Ares Capital’s NAV, Valuation, And Dividend Vs. 13 BDC Peers – Part 1 (NASDAQ:ARCC) (2024)

Focus of Article

The focus of PART 1 of this article is to analyze Ares Capital Corp.’s (NASDAQ:ARCC) recent results and compare a handful of the company’s metrics to 13 business development company (“BDC”) peers. This analysis will show past and current data with supporting documentation within two detailed tables. Table 1 will compare ARCC’s recent net asset value (“NAV”) economic return (loss), net investment income (“NII”), stock price to annualized NII ratio, and percentage of total investment income attributable to capitalized payment-in-kind (“PIK”)/deferred income to the 13 BDC peers. Table 1 will also provide a premium (discount) to estimated CURRENT NAV analysis using stock prices as of 5/27/2024. Table 2 will compare ARCC’s investment portfolio (including several additional metrics) as of 12/31/2023 and 3/31/2024 to the 13 BDC peers.

I am writing this two-part article due to the continued requests that such an analysis be specifically performed on ARCC and some of the company’s BDC peers at periodic intervals. These BDC peers include Capital Southwest Corp. (CSWC), FS KKR Capital Corp. (FSK), Gladstone Investment Corp. (GAIN), Golub Capital BDC Inc. (GBDC), Main Street Capital Corp. (MAIN), MidCap Financial Investment Corp. (MFIC), Oaktree Specialty Lending Corp. (OCSL), Blue Owl Capital Corp. (OBDC), PennantPark Floating Rate Capital Ltd. (PFLT), SLR Investment Corp. (SLRC), BlackRock (BLK) TCP Capital Corp. (TCPC), TriplePoint Venture Growth BDC Corp. (TPVG), and Sixth Street Specialty Lending Corp. (TSLX).

I have decided to drop coverage of Prospect Capital Corp. (PSEC) due to continued operational underperformance versus a majority of sector peers (amongst other factors). I am planning to pick up coverage of a new BDC stock starting on 7/1/2024 (subscribers will help decide which stock to add).

Understanding the characteristics of a company’s investment portfolio and operating performance can shed some light on which companies are overvalued or undervalued strictly per a “numbers” analysis. This is not the only data that should be examined to initiate a position within a particular stock/sector. However, I believe this analysis would be a good “starting-point” to begin a discussion on the topic. My BUY, SELL, or HOLD recommendation and current price target for ARCC will be in the “Conclusions Drawn” section of the article. This includes providing a list of the BDC stocks I currently believe are undervalued (a buy recommendation), overvalued (a sell recommendation), or appropriately valued (a hold recommendation).

NAV, Economic Return (Loss), Current Premium (Discount) to NAV, and NII Analysis - Overview

Let us start this analysis by getting accustomed to the information provided in Table 1 below. This will be beneficial when explaining how ARCC compares to the company’s 13 BDC peers regarding the metrics stated above. Due to the fact several BDC peers listed in Table 1 have a different fiscal year-end, all quarterly results are based on a calendar year-end. For instance, all metrics below are stated “Q1 2024” even though this does not correspond to every company’s fiscal year-end. Readers should be aware as such when the analysis is presented below.

Table 1 – NAV, Economic Return (Loss), Current Premium (Discount) to NAV, NII, and Capitalized PIK Analysis

(Source: Table created by me, obtaining historical stock prices from NASDAQ and each company’s NAV per share figures from the SEC’s EDGAR Database)

Table 1 above provides the following information on ARCC and the 13 BDC peers (see each corresponding column): 1) NAV per share at the end of calendar Q4 2023; 2) NAV per share at the end of calendar Q1 2024; 3) NAV per share change during calendar Q1 2024 (percentage); 4) economic return (loss) (change in NAV and accrued dividend) during calendar Q1 2024 (percentage); 5) economic return (loss) during the trailing 12-months (percentage); 6) my estimated CURRENT NAV per share (NAV as of 5/27/2024); 7) stock price as of 5/27/2024; 8) 5/27/2024 premium (discount) to my estimated CURRENT NAV (percentage); 9) NII per share during calendar Q1 2024; 10) NII per share change versus the prior quarter; 11) NII per share change versus calendar Q1 2023; 12) 5/27/2024 stock price to annualized NII ratio; and 13) percentage of total investment income attributable to capitalized PIK (deferred) income during calendar Q1 2024 (percentage).

