FS KKR: Is The Discount To NAV Justified Or Is It A Bargain?

Introduction

Last time I wrote on FS KKR Capital (NYSE:FSK) was back in August in an article titled, “The Road Ahead Looks Promising.” That was right before the BDC reported its Q2 earnings. Some time has passed since reporting Q3 earnings. So, I felt like it was time to take another look at them. There also have been several positive articles on the company. I typically like to see what companies who recently merged or made an acquisition do months or even years after. Are they continuing to grow? Is the acquisition accretive? Are they having issues?

All these are questions I look to have answered. And by doing your due diligence you can get somewhat of a picture on how the business is doing. Sure, making an acquisition is usually good for the business, but sometimes investors can get ahead of themselves with the excitement. The merger I discussed last article actually happened in 2021 but most know the synergy can take some time to be accretive. In August, I was fairly new to the BDC having heard of them, but never really doing any research on them until then.

But now that two quarters have gone by, I revisit the third largest BDC by market cap to see how they have done in the past few months. Many in the sector (BIZD) have performed well this year as a result of the macro environment and their business structures. But there are some who have not and saw their credit quality diminish in the process. In this article I dive into whether FSK discount is justified, or is a great bargain currently.

How’s The Company Growing?

At the end of Q1, FS KKR Capital had 189 portfolio companies with 89% of their debt being floating rate and 69% of their investments in senior-secured debt. The median portfolio company EBITDA & leverage were $114 million and 6.0x.

Many BDCs in 2023 have been repositioning their portfolios by focusing more on first-lien/senior secured loans. This is great because it positions them to be more defensive during economic hardships or downturns. Some have a higher percentage in first-liens/senior secured loans than others. But the ones with a lower percentage are not necessarily lesser quality. It just means they are less defensive and more on the offense. Think of it like a game of basketball. Most of us know the saying, “Offense wins games, defense wins championships.”

So, that’s how I like to look at it. At the end of the day it’s management’s choice how they want to position their portfolios. It’s important for me because I like to keep a perfect balance in mine. But every person or investor may differ depending on their goals or values.

Fast forward nearly 5 months later and FSK has managed to grow their portfolio to a total of 200 companies from 189 in Q1. These had a fair value of $14.7 billion.

So, the BDC is growing and making acquisitions. The median portfolio company EBITDA also increased to $212 million according to management. Leverage stayed flat at 6.0x. Additionally, companies in the portfolio reported weighted-average year-over-year EBIDTA growth rate of 6%.

During Q3 FSK reported net investment income of $0.84 and total investment income of $465 million. Both of these grew roughly 7.6% and 0.6% respectively from the first quarter. Nothing spectacular but growth is always good. Especially when you factor in the challenging environment. Yes, BDCs’ business models allow for them to benefit from the high interest rate environment, but this still puts financial stress on their portfolio companies. We’ll talk about this later in the article.

During the quarter the BDC originated $504 million in new investments with 65% focused on add-on financings to existing portfolio companies. 92% of these were first-lien. Furthermore, one new investment of note was a partnership with PayPal (PYPL). They agreed to purchase more than $40 billion of the company’s consumer receivables originated in Europe. The BDC committed approximately $40 million towards the transaction.

Working with a company like PYPL shows the financial strength of KKR’s credit’s asset-based finance business. So, the company has been focusing on continued growth through strategic partnerships. This will likely position them for other key business relationships in the future.

Furthermore, they grew their portfolio by nearly 6%. Their exposure to floating rate debt investments stayed the same as in Q1. But this is not a bad thing.

Additionally, FSK currently has a higher exposure to both first-lien and senior secured loans than that of Ares Capital’s (ARCC) 43% & 66% respectively. This puts them in a better position defensively.

Further Strengthening The Balance Sheet

This year the BDC has also been enhancing its liquidity and further strengthening its balance sheet. Liquidity increased more than a half a billion from Q1 to a total of $3.6 billion at the end of Q3.

They also have been decreasing their debt-to-equity ratio by paying down a decent amount of debt. This decreased year-over-year by more than 12% from roughly $9.2 billion to nearly $8 billion. Their debt-to-equity ratio declined from 1.19x to just 1.10x over the same period. That’s slightly above largest peer ARCC’s 1.03x, and lower than the second largest BDC by market cap Blue Owl Capital’s (OBDC) 1.13x.

Next year the BDC does have some debt maturing but with the available liquidity and IG ratings from all three agencies, the BDC maintains a great financial position currently. Furthermore, most of their debt matures in 2025 & beyond. Combined, this has an average interest rate over 5%, but with at least 3 rate cuts expected next year, it’s likely they will refinance this at a lower rate.

Strong Total Returns YTD

Because of the macro environment the sector has performed well YTD. Investors who’ve been invested in BDCs have enjoyed not only strong price returns, but total returns also. Throw in the extra dividends from the supplementals and specials some have paid out and this year has been even better. And to be honest I think 2024 will be more of the same, especially for the quality ones such as FSK.

In the chart below you can see FSK has only trailed behind Capital Southwest (CSWC) & Blackstone Secured Lending (BXSL), two of my favorite BDC holdings.

Below you can see they trail behind everyone with the exception of ARCC. But investors shouldn’t complain as 2023 has been a very volatile and unforgettable year for dividend investors. And more than 32% in total returns isn’t too shabby if you ask me. Especially when you factor in that companies like Walmart (WMT) and McDonald’s (MCD) are up only roughly 13% & 9% respectively.

Undervalued

Trading roughly at $20 at the time of writing, the stock is significantly undervalued when you compare it to its NAV of $24.89. That’s a discount of nearly 24%. Additionally, the Quant rating gives them a valuation grade of A+, further signifying the BDC may be undervalued.

This is great when you consider that many BDCs in the sector currently trade at premiums to their NAV because of the environment. I think similarly the market still has questions about FSK after the merger but the company has been doing all the right things, warranting a higher valuation in my opinion. Enhancing their liquidity profile, growing their portfolio, both which will make them better positioned financially for the foreseeable future. As time goes on I expect the share price to reflect this and continue higher.

Risk Factors

In the third quarter the company did add one new portfolio (company) on non-accrual status bringing their total to 2.4% at fair value. But this is down from 2.7% in the first quarter and 2.5% in Q2, which means the BDC has been doing a great job at managing their companies.

With the cost of borrowing higher, several companies have continued to face financial distress and even had to file bankruptcies. Managing to stay flat or even see a decline speaks volumes of not only the strength of their portfolio, but management as well. Of course I would like to see non-accruals lower but 2.4% is manageable and they have been on the decline which is reassuring. With rates expected to drop next year I expect to see this rate continue to decline slowly over the coming quarters.

Conclusion

As a buy-and-hold investor one thing I like to see from businesses is how they do during tough times like 2023 has presented. Many BDCs have performed well in the last year, even outperforming the S&P due to their business structures.

With these being high income vehicles, investors have to be careful not to get caught up in chasing high-yields. Since covering FS KKR this past summer the BDC has performed well. By growing their portfolio, further strengthening their balance sheet, and managing to lower their non-accruals, this speaks volumes about the management team. I like what I see from the company and will be watching them closely in the coming quarters. For those who believe in the long-term outlook of the company, now is a great time to grab this stock at a discount to NAV.

Although I think the market still has some questions since the merger, the BDC looks to be doing everything right. I currently think FSK has all the right makings to be a long-term holding for dividend investors and rate them a buy.