Capital Southwest: 11% Yield, Rising Rates Boosting Earnings, Dividend Hike

Summary

CSWC yields 11.6% - Management made its 3rd straight quarterly dividend hike this week.
CSWC just reported big growth for quarter ending 12/31/22 - NII rose 63%.
Rising rates continue to boost CSWC's earnings.
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BDC concept is shown by businessman. — 8vFanI

Has your portfolio been fighting the Fed? It may have felt like that in 2022, with all sectors but Energy declining, and the S&P 500 losing -19%, as the Fed kept raising rates all year.

There's another side to the rate-rising coin, though, as some companies actually benefit from rising rates. Among them are BDCs, Business Development Companies, many of whom have high percentages of fixed rate debt, but also have higher percentages of floating rate investments.

Capital Southwest Corp. (NASDAQ:CSWC) is one of those companies with that timely mix: 96% of its credit portfolio has floating rates. Management estimates that CSWC gains an extra $.22 in annual NII for each 100 basis point increase in interest rates:

Company Profile:

CSWC is an internally managed BDC, specializing in credit and private equity and venture capital investments in lower and middle market companies with EBITDA between $3M and ~$20M; and leverage of 2X to 4X Debt/EBITDA through CSWC's debt position. Being internally managed is a plus for CSWC - it avoids those often expensive management and incentive fees that externally managed BDCs must deal with. Operating Expenses have improved from 4.9% in fiscal 2016, all the way down to 1.9%, as of 12/31/22.

83% of CSWC's investments are 1st Lien, up from 80.7% last quarter.

There's also 9.8% in Equity, 3.1% in 2nd Lien, and 4.1% in its I-45 JV.

Media & Marketing remained the largest industry exposure in the quarter ending 12/31/22, climbing 1% to 12%. Business Services slipped to 11%, while Healthcare Services remained at 10%. The 2 Consumer categories remained at 16%:

CSWC also manages a JV - its I-45 Senior Loan Fund ("I-45 SLF"), in partnership with Main Street Capital. As of 12/31/22, 94% of that portfolio's investments were in Senior Loans. There were ~$161M in debt investments in 39 companies, with an average issuer EBITDA of ~$82M, and a 6.3% LIBOR spread, the same as in the previous quarter.

The top 5 industries comprised 57% of this portfolio, led by Business Services at 14%, and Healthcare at 13%. The average investment size was 2.6% of the portfolio.

CSWC's overall portfolio companies increased from 78 to 81 in this latest quarter, with 1st Lien holdings climbing from 84.8% to 86.5%, and the weighted average company leverage decreasing from 4.1X to 3.6X:

Ratings:

CSWC's portfolio continues to look healthy, with ~95% of it in the top tiers of ratings. Current non-accruals had a fair value of $3.8M, representing 0.3% of the total investment portfolio.

Earnings:

CSWC's fiscal year ends on March 31st.

Its Fiscal Q3 earnings, (quarter ending 12/31/22) were robust, with total Investment Income rising 47% to $32.77M; Net Investment Income, NII, up 63%, to $19.43M; and NII/Share up 17.6%, to $.62, supported by spreads that were 50 to a 100 basis points wider than a year ago.

Fiscal Q1-3 earnings have also had strong growth, with NII up 51%, total investment income up 34%, and NII/Share up ~20%. CSWC has an ATM program, which it used to raise additional cash - the share count rose 34%.

Like many BDCs, CSWC's latest fiscal year (which ended 3/31/22) saw a big rebound from the previous, pandemic-challenged year.

However, CSWC's growth has accelerated even more over the past 3 quarters. Total Investment Income of $82M is already even with its full fiscal year total, while NII of $46M has already eclipsed the $42.7M earned in fiscal year ending 3/31/22:

New Business:

During the quarter ending 12/31/22, management originated $164M in new commitments, consisting of investments in 5 new portfolio companies totaling $122.4M and add-on commitments in 12 portfolio companies totaling $41.6M. CSWC received full prepayment on 1 debt investment totaling $11.5M and proceeds from the sale of one equity investment totaling $0.9M.

CSWC has a cumulative IRR of 14.6% on 67 portfolio company exits, generating $775.4M in proceeds since the launch of its credit strategy in January 2015.

