Ares Capital: 9% yielding industry leader looks undervalued (NASDAQ:ARCC)


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If you are looking to invest in a leading business development company known as BDC, you may want to check out Ares Capital Corp. (ARCC).

Like most BDCs we’ve covered our itemsARCC has a well-hedged high dividend yield.

ARCC is one of the largest BDCs – it’s a US direct lender with a portfolio of $20 billion and a long track record – it has invested $77 billion since its IPO in 2004.

Profile:

ARCC specializes in acquisitions, recapitalizations, mezzanine debt, restructurings, rescue financings and leveraged buyouts of middle market companies. He also does growth capital and general refinancing. He prefers to invest in companies active in basic and growth manufacturing, business services, consumer products, healthcare products and services, and information technology services.

ARCC is externally managed by Ares Management, which manages over $200 billion in global assets and is active in credit, private equity, real estate and strategic initiatives.

ARES

ARCC website

A major change in financial markets that has benefited ARCC and other BDCs in recent years has been the exit of traditional banks from direct lending to middle-market businesses.

banks continue to withdraw from direct landing in the middle market

ARCC website

ARCC has seen its investments reviewed increase 4x since 2015. Management has strict investment guidelines – ARCC only supports around 5% of the investments it reviews.

ARCC Total amount of investments reviewed

ARCC website

This led to a very low loss rate of less than 10 basis points in its 1st Lien category and less than 20 basis points in its 2nd Lien & Subordinated program. As of 12/31/21, outstanding loans represent 0.8% of total investments at amortized cost (or 0.5% at fair value).

The ARCC credit experience since its creation

ARCC website

Assets:

75% of ARCC’s loans are Senior Loans, with 1st Lien at 47%, 2nd Lien at 23% and 5% in its Senior Direct Lending segment. He also owns 4% senior subordinated loans, 8% preferred stock and 13% stock.

ARCC portfolio by asset class

ARCC website

Software and services remained their top sector exposure, rising to 22% in Q4 21 from 19% in Q3 21; followed by health, 11%, and business and professional services, 9%. These 3 industries represented 42% of ARCC’s portfolio, as of 12/31/21. ; and less than 2% exposure to Oil & Gas, and Media & Entertainment.

ARCC portfolio by industry

ARCC website

ARCC’s largest exposure was 1.3%, versus an average of 4.8% for BDC’s peers, as of 12/31/21, while its top 10 positions made up about 11% of its portfolio, versus an average of 25.7% for peers.

ARCC's Greatest Holdings

ARCC website

Earnings:

The fourth quarter of 2021 saw strong revenue growth, with total investment income up 20%. NII increased 5.68%, while core EPS increased 7.4%. Realized gains, which are traditionally lumpy on a quarterly basis, went from a loss of -$183 million to a gain of $16 million in the quarter, while unrealized gains fell to $124 million. dollars, compared to $332 million in Q4 ’20. The total number of shares increased by 9.46%, resulting in a 3.7% decline in NII/share during the quarter.

Total investment income for the year 2021 increased by 20%, while the NII fell by -6.7%. However, core EPS increased by 16% in 2021. NII/Share fell by 11.23%, while NAV/Share increased by 11.73%.

The number of shares increased by approximately 5% in 2021 and, in January 2022, the ARCC made another public offering of 10,000,000 ordinary shares, which represents approximately 2%.

ARCC Finances

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New engagements and releases:

ARCC made new investment commitments of approximately $5.9 billion in Q4 2021, of which approximately $5 billion was funded. 64% were senior secured loans, 17% senior secured loans, 2% subordinated certificates, 2% senior subordinated loans, 4% preferred shares and 11% other shares. 83% of these commitments were in variable rate debt securities, of which 95% contained interest rate floors.

New investment commitments included 28 new portfolio companies, 55 existing portfolio companies and 3 additional portfolio companies through the Senior Direct Lending Program, a joint venture with Varagon Capital Partners and its clients, to fund senior secured loans first-class.

As of 12/31/21, 192 separate private equity sponsors were represented in Ares Capital’s portfolio. Having so many sponsors involved has been a boon during the pandemic, as sponsors typically offer extra help to struggling businesses, in an effort to not lose their investments.

ARCC released approximately $3.9 billion in investment commitments in the fourth quarter of 2021.