Now that an overview has been provided, let us start the comparative analysis.

Analysis of ARCC

Using Table 1 above as a reference, ARCC had a NAV of $19.24 per share at the end of calendar Q4 2023. ARCC had a NAV of $19.53 per share at the end of calendar Q1 2024. This calculates to a quarterly NAV increase of $0.29 per share or 1.51%. When including ARCC’s quarterly dividend of $0.48 per share and no special periodic dividend, the company had an economic return (change in NAV and accrued dividend) of $0.77 per share or 4.00% for calendar Q1 2024. It should also be noted ARCC had a trailing 12- and 24-month economic return of 16.29% and 22.70%, respectively. Both percentages were above the covered peer average.

ARCC’s performance during the past four quarters was mainly attributable to the following three factors: 1) modest net underpayment of dividends when compared to the company’s NII/core earnings; 2) minor - modest net realized losses within a handful of exited portfolio companies; and 3) minor - notable net unrealized appreciation within a majority of the company’s active investment portfolio. This is a good transition to the next topic of discussion, an analysis of ARCC’s investment portfolio (including several additional metrics) as of 12/31/2023 and 3/31/2024. To begin this analysis, Table 2 is provided below.

Tables 2a + 2b – Investment Portfolio Composition Analysis (Including Several Additional Metrics; 3/31/2024 Versus 12/31/2023)

(Source: Tables created by me, directly obtaining some figures/percentages from the SEC’s EDGAR Database [link provided below Table 1]. All remaining figures/percentages were calculated using data obtained within the SEC’s EDGAR Database)

Using Tables 2a and 2b above as a reference, ARCC had 46% and 14% of the company’s investment portfolio in senior secured first- and second-lien loans as of 3/31/2024, respectively. As such, these types of loans comprised the majority of ARCC’s investment portfolio. When compared to the prior quarter, ARCC’s percentage of senior secured first- and second-lien loans increased 2% and decreased (3%), respectively. ARCC also had 11%, 0%, and 29% of the company’s investment portfolio in subordinated debt (unsecured loans), collateralized loan obligations (“CLO”)/credit-linked notes (“CLN”) (structured securitizations) + other, and equity/warrants, respectively. When compared to the prior quarter, ARCC’s percentage of subordinated debt (unsecured loans), CLO/CLN (structured securitizations) + other, and equity/warrants increased 1%, remained unchanged, and remained unchanged, respectively. As such, there was not a notable shift in investment portfolio composition during calendar Q1 2024.

I would also point out while ARCC’s proportion of second-lien loans and subordinated debt are high when compared to the company’s 13 BDC peers, the vast majority of underlying portfolio companies are classified as “middle market” (“MM”) or “upper middle market” (“UMM”) investments. Simply put, ARCC typically invests in more “established” companies with higher earnings before interest, taxes, depreciation, and amortization (“EBITDA”) which inherently lowers overall credit risk versus companies classified as “lower middle market” (“LMM”) investments. While, yes, LMM investments have the potential reward of notable capital appreciation in the long-term (higher equity multiples over time), these portfolio companies also have inherently higher credit risk (including throughout the entire credit hierarchy). So, a bit of a “give and take” with this specific characteristic/comparison; especially when recessionary risk is elevated/rises.

As of 3/31/2024, ARCC’s investment portfolio had a “fair market value (“FMV”) versus cost” ratio of 1.0140x. When compared to the 13 other BDC peers within this analysis, this ratio was slightly above the mean of 0.9997x (a slightly positive catalyst/trend). When compared to a ratio of 1.0091x as of 12/31/2023, ARCC’s ratio slightly increased during calendar Q1 2024 which was mainly due to the fact ARCC, like most BDC peers, generally experienced slightly tighter quarterly credit spreads; partially offset by continued heightened credit risk within a handful of portfolio companies. A more detailed “breakdown” of ARCC’s quarterly performance was recently provided to our Investing Group subscribers via a quarterly earnings chat note/assessment article.

