Ares Capital: It’s Time To Be Patient (NASDAQ:ARCC)

Thesis

Ares Capital (NASDAQ:ARCC) has performed well since our previous update encouraging investors to ignore the pessimism and buy its panic selloff. Accordingly, ARCC formed its October lows (pre-earnings), helping it to rally more than 20% in price gains toward its recent November highs (post-Q3 earnings).

Relative to its 5Y and 10Y total return CAGR of 14% and 11.3%, respectively, we believe it’s reasonable to expect near-term consolidation. Moreover, coupled with near-term overbought momentum and more tentative price action, a potential pullback to digest its recent gains should be considered.

Notwithstanding, we believe Ares Capital remains well-positioned to ride the market volatility driven by the Fed’s record rate hikes. Furthermore, Areas has continued to benefit from its mainly floating-rate portfolio (73% as of Q3), driving its core earnings per share in Q3 above the previous consensus estimates.

However, it has also driven volatility in its net asset value (NAV) and impacted the weighted average interest coverage for its portfolio companies through Q3.

Still, management remains confident in the resilience of its portfolio companies and credit performance track record. As such, it didn’t expect a significant deterioration in the earnings potential for its portfolio companies if we don’t fall into a severe recession (which is not ARCC’s base case).

Our assessment suggests that ARCC remains cautiously configured with its valuation suggesting earnings growth normalization moving ahead. However, its TTM tangible book value (TBV) multiples have recovered to recent highs after the surge from its October lows. Hence, we view the market has likely reflected its core EPS accretion from the rate hikes accordingly while positioning for market volatility. Therefore, we view ARCC’s valuation as relatively well-balanced at the current levels.

Revising from Buy to Hold for now.

ARCC: Dividend Sustainability Should Not Be A Significant Challenge

Ares Capital highlighted the benefits from the Fed’s rate hikes, as it posted core EPS of $0.5 in FQ3, up 6.4% YoY and up 8.7% QoQ. Management also telegraphed confidence in the sustainability of its earnings power as it lifted its base quarterly dividends to $0.48 (from $0.43 previously). Coupled with its additional dividend of $0.03, investors are looking at $0.51 in total dividends from Q4 onwards.

Notably, management was confident in sustaining its dividend raise, despite the prospect of a slowdown in the Fed’s rate hike cadence. CEO Kipp DeVeer accentuated:

We obviously raise our dividend only when we feel that the core earnings can support it over the long haul. And I think, unless something really severe happens quickly, which is not what we would expect, I’ll just reinforce that we feel good about this higher level of earnings supporting the dividend. So it looks to say the company is just earning significantly more than that $0.48 dividend today, and we feel good about it being able to be supportable into the future for a while. (Ares Capital FQ3’22 earnings call)

We discussed in an October article why we think the S&P 500 (SP500) (SPX) had already bottomed. As a result, we are of the view that the market has reflected a mild-to-moderate recession (our base case), in line with management’s commentary.

While interest rates are expected to remain elevated in the near- to medium-term, we expect the Fed to move into data dependency mode from H2’23. Therefore, it should help lift investors’ confidence that we could potentially avoid significant damage from a severe recessionary scenario if rate hikes continued unabated.

As such, it should continue to provide a sizeable tailwind to Ares Capital’s earnings power while keeping spreads and market volatility in check, mitigating the impact on its portfolio value.

Also, Ares is one of the leading business development companies (BDC) with an enviable track record of dividends keeping up with its core EPS. Hence, we have confidence in management’s execution and capital allocation discipline in the sustainability of its dividend hike, despite challenging conditions.

Is ARCC Stock A Buy, Sell, Or Hold?

ARCC last traded at a TTM TBV multiple of 1.1x, above its 10Y average of 1x. Hence, it recovered remarkably from its dislocated levels in October.

ARCC’s NTM core earnings multiple of 9x is priced at a slight premium against its peers’ median of 8.6x (according to S&P Cap IQ data). We believe the premium is justified, given its market leadership in the BDC space. Hence, there’s no apparent valuation discount against the market to capitalize on.

ARCC’s price action suggests a sharp recovery from its October lows, with a pullback likely to follow.

Also, it was resisted by the 50-week moving average (blue line), which proved its mettle in August, and has continued to reject further buying advances from the current November highs.

Coupled with overbought momentum, we urge investors to be cautious at the current levels and wait for a retracement first.

Revising from Buy to Hold for now.