Saratoga: The Time Has Come, Execute Buy Order

Summary

• SAR’s debt structure is ideal for the rising interest rate environment.
• The dividend yield climbed above 9% with strong management intentions to maintain the dividend payments in the future.
• SAR has outperformed its earnings per share estimates 79% of the time in the last 10 years.

Lari Bat/iStock via Getty Images

Investment thesis

The last 3-to 4 months (since I published an article about SAR) have been rough in terms of price appreciation if you already held a position in Saratoga Investment Corp. (NYSE:SAR) and watched your position closely. But if you are about to execute a buy position, it is time to do so. The management continued the debt restructuring in January and I am certain they will continue to do so in the near future by redeeming high floating rate notes and issuing fixed-rate notes instead. NAV grew in the last 4 months, and Return on Equity slightly grew. The company has a better valuation than in December (partly because of the general market downturn). It is trading at a better dividend yield and due to the first interest rate rise in March, the broader economic environment is turning in SAR's favor.

Portfolio structure

Saratoga Investment is one of the 49 publicly traded business development companies that provide customized financing solutions for middle-market companies located in the U.S. The company focuses on firms that have EBITDA of $2 million or greater and revenues of $8 million to $250 million. SAR invests through direct lending as well as participation in loan syndicates. Three-quarters of its portfolio consists of first-lien loans and the management likes to not only be on the top of the capital stack but if possible, make additional money from its equity holdings beyond the interest payments on loans. Their riskiest holdings are the Structured finance securities but the 280 basis point risk premium to first-lien loans could justify their part in SAR's portfolio. Their total portfolio is well-diversified geographically and I am not expecting any significant change in the upcoming years.

2022 Q3 Shareholder Presentation

Q3 2022 Shareholder Presentation

Financials & Earnings

Q3 results

SAR has continued to perform well in its third quarter. The ROE grew from 14.4% ttm in Q2 to 14.6% ttm by Q3 2021. The total net assets grew by 5.71% and the fair value of the investment portfolio also slightly grew compared to second-quarter results. SAR's loan investments held in performing credit ratings remained strong (95%) compared to year-on-year data (92.8%) and second-quarter results (93.2%). The net investment income decreased from Q2 to Q3 by approximately 21.1% but grew on a year-on-year basis by 12.5%. The reported NII per share was $0.45.

The debt restructuring has been accelerated as the management wants to secure SAR's place in a rising interest rate environment. By January 19th SAR closed a public offering of $75 million 4.35% notes due 2027. The final yield to maturity will be approximately 4.5%. This will be highly advantageous to SAR with expectations that by the end of 2022 the fed funds rate could be realistically 1.5-1.75%.

Earnings statistics

SAR will announce its fourth-quarter results on May 3rd, 2022, after market close and has an EPS estimate of $0.54. In the last 10 years, SAR outperformed the EPS estimates 79% of the time and only underperformed the previous estimates 21% of the time. The biggest price drop after a worse than expected earnings was 3.97% and the average price drop after a worse than expected EPS is 2.91%. So now you can see the statistics and decide if this risk is too much for you to take a position in SAR before the next earnings results in May or not. (These numbers are based on standardized EPS.)

Debt profile and valuation

SAR has total debt outstanding of $457.6 million as of November 30, 2021. The management is well prepared for a rising interest rate environment because $445.1 million of the total outstanding is fixed-rate debt and only a tiny fraction (2.73%) is floating rate. Going forward, available liquidly is $76 million at a fixed rate and $37.5 million as floating-rate loans. (Plus, the $144.1 million of cash and cash equivalents).

Q3 2022 Shareholder Presentation

SAR is fairly valued at the moment but income investors can lock in the trade with a great dividend yield. In addition, SAR is a bit undervalued compared to my last publication. SAR has a price to book ratio of 0.93 lower than in my last publication (0.99). In the last 3 months as the overall markets declined SAR declined sharply as well and is now stabilized at approximately 4.5-5% below its November-December price range which means there is upside potential.

Seeking Alpha

In terms of dividend yield, income investors can buy in at a great point because SAR has been trading above 8.9% dividend yield only approximately 12% of the time in the last 12 months. Looking at the 4-year average yield we can see an 8.07% figure and the current dividend is 11% higher than this average.