ARCC had 1.7% and 0.7% of the company’s investment portfolio on “non-accrual” status as of 3/31/2024; based on its amortized cost basis and FMV, respectively. When compared to the 13 BDC peers as of 3/31/2024, ARCC’s amortized cost and FMV non-accrual percentage were slightly below the mean of 3.2% and 1.9%, respectively (a slightly positive catalyst/trend).

Since the company’s initial public offering (“IPO”) in 2004, ARCC’s investment portfolio as of 3/31/2024 has generated a cumulative realized loss of ($0.36) per share (when based on a per share count as of 3/31/2024). ARCC’s cumulative realized loss figure was modestly more attractive when compared to the mean loss of ($1.27) per share (a positive catalyst/trend). I believe calculating a BDC’s cumulative realized gain (loss) per share amount provides an extremely useful metric when analyzing the long-term performance of management’s underwriting abilities, due diligence, expertise, and operational performance. This metric provides direct evidence ARCC’s management team has, regarding a majority of instances, continued to find attractive debt/equity investments over a long period of time which, more times than not, have ultimately delivered attractive risk-adjusted returns.

As of 3/31/2024, 1.85% of ARCC’s portfolio had debt and equity investments within the oil and gas sector (based on FMV; including certain investments in the energy sector which had “oil and gas” characteristics and/or services closely linked to the sector). When compared to the 13 other BDC peers within this analysis, ARCC’s oil and gas exposure was very slightly above the mean of 1.46%. When compared to the prior quarter, ARCC’s exposure to the oil and gas sector very slightly decreased. Even though larger oil and gas companies benefited during 2022 – early 2023 from a net increase to commodity prices (tied to inflation and the ongoing Russia/Ukraine conflict; though most sector prices have partially retraced during late 2023 - early 2024), I would point out smaller/private oil and gas companies are still not “out of the woods” yet (still high-cost outlays making breakeven prices higher). This could be a short- or long-term event dependent upon many unknown geopolitical/macroeconomic variables. As such, I would remain a bit cautious considering the ramifications of this specific sector regarding high-yield/speculative-grade credit. I believe ARCC’s continued low percentage attributed to oil and gas companies is a positive catalyst/trend.

Once again using Table 1 as a reference, ARCC reported NII of $0.550 per share during calendar Q1 2024. Providing a more “specialized”/useful metric, ARCC reported core earnings of $0.592 per share during calendar Q1 2024. I prefer to track/utilize ARCC’s core earnings metric as opposed to NII (more indicative of net investment company taxable income [ICTI]). When comparing each company’s stock price as of 5/27/2024 to its annualized NII, ARCC had the third highest ratio at 9.71x. That said, ARCC’s annualized NII ratio was very close to the 13-peer ratio of 9.67x as of 5/27/2024 (a neutral factor/trend). When based on core earnings, ARCC’s ratio comes down to 8.66x (just something to be mindful of as this would be the fifth lowest). Historically speaking, ARCC’s price-to-earnings ratio as of 5/27/2024 was still attractive/low (a positive catalyst/trend).

During calendar Q1 2024, 6.85% of ARCC’s total investment income was attributable to capitalized PIK/deferred income which was an increase of 0.82% when compared to the prior quarter. As such, a very slight increase (a slightly negative catalyst/trend). When compared to the 13 other BDC peers within this analysis, this was slightly (at or great than 1.0% but less than 2.5%) above the mean of 5.83%. I believe it is never a positive catalyst/trend when a BDC has any portion of its accrued income classified as being capitalized/deferred. Simply put, under GAAP, capitalized PIK income is revenue that is currently being “booked” but has not actually been received in cash yet (deferred). In a majority of cases, capitalized PIK income is paid in cash at the maturity of that particular loan/when a sale occurs. However, in my experience, more times than not capitalized PIK income is a contractual amendment regarding a specific portfolio company who is, at the time, having operational difficulties (which increases the probably of the eventual inability of paying its loan obligations). This is especially the case when a specific debt investment had no PIK-attached feature at the origination of said loan but is currently accruing 100% capitalized PIK income.

