Better BDC Buy After Q3: Ares Capital Or FS KKR? (NASDAQ:ARCC)

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Both Ares Capital Corp. (NASDAQ:ARCC) and FS KKR Capital (NYSE:FSK) are high yield business development companies (i.e., BDCs) that recently reported Q3 earnings. In this article, we will compare them side by side and offer our take on which one is a better buy at the moment.

Ares Capital Vs. FS KKR Capital – Q3 Results

ARCC reported excellent Q3 results. Earnings are shooting higher thanks to higher interest rates and stable underwriting performance. Core earnings per share increased 6.4% year-over-year while net investment income increased by a whopping 42.5% year-over-year from $0.40 to $0.57.

Thanks to the rapid growth in the income, management decided to declare the largest hike of its quarterly dividend in the company’s history, growing it by 11.6% sequentially and 17% year-over-year to $0.48. On top of that, ARCC will also be paying out a $0.03 special dividend as per its announcement back in February.

That said, rising interest rates and a softening economic outlook hurt the mark-to-market value of ARCC’s investments, dropping the NAV from $18.81 to $18.56.

FSK also reported solid Q3 results. Adjusted net income per share increased significantly sequentially from $0.67 to $$0.73 per share and the net asset value per share declined sequentially by 4.2% from $26.41 to $ 25.20 due to declining mark-to-market valuations of the investment portfolio. The strong growth in earnings resulted in management increasing their supplemental distribution by $0.01, resulting in a total Q4 payout of $0.68 per share.

Ares Capital Vs. FS KKR Capital – Balance Sheet

Both boast investment grade credit ratings of Baa3 (Stable) or equivalent with significant liquidity.

ARCC’s debt-to-equity ratio of 1.27x was flat sequentially and the balance sheet continues to have significant flexibility, with $4.5 billion of total available liquidity and only $750 million in debt obligations maturing in the next 16 months.

Meanwhile, FSK’s balance sheet remained very flexible with total liquidity of approximately $2.75 billion and a net debt to equity ratio of 1.19x.

While both appear to be in solid shape, we give ARCC the slight edge here due to its superior liquidity and greater exposure to fixed rate debt in a rising interest rate environment.

Ares Capital Vs. FS KKR Capital – Investment Portfolio

ARCC’s investment portfolio health remained in sound shape despite the deteriorating economic environment. The non-accrual rate at cost was 1.6% – flat compared to last quarter – and continues to be meaningfully below ARCC’s 10-year average of 2.5%. During the quarter, they added two companies to non-accrual and removed three from the list. As management stated on the earnings call:

We believe our portfolio continues to deliver healthy overall performance and is well positioned to weather future market challenges. Two measures of portfolio credit quality, our nonaccrual rate at cost and the weighted average portfolio grade both remained static quarter-over-quarter and show stronger metrics than our historical averages. The stability in these credit metrics is supported by a healthy level of weighted average EBITDA growth of 13% year-over-year.

ARCC also remains well-positioned to benefit from further increases in interest rates. As it stated on the earnings call:

we remain well positioned to continue benefiting from a rising rate environment. Given 73% of our total portfolio at fair value was in floating rate investments as of September 30, 2022, we expect continued increases in short-term rates to have a positive impact on the net interest earnings performance of the company. A 100-basis point increase in market rates from September 30 could add about $0.07 per share quarterly or approximately $0.27 per share annually.

That said, management did highlight the fact that he expects credit performance to decline – though not in an extreme manner – moving forward, stating:

my expectation would be that defaults will increase. I’ve said this in other settings, defaults will increase broadly in the corporate credit markets through the back part of this year and into next year. But just as a reminder and I did say this in the prepared remarks, the credit quality today is better than our historical averages. When you look at both the non-accrual rates and the portfolio grades, would I expect that to get a little bit worse? If I had to guess, I’d say probably yes. But do we view it as something that is extraordinary and not manageable? The answer of that is we don’t.

FSK’s underwriting performance remained solid during the period as three investments were removed from non-accrual status and non-accruals totaled 2.5% on a fair value basis, down 40 basis points sequentially. On a cost basis, nonaccruals were at 4.9%. Most importantly, none of the nonaccruals were due to assets originated by the FS/KKR Advisor since April 2018, reflecting very well on the underwriting skill of the current manager. Additionally, the median interest coverage ratio was 2.3x, reflecting satisfactory positioning for its counterparties to weather further interest rate hikes, especially considering that most of FSK’s counterparties have revolving lines of credit to provide them with additional liquidity if needed.