Dividends:

Management just announced its 3rd straight quarterly dividend hike this week - they increased it from $.52 to $.53 and maintained the $.05 supplemental payout.

Things look good for more supplemental dividends in 2023:

"...it is our intent and expectation that Capital Southwest will continue to distribute quarterly supplemental dividends for the foreseeable future while base rates remain materially above long-term historical averages." (Fiscal Q3 call)

At its 2/1/23 $20.03 closing price, the total yield is 11.58%. Both dividends go ex-dividend on 3/14/23, with a 3/31/23 payout.

CSWC has one of the highest 5-year dividend growth rates in the BDC industry, at 19.53%:

Pre-Tax NII/ coverage for regular dividends was 1.08X during the 12 months ending 12/31/22. CSWC also paid $.20 in supplemental dividends in 2022, bringing the total dividend amount to $2.18. There was $1.58/share in realized earnings, bringing total earnings/share to $3.72, for a strong total dividend coverage figure of 1.71X.

There was $0.34/share in UNII, Undistributed NII/Share, as of 12/31/22:

CSWC has paid a total of $13.11/share in regular and supplemental dividends since 9/30/15:

Taxes:

CSWC's 2022 distributions were 100% ordinary dividends, as shown on their 1099-DIV form:

Profitability & Leverage:

ROA and ROE both rose a bit over the past 4 quarters, as did EBIT Margin - all 3 metrics remain well above BDC industry averages. Increased earnings pushed EBIT/Interest to 3.39X, while Debt/NAV was down considerably, to 1.09X. Both figures compare well to BDC industry averages.

Debt & Liquidity:

CSWC has no debt maturities until 2026, when $619M come due in Credit Facilities, Notes, and SBA Debentures.

As of December 31, 2022, Capital Southwest had ~$21.7M in unrestricted cash and money market balances; and $175M and undrawn capital commitments. It raised a total of $104.3M in gross equity proceeds during the quarter, included $58.3M raised through its equity ATM program, at a weighted average price of $17.99/share, which was 109% of the prevailing NAV/share.

Performance:

CSWC has outperformed the BDC industry, the Financial sector, and the S&P 500 by a wide margin so far in 2023 - it's up ~17%, vs. ~9% for the BDC industry, 7% for the Financial sector, and 7.4% for the S&P:

Analysts' Upgrades & Targets:

CSWC received an upgrade from Neutral to Buy, with a $20.00 price target, from B. Riley on 12/9/23. At its 2/1/23 $20.03 closing price, CSWC was ~even with the street's $20.00 lowest price target, and ~9% below the $22.00 average price target.

Valuations:

At its 2/1/23 $20.03 closing price, CSWC is priced at a 23% premium to its $16.25 NAV/Share, vs. a 3% BDC industry average premium to NAV.

While that sounds expensive, this current pricing is still below many of the premium to NAV valuations that CSWC had in 2021-2022, when its P/NAV was as high as 1.60-plus.

A more appropriate way of valuing it would be to look at its earnings multiple, Price/Net Investment Income per Share, or P/NII. With a P/NII of 9.36X, CSWC is actually undervalued vs. the broad industry average of 12.90X.

CSWC's base dividend yield of 10.58% is in line with the industry average, while its total yield of 11.58% is a bit above average.

However, CSWC's 19.53% 5-year dividend growth rate is another reason that it commands higher Price/NAV valuations than the BDC industry average.

Parting Thoughts:

With an underpriced earnings multiple, one of the highest dividend growth rates in its industry, a well-covered attractive dividend yield, and management's intent to keep paying supplemental dividends, we continue to rate CSWC a buy.

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This article was written by

Double Dividend Stocks

38.55K Followers

Robert Hauver, MBA, aka “Double Dividend Stocks” was VP of Finance for an industry-leading corporation for 18 years and has been investing for more than 30 years. He focuses on undercovered and undervalued income vehicles and he leads the investing group Hidden Dividend Stocks Plus.

With Hidden Dividend Stocks Plus he scours the world's markets to find solid income opportunities with dividend yields ranging from 5% to 10% or more, backed by strong earnings. Features include: a portfolio with up to 40 holdings at a time including links to associated articles, a dividend calendar, weekly research articles, exclusive ideas, and trade alerts. Learn More.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CSWC either through stock ownership, options, or other derivatives. 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.

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