Simply put, in a majority of cases, it is a “slick” strategy of continuing to record accrued interest income only to write-off this capitalized interest income at a later date; usually at loan maturity by classifying that “lost deferred interest” as a reduction in the debt investment’s proceeds (a realized loss) as opposed to lowering previously accrued income by the accumulated capitalized PIK balance. I am not stating this occurs all the time but certain BDC peers tend to utilize this “phantom income” strategy regularly. In particular, PSEC has been prone to this strategy to a greater degree over the years versus all the other BDC peers within this analysis which was pointed out for years (and one of the reasons I am dropping that BDC). As such, it could be the case capitalized PIK income is never “completely” received in cash upon maturity/when a sale occurs. In my professional opinion, if a BDC has a large/above average portion of its investment income classified/accrued as capitalized PIK income, it should be seen as a potential concern regarding future performance/credit quality. In the end, one really just has to go “case-by-case” to determine the overall “viability” of a BDC actually eventually receiving this capitalized PIK/deferred income in the future. Something I continually monitor/track.

As of 5/27/2024, ARCC’s stock price traded at $21.35 per share. When calculated, ARCC’s stock price was trading at a premium to my estimated CURRENT NAV (NAV as of 5/27/2024; $19.60 per share) of $1.75 per share or 8.93%. This was slightly more attractive than the 13-BDC average of a premium of 10.17% (a slightly positive factor/trend). I continue to believe ARCC should trade at a modest-notable premium to the company’s CURRENT NAV. As such, based on my proven valuation methodology over various interest rate/economic cycles, ARCC continues to be one of a handful of BDC peers that is appropriately valuedin my professional opinion.

Comparison of ARCC’s NAV, Economic Return, Valuation, NII, and Other Metrics to 13 BDC Peers in Ranking Order

Conclusions Drawn (PART 1):

PART 1 of this article has analyzed ARCC and 13 other BDC peers with regards to the following metrics: 1) trailing 12-month economic return (loss) (good indicator of recent overall performance); 2) percentage of investments on non-accrual status as of 3/31/2024 (good indicator of overall portfolio health/credit risk); 3) cumulative gain (loss) per share as of 3/31/2024 (great indicator of long-term performance); 4) current premium (discount) to my estimated CURRENT NAV per share (NAV as of 5/27/2024) (very good indicator of overall valuation); 5) current stock price to annualized NII ratio (good indicator of overall valuation); and 6) percentage of total investment income attributable to capitalized PIK (deferred) income (good indicator of overall portfolio health/credit risk).

When compared to the 13 other BDC peers within this analysis, I believe ARCC continues to outperform a majority of the company’s BDC peers I currently cover. This includes, but is not limited to, ARCC’s prior growing/recent fairly consistent core earnings per share, a very slightly above average FMV versus cost ratio, a slightly below average percentage of investments on non-accrual status as of 3/31/2024, a modestly more attractive cumulative realized gain (loss) per share amount as of 3/31/2024, a very low exposure to the oil and gas sector (including certain investments in the energy sector which had oil and gas characteristics and/or services closely linked to the sector), and an above average trailing 12-month economic return percentage (all positive catalysts/trends).

That said, to remain non-bias, this article also highlighted ARCC had a near average stock price to annualized NII/core earnings ratio and a very slightly above average capitalized PIK income percentage (all neutral/negative factors/trends). In my opinion, ARCC’s PIK percentage continues to be the company’s biggest negative factor/trend (although there was a slight net decrease over the past combined several quarters).

