Ares Capital: A High Yield Blue-Chip BDC For Uncertain Times

Dec. 04, 2021 12:22 AM ETAres Capital (ARCC)48 Comments

Summary

ARCC recently hiked its dividend.
ARCC has outperformed the market through cycles.
ARCC is one of the safest BDCs you can buy today and offers a 8%+ yield.
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Ares Capital Corp (NASDAQ:ARCC) is a blue-chip BDC that enjoys the dual safety net that comes from being backed by a large global asset manager Ares Management (ARES) as well as an investment grade balance sheet.

The company enjoys 3 competitive advantages that combine with its reasonable valuation to make it a solid choice for a high yield portfolio during these uncertain times. We will detail these in this article.

#1. Proven Management

ARCC's track record speaks for itself as it has crushed the S&P 500 (SPY) over the course of two market crashes and two major market rallies:

ARCC has therefore proven itself to be a superior allocator of capital in the face of numerous economic upheaval, disruption, and uncertainty, which should earn the confidence and trust of shareholders in the current environment.

A big reason for this is that the ARCC team provides superior deal flow and access to informational edges from the ARES team. Additionally, the capital scale at which ARCC can operate gives it access to more deals than many of its competitors can service, thereby reducing competition and improving its optionality.

The company has also fine-tuned its underwriting practices over its significant experience built up over the years, helping it to improve performance and reduce risks moving forward.

#2. Well-Structured Portfolio

On that note, the next competitive advantage that ARCC enjoys today is its portfolio structure. Given its immense size, ARCC has tremendous diversification (its top 15 investments only make up 23.4% of the total investment portfolio and the company has a total of 371 portfolio companies) and also invests in larger sized companies, improving the safety of the underlying investments. Furthermore, given that its size enables it to make larger sized investments in companies without sacrificing adequate diversification, ARCC is given much greater control over the companies that it invests in. This in turn drives stronger outcomes for its investments.

On top of that, 72% of ARCC's portfolio is invested in senior secured loans and a total of 83% is invested in senior debt. 7% is invested in preferred equity and the final 10% is invested in equity. The leading industries it invests in are software and services, healthcare services, and commercial and professional services, representing ~40% of the total investment portfolio and demonstrating 30% faster EBITDA growth on average than the overall portfolio as a whole. Furthermore, the non-accrual at cost rate is at 1.7% (and just 1% at fair value), which is below historical and pre-COVID-19 levels.

Source: Investor Presentation

#3. Strong Balance Sheet

ARCC also boasts a very robust balance sheet with an investment grade credit rating, well-laddered debt maturities with the vast majority of its debt due in 2025 or thereafter, and significant liquidity.

Source: Investor Presentation

The company recently raised $700 million of 10 year unsecured debt at a very compelling 3.2% interest rate, reflecting its access to plenty of cheap capital.

#4. Attractive Total Return Profile

On top of these three aforementioned competitive advantages and despite seeing strong recent performance:

ARCC still offers investors attractive total return potential.

First and foremost, its growth momentum is strong, enabling it to generate 20.5% year-over-year core earnings per share growth and 2% sequential NAV per share growth during Q3 despite the company having to pay out such a high percentage of earnings in dividends and issuing additional common shares over the past year. This strong growth led to management hiking the quarterly dividend by 2.5% earlier this year and we think the dividend could grow in the future as well given the strong growth momentum in the company and its investment impressive backlog.

Even better, ARCC yields over 8% right now and is covering the dividend by a sustainable 1.15x. The dividend is even safer due to the significant undistributed spillover income that the company has.

For those concerned about interest rate volatility and inflationary pressures, ARCC's management had this to say on the Q3 earnings call:

We're probably one of the least interest rate sensitive stocks around, because we obviously run with materially lower leverage than most financial institutions, right? So as we mentioned, our leverage tends to run somewhere between where we are today, 1, 1.25. And on the asset side, all of our assets -- most of our assets, I should say, are floating rate, so we're positively inclined toward rates going up.

We lose a little bit on the financing side, but again, it's immaterial. So for us, rates isn't a huge consideration... [in terms of inflation] if you look at our largest industries, it tends to be things like software and services and healthcare services and all of that, things that really have not been impacted in any way, shape, or form... For the most part our companies are underwritten, to really try to waive those in that have good pricing power. We have very little exposure to industries and the companies, where there's no pricing power. But I think look, because you read the headlines, right John? Lots and lots of CEOs out there saying yes, we're raising prices. We're seeing supply disruptions, we're seeing input cost inflation, and our turn is to obviously turnaround and pass that onto the consumer, of whatever those goods or services are so. I think it's real, and I think it's going to last a while, but I do think that were underexposed, and not as impacted as a whole host of others.

Investor Takeaway

Between its impressive track record and top notch management team, stellar balance sheet, well-structured portfolio that is set up to weather interest rate volatility and soaring inflation, and strong dividend coverage, ARCC is one of the safest high yield BDCs - if not stocks in general - that you can invest in during these uncertain times.

While the stock could certainly be cheaper, it is also not expensive, with a pretty reliable 8% dividend yield and good growth potential on top of that.

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