tamaya
FS KKR (NYSE:FSK) is one of the largest Business Development Companies (i.e., BDCs) and also boasts an investment grade balance sheet.
While it has a spotty track record, it recently closed a merger, helping to drive fresh synergies and unlock for shareholders via buybacks while the stock trades at a massive discount to NAV.
In this article, we will discuss three important takeaways from FSK’s Q2 results and provide our updated outlook on the stock.
#1. Underlying Earnings Power & Quality Improving
FSK has been busy improving its earnings power and quality since completing its merger a year ago. Management’s progress towards this end was evident in the Q2 report.
While adjusted net income per share declined sequentially from $0.72 to $0.67 and net asset value per share declined sequentially from $27.33 to $26.41, the underlying durable earnings power of the business actually improved during the quarter, as reflected by management increasing the base quarterly distribution from $0.60 to $0.61. This is due to several factors:
1. Interest rates are expected to continue rising, benefiting FSK’s net income, thanks to the fact that 87% of its debt investments have floating interest rate structures.
2. Management has effectively pruned legacy investments from all but 10% of its portfolio, meaning that ~90% of its investment portfolio is now comprised of investments originated either by KKR Credit or the FS/KKR advisor.
3. The portfolio’s structuring is also pretty conservative, with 71% of it invested in senior secured debt and an additional 22.4% of it invested in joint venture and asset-based finance investments which are “comprised predominantly of first lien loans or asset-based finance investments” making them quite defensive as well.
#2. Inferior Underwriting
That said, it was not all good news. As the headline numbers reflected, NAV per share declined sequentially. This was due primarily to the hefty dividend payout to shareholders during the quarter, spread widening, and market multiple contraction on equity investments.
However, subpar performance was also a factor for the declining NAV per share. During Q2, the percentage of investments on non-accrual status nearly doubled on a fair value basis, increasing from 1.5% at the end of Q1 to 2.9% at the end of Q2.
That said, the bright side is that of the 90% of the portfolio that has been originated by KKR, only 0.5% of them are on non-accrual on a fair value basis, so as the legacy assets continue to phase out, the underwriting performance should improve.
#3. Valuation Remains Compelling
Last, but not least, while the underwriting performance continues to lag some of FSK’s fellow investment grade BDCs, the valuation here remains compelling. While the likes of Main Street Capital (MAIN) and Ares Capital (ARCC) trade at meaningful premiums to NAV, FSK continues to trade at a massive 15.90% discount to NAV.
As a result, we are glad to see management continuing to buy back stock and reaffirm their commitment to continue doing so, as we believe this is an excellent way to unlock value for shareholders.
On top of that, the net debt to equity ratio as of quarter end was 1.15x, which is firmly in management’s target range. This provides a pretty optimal balance between juicing the return on equity and keeping risks from getting too high. Given that their weighted average effective interest rate (including non-usage fees) is 3.51% and their average investment yield is well over 9%, they are generating phenomenal spreads on their investments. Total available liquidity at the end of Q2 was $2.7 billion, giving them plenty of capacity to continue buying back shares and/or making growth investments opportunistically to continue unlocking value for shareholders.
Investor Takeaway
FSK continues to make incremental progress towards reshaping itself into a higher quality BDC as opposed to the one that serially underperformed the broader sector for years. Management has done a great job so far, and has the liquidity it needs to continue making incremental progress in the coming quarters by continuing to buy back shares, continuing to unload underperforming legacy investments and replace them with KKR originated investments, and ultimately continuing to boost the return on equity for the business. On top of that, its defensively-postured investment portfolio is also positioned to continue growing in earnings power in the coming months as interest rates are poised to continue rising over that period.
As FSK continues to make progress, we expect its discount to NAV to continue to dwindle, combining with the fat dividend yield to generate alpha for shareholders. We rate the stock as one of the most attractive Buys in the BDC space today and remain long with an eye towards adding on future dips.
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