Data by YCharts

SAR's dividend

Current dividend

I have already shared my thoughts about SAR's dividend in my previous article so I am going to add bits and pieces since not many things have changed. SAR is paying a $0.53 per share dividend and is yielding at 9.01% while in my last publication the dividend yield was 7.34%. The management continues the DRIP and some share repurchases. These buybacks only decrease NII per share by $0.01 while adding $0.01 to the NAV per share but those only count for 0.03% of the NAV per share.

Future sustainability

As I mentioned before SAR's payout ratio is overstretched and this has not changed since. I am aware that due to its BDC status they need to pay out a certain amount for dividends to keep up the BDC status, however, I am still not convinced about SAR's long-term dividend safety. Although, it is worth noting that the management is still keen on paying dividends regularly and the company has all the necessary fundamentals to do so. I am not expecting any dividend cuts in the upcoming years due to the expanding NAV and because of the company's low debt profile combined with floating-rate investments. This means the broader economic cycle and the interest rate increases are in SAR's favor and could support the current payout ratio.

The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.

Final thoughts

I am certain that SAR can be a good choice to hedge inflation risk. The company could grow in many segments and the debt restructuring was a great management decision. When the interest rate will be above 1.5% the fixed-rate debt of SAR combined with its floating rate investments will bear fruit. The only part I am reluctant about is the dividend coverage but if the broader economic environment supports the company's growth, the payout ratio will decline despite any minor dividend increases. For investors looking for a longer-term position in a BDC, Saratoga can be the right choice.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in SAR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[firstaidkit]

This advise did not age well, like so many others. It was an orderly down turn, showing an apparent bottom, that turned into a liquidation run that is yet to abate. When it does there will be some very nice buying opportunities but until then I'm going to go find something else to do.

[Damon Judd]

@firstaidkit this comment did not age well. SAR is one of a handful of stocks that are up today after the latest CPI report. Seems to be holding up pretty well relative to just about anything else with a 9% yield.

[firstaidkit]

@Damon Judd I stand corrected sir. Still on my watch list and I await the next dip.

[Damon Judd]

@firstaidkit fair enough. Likely will dip again. Good luck!

[I like dividends]

Thanks for the article. You convinced me to sell. The dividend coverage is terrible. Are there revenues floating rate? I see you do not own any shares, so I guess you really do not really support your buy recommendation. Pretty weird.

[northharrow]

It is not clear to me why you state that SAR is yielding at 9.01% based on the price of $27.29 and a dividend of $2.12. Looks like 7.8%. Please explain.
I don't know why you picked SAR as an exceptional opportunity. You state the dividend may be overstretched which doesn't auger well. The payout ratio is one of the highest. It is a modest sized BDC with modest growth and nothing particular to recommend it more highly than at least 30 of the 50 BDCs which are out there.

[Robin Heiderscheit]

@northharrow I have been in and out since 2010. If you do a long run NAV return comparison, even risk adjusted, this is a top 10% BDC, period. They have a tremendous underwriting track record. They have doubled NAV while paying out a nice dividend. Only TSLX, MAIN, CWSC, HTGC (beneficiary of the second great tech bubble) and maybe a couple others are comparable on underwriting record. All the outperforming comps trade at hefty premiums.

I want to own it again but sold at $28 and probably won't be back in again until credit spreads blow out which I expect later this year as the Fed and markets overshoot on tightening and inflation begins to collapse.

[northharrow]

@Robin Heiderscheit A longer run of 15 years certainly doesn't impress. But of course you may choose where to start your run.

[Robin Heiderscheit]

@northharrow the first iteration of the company was called GSVC or something like that . . . anyway they ran it into the ground during the GFC . . . The current management team came over from the old Dillon Read in 2010 and that is the track record I am referring to . . . they had no involvement whatsoever prior to 2010 . . . portfoliovisualizer says the total return has been about 14% annually since they took over, which sounds about right to me

[Brucejfern]

SAR's cost of debt in JAN 4.50%. That is almost 200 basis points higher than better and best of breed BDC borrowings. We are at the end of an interest rate cycle and this is the time where bigger, better, and best of breed BDCs will outperform smaller BDCs like SAR because that 200 basis point borrowing difference is the difference between lending to top notch small businesses and being forced to lend to riskier businesses because you have a 200 basis point differential that can only be covered by taking on greater risks.

It means that better quality businesses will approach better and best of breed BDCs knowing they can get a lower rate than at an SAR.