That said, management also recognized that the environment is becoming increasingly challenging for its counterparties and that it could begin to pressure the fundamental performance of its investment portfolio and is also causing a slowing in growth of the portfolio:

Certain companies in our portfolio have been meaningfully impacted by a combination of inflation, supply chain issues and the increasing interest rate environment, which contributed to a portion of our portfolio depreciation during the quarter. Given the macroeconomic environment still includes many uncertainties, we are exercising caution with respect to new originations.

The investment portfolio remains fairly conservatively positioned with a focus on more defensive sectors and 61.9% exposure to first lien loans and 70.5% senior secured debt along with a joint venture representing 9.3% of the fair value of the portfolio and asset-based finance investments representing 11.6%, equating to an additional 20.9%, which is comprised predominantly of first lien loans or secured asset-based finance investments.

Moving forward, FSK should continue to benefit from rising interest rates. As management pointed out on the earnings call:

The recent increases in interest rates have positively impacted our net investment income. And as Brian mentioned, we are well positioned to continue to benefit from the Fed’s most recent action as 89% of our debt investments or floating rate. From a starting point of September 30, a 100-basis point move and higher and short-term rates ultimately will increase our net investment income by approximately $0.25 per share per year, which equates to approximately $0.06 per share per quarter.

It is also important to note that Q4 2022 is the final quarter with the incentive fee waiver by the manager. This will result in a ~$0.21 per share – or ~0.8% of NAV – annualized headwind for the company, which is not a deal breaker, but will reduce the amount of cash available for supplemental distributions moving forward. The base distribution should be pretty sustainable moving forward, however, as FSK’s spillback level currently approximates 2 quarters’ worth of dividends.

Overall, we give the edge to ARCC here as its non-accruals on cost are considerably lower than FSK’s.

Ares Capital Vs. FS KKR Capital – Track Record

ARCC has a hands-down better track record than FSK, as it has crushed FSK in the period since both have been public:

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Data by YCharts

However, it is important to note that FSK recently completed a merger that led to improved efficiencies and synergies, improved diversification, and also set off a buyback program. As a result, we expect FSK’s performance to improve moving forward.

Ares Capital Stock Vs. FS KKR Capital Stock – Valuation

FSK’s valuation is considerably cheaper than ARCC’s across a variety of metrics on both a relative and historical basis:

Valuation Metric FSK ARCC
P/E 6.47x 8.65x
P/E (5-Year Average) 7.93x 10.18x
Dividend Yield 13.89% 10.36%
Dividend Yield (5-Year Average) 12.74% 9.37%
P/NAV 0.74x 1.03x
P/NAV (5-Year Average) 0.76x 1.02x

While ARCC does have a slightly stronger balance sheet, portfolio, and track record, FSK’s considerably deeper value appears to more than compensate for those factors.

Investor Takeaway

Overall, we were really satisfied with ARCC’s quarter and are glad to hear that their underwriting is handling the current stress well. While they are making some amendments to help companies whose interest coverage ratios are approaching a stress zone, the amount is pretty normalized. Meanwhile, management said that they believe their current quarterly dividend is sustainable for the long-haul, even if interest rates begin to decline somewhat. We remain happily long here and are especially excited about the annualized regular dividend yield of 10.36%. You can read our full investment thesis on ARCC here.

Meanwhile, we remain happy with FSK’s risk-reward profile. The dividend payout is very attractive and the discount to NAV is steep, while the balance sheet is solid, and the underwriting performance continues to improve. While it is definitely not the best fundamentally performing BDC in the sector, its deep discount to NAV makes it a compellingly attractive investment opportunity. You can read our full investment thesis on FSK here.

Ultimately, this comes down to a choice between value and quality. ARCC is one of the highest quality BDCs in the market today and appears to be trading at a fair price. Meanwhile, FSK – though slightly inferior to ARCC across virtually every metric – is making considerable progress towards optimizing its balance sheet and investment portfolio. Furthermore, FSK trades at a much cheaper valuation than ARCC. As a result, we give the edge to FSK here, rating it a Strong Buy. That said, we are also long ARCC given its proven track record, strong current fundamentals, and attractive and safe dividend.

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