Looking back,I previously correctly identified the high-very high probability of multiple ARCC dividend increases and/or special periodic dividends during late 2021-2022.This was mainly due to the U.S. London Interbank Offered Rate (LIBOR)/Standard Overnight Financing Rate (“SOFR”)/PRIME very quickly moving past all floors on the asset side of the balance sheet, along with refinancing outstanding borrowings with longer-term, lower cost debt on the liability side of the balance sheet, during 2020 - 2021.

That said, to remain non-bias, during 2024-2025 one has to continue to monitor the weighted average annualized yield on new loan originations versus exiting debt investments as there remains a pretty good “lag” in this specific metric. Something I continually track. In addition, I believe the majority of sector earnings peaked during late 2023 – early 2024 (very recently plateaued). The rapid NII growth that sector peers experienced during 2022 - 2023 will simply not occur during 2024. As the FOMC eventually likely begins to reduce the Federal Funds Rate later this year, sector earnings will GRADUALLY decrease over time. The severity of decreases will vary peer-to-peer (which I continuously project/model). This notion is already embedded in all price targets. Furthermore, credit risk will almost certainly continue to rise (albeit mildly) throughout the sector during 2024.

That said, I continue to believe ARCC is better positioned to weather an eventual minor-modest recession when compared to most sector peers (as highlighted in the analysis above).In addition, ARCC’s “cushion” to maintain the company’s previously increased quarterly dividend per share rate of $0.48 per share remains better (in most cases much better) than most peers.

My BUY, SELL, or HOLD Recommendation:

From the analysis provided above, including additional factors not discussed within this article (additional metrics covered in PART 2), I currently rate ARCC as a SELL when I believe the company’s stock price is trading at or greater than a 15% premium to my projected CURRENT NAV (NAV as of 5/27/2024; $19.60 per share), a HOLD when trading at greater than a 5% premium but less than a 15% premium to my projected CURRENT NAV, and a BUY when trading at or less than a 5% premium to my projected CURRENT NAV.

Therefore, with a closing price as of 5/27/2024 of $21.35 per share, I currently rate ARCC as APPROPRIATELY VALUED from a stock price perspective.

As such, I currently believe ARCC is a HOLD recommendation.

My current price target for ARCC is approximately $22.55 per share.This is currently the price where my recommendation would change to a SELL. The current price where my HOLD recommendation would change to a BUY is approximately $20.60 per share. Put another way, the following are my CURRENT BUY, SELL, or HOLD per share recommendation ranges for ARCC (our Investing Group subscribers get this type of data on all 15 BDC stocks I currently cover on a weekly basis):

$22.55 per share or above = SELL (Overvalued)

$20.61 - $22.54 per share = HOLD (Appropriately Valued)

$18.61 - $20.60 per share = BUY (Undervalued)

$18.60 per share or below = STRONG BUY (Notably Undervalued)

BDC Sector Recommendations as of 5/27/2024

Table 9 – Past and Current BDC Recommendations

(Source: Table created by me, including all past and present recommendations based on data obtained from the SEC’s EDGAR Database [link provided below Table 1a])

Table 9 above provides the following information on ARCC and the 13 BDC peers (see each corresponding column): 1) 2/21/2020 BUY, SELL, or HOLD recommendation (pre COVID-19 sell-off); 2) 3/31/2020 BUY, SELL, or HOLD recommendation (pre COVID-19 rally); and 3) 5/27/2024 BUY, SELL, or HOLD recommendation range, relative to my estimated CURRENT NAV.

Using Table 9 above as a reference, I now have 0 BDCs rated as a NOTABLY UNDERVALUED (STRONG BUY), one rated as UNDERVALUED (BUY), six rated as a APPROPRIATELY VALUED (HOLD), four rated as a SELL (OVERVALUED), and three as a STRONG SELL (NOTABLY OVERVALUED).Simply put, certainly not as bullish as March - April 2020. There currently are 3 BDCs listed as NOTABLY OVERVALUED/a STRONG SELL recommendation. So, I believe the sector is getting a bit “pricey” in general. I would just be mindful knowing high-yield/speculative-grade credit spreads directly impact broader asset valuations. I continue to project a net widening of spreads during 2024.This is something I have continued to discuss with subscribers. Important to understand.

