments.
It's very likely that either they will increase the regular dividend later this year or announce another special dividend to reduce this extra cash.
ARCC is a top-notch BDC with close to 15 years of track record and out-performance. It still trades well below the valuation of peers with similar performance. Yes, it does have external management, and that's likely why it doesn’t trade at the same NAV premium as similar peers. The good news is that income investors can still buy it at cheap valuations compared to other quality BDCs trading at exorbitant valuations of over 80% above NAV.
This management has navigated the company though good and bad times, acted in shareholders’ interest, outperforming the S&P 500 index by a large margin. This is a "battle-tested BDC" and we like to call it the blue chip of the sector. With ARCC you are getting a quality company at a good price and a fat yield of close to 9%, plus upside potential.
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