Dividends:

Management increased the quarterly dividend from $0.41 to $0.42 in Q1 2022 and also declared 4 additional quarterly dividends of $0.30 for 2022:

ARCC additional dividends

ARCC website

The ARCC becomes ex-dividend on 3/14/22, so you may get a slight drop if you’re looking to buy new shares. At its 3/10/22 closing price of $20.49, ARCC returned 8.78%, including the additional dividend of $0.03/share.

ARCC Dividend Schedule

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NII/Dividend coverage was 1.27X in Q4 21, the highest coverage in 2021, thanks to NII jumping to $0.52/share. NII coverage averaged 1.01X for the full year 2021. Core EPS coverage was 1.41X in Q4 2021, again well above Q1-3 21, and averaged 1.24X in 2021:

ARCC dividend coverage

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ARCC has a long history of positive dividend coverage through Core EPS, which equals “the net increase (decrease) in equity resulting from transactions less professional fees and other costs related to the acquisition of American Capital, the repayment expenses of Ares Capital Management LLC, net realized and unrealized gains and losses, all capital gains incentive expenses attributable to such net realized and unrealized gains and losses and any income taxes relating to such gains and net realized losses.” (ARCC website)

ARCC dividend history

ARCC website

Profitability and leverage:

ROA and ROE both fell in 2021, as did ARCC’s EBIT margin. Both ROA and ROE were below BDC’s industry averages, while Debt/NAV increased slightly to 1.24X, slightly above BDC’s average of 1.14.

However, higher leverage is not necessarily a bad trait in the BDC industry, as higher levels of leverage are used to create more revenue – the trick is for management not to being overloaded with too much leverage. Given ARCC’s seasoned management, that seems unlikely to happen to this company.

ARCC ROE

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ARCC’s Asset/Liability ratio remained stable in 2021, while its EBIT/Interest ratio fell from 3.5X to 2.99X:

ARCC debt to assets

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Debt & Liquidity:

As of December 31, 2021, Ares Capital had $0.4 billion in cash and cash equivalents and $11.1 billion in total principal of outstanding debt ($11.0 billion at book value). Subject to the borrowing base and other restrictions, Ares Capital had approximately $4.1 billion available for additional borrowings under its existing credit facilities as of December 31, 2021.

The next debt maturity is not until 2023, when $750 million of unsecured notes mature:

CCRA debt

ARCC website

ARCC’s debt is rated investment grade by Fitch, Moody’s and S&P Global:

ARCC Investment Notes

ARCC website

Estimates:

At its closing price of $20.49 on 3/10/22, ARCC was selling at an 8% premium to its 12/21/21 NAV/share of $18.96, compared to the BDC industry average premium of 13%. Its price/NII per share of 12.34X is cheaper than the industry average of 14.50X. Its P/Sales of 5X is also below the 6X industry average, while its dividend yield of 8.78% is a bit better than average.

ARCC Prices/Booking

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Like other BDCs, ARCC sold at a discount to book value during the financial crash of 2008 and the Covid crash of 2020, although it rebounded much faster in 2020. In general, investors who were able to buy it at ~1X book value has done well over the past few years, especially in light of ARCC’s dividends.

Ares Capital Price to Book value

Y-Charts

Performance:

The ARCC was roughly in line with the 1-year performance of the BDC industry and the broader financial services sector over the past year, while slightly lagging the S&P. It has held up better than the S&P and the financials sector so far in 2022, but has fallen more than the S&P over the past month.

ARCC performance

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A closer look, however, shows that ARCC has achieved much higher annualized returns than its BDC peers over the past 3 and 5 years:

ARCC Annualized Returns

ARCC website

Analyst price targets:

At $20.49, the ARCC is 6.86% below analysts’ low price target of $22.00 and 11.6% below the mid-price target of 23.18 $. Hovde Group launched a hedge on ARCC this week, with a price target of $22.50 and a market performance rating.

ARCC Price Targets

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Parting Thoughts:

Here we have an industry leader selling at a slightly lower premium of around 8% to its net asset value compared to the industry average of 13%, and at a lower price/NII. If it drops on Monday, 3/14/22, its ex-dividend date, by the dividend amount of $0.45, that would give you a lower premium of about 5.7% and a return on cost of about 9 %.

Of course, with the current market volatility, we could see further price cuts any day that would allow you to buy ARCC at an even smaller premium.

All charts are provided by Hidden Dividend Stocks Plus unless otherwise stated.

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