The analysis performed above does not provide “every” catalyst/factor to consider when choosing a BDC investment. However, I believe this analysis is a good starting point to begin a discussion on the topic. Additional metrics will be analyzed in PART 2 of this article. PART 2 will take a look at ARCC’s past and current dividend rates, yields, and other similar metrics and compare the results to the 13 other BDC peers. Several of these metrics have a direct impact on future operations/results as events unfold. This includes dividend projections for all 15 peers for the calendar third quarter of 2024/each applicable company’s next set of dividend projections.

My Personal ARCC Past + Current Stock Disclosures:

The following are my ARCC past and current stock disclosures and total returns since I have been writing on Seeking Alpha (since 2013):

Table 10 – ARCC Past + Current Stock Disclosures/Returns

Source: Taken Directly from the REIT Forum’s © Spreadsheets/Data

Final Note: All trades/investments I have performed over the past 8+ years have been disclosed to readers in “real time” (that day at the latest) via either the StockTalks feature of Seeking Alpha or, more recently, the “live chat” feature of our Investing Group (which cannot be changed/altered). Through these resources, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered). Through StockTalk disclosures and/or the live chat feature of our investing group, at the end of April 2024 I had an unrealized/realized gain “success rate” of 90.3% and a total return (includes dividends received) success rate of 95.8% out of 72 total past and present mortgage real estate investment trust (mREIT) and BDC positions (updated monthly; multiple purchases/sales in one stock count as one overall position until fully closed out).I encourage other Seeking Alpha contributors to provide real time buy and sell updates for their readers/subscribers which would ultimately lead to greater transparency/credibility. Beginning in January 2020, I transitioned all my real-time purchase and sale disclosures solely to members of the REIT Forum. All applicable public articles will still have my “main ticker” purchase and sale disclosures (just not real-time alerts).

Understanding My/Our Valuation Methodology Regarding mREIT Common and BDC Stocks

The basic "premise" around my/our recommendations in the mREIT common and BDC sectors is value. Regarding operational performance over the long-term, there are above average, average, and below average mREIT and BDC stocks. That said, better-performing mREIT and BDC peers can be expensive to own, as well as being cheap. Just because a well-performing stock outperforms the company’s sector peers over the long-term, this does not mean this stock should be owned at any price. As with any stock, there is a price range where the valuation is cheap, a price where the valuation is expensive, and a price where the valuation is appropriate. The same holds true with all mREIT common and BDC peers. As such, regarding my/our investing methodology, each mREIT common and BDC peer has their own unique BUY, SELL, or HOLD recommendation range (relative to estimated CURRENT BV/NAV). The better-performing mREITs and BDCs typically have a recommendation range at a premium to BV/NAV (varying percentages based on overall outperformance) and vice versa with the average/underperforming mREITs and BDCs (typically at a discount to estimated CURRENT BV/NAV).

Each company’s recommendation range is "pegged" to estimated CURRENT BV/NAV because this way subscribers/readers can track when each mREIT and BDC peer moves within the assigned recommendation ranges (daily if desired). That said, the underlying reasoning why I place each mREIT and BDC recommendation range at a different premium or (discount) to estimated CURRENT BV/NAV is based on roughly 15-20 catalysts which include both macroeconomic catalysts/factors and company-specific catalysts/factors (both positive and negative). This investing strategy is notfor all market participants. For instance, not likely a “good fit” for extremely passive investors. For example, investors holding a position in a particular stock, no matter the price, for say a period of 5+ years. However, as shown throughout my articles written here at Seeking Alpha since 2013, in the vast majority of instances I have been able to enhance my personal total returns and/or minimize my personal total losses from specifically implementing this particular investing valuation methodology. I hope this provides some added clarity/understanding for new subscribers/readers regarding my valuation methodology utilized in the mREIT common and BDC sectors. Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader’s current investing strategy.The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions. Please disregard any minor “cosmetic” typos if/when applicable