FS KKR Looks Undervalued Heading Into Earnings Yielding 12.38% (NYSE:FSK)

FS KKR Capital Corp (NYSE:FSK) delivered across the board for income investors over the past year. Business Development Corporation’s (BDC) are more common among income investors rather than investors focused on generating capital appreciation because BDCs must pay out at least 90% of their taxable income to shareholders in the form of a dividend. Over the past year, shares of FSK have appreciated by 7.91% while paying out $2.56 in standard distributions and an additional $0.39 per share in special distributions. This time last year, shares of FSK traded for $19.16, and investors who added FSK to their portfolio at that time generated 15.4% of their original investment in distributed income from the dividend while watching shares appreciate by almost 8%. I am still bullish on shares of FSK going into earnings, as they should continue to generate significant amounts of income for years to come. While BDCs are a relatively unknown investment compared to REITs, I feel the higher rate environment has played a beneficial role in strengthening their future returns. Just because we’re likely headed into a rate-cutting environment doesn’t mean the BDC story is over, rather, I think FSK will produce similar results for investors in 2024.

Following up on my previous article about FSK

I had previously written an article about FSK on November 13^th (can be read here), where I discussed their special distributions and why I felt it was undervalued. Since then, FSK has appreciated by 4.17% compared to the S&P 500, increasing by 10.99%. When FSK’s distributions are factored in, the total return increases to 8.17%. I have been bullish on FSK and wanted to follow up with a new article discussing why I am still bullish for 2024. I will discuss why the higher for longer rate environment should work in FSK’s favor, why I like FSK as an income play again in 2024, and how I feel FSK is undervalued going into earnings.

Despite heading into a rate cutting cycle, the higher for longer environment should be a strength for FSK that pays dividends for years to come

We’re headed into the Fed meeting on Wednesday, 1/31 at 2pm, and CME Group is projecting a 97.4% chance that rates remain where they are with only a 2.6% chance that we see a 25 bps reduction. CME Group isn’t reaching a greater than 50% chance of a rate cut until the May meeting, where there is a 50.9% chance that rates will come down by 25 bps. In the May projection, there is also a 36% chance that a rate hike could have already occurred and that rates will be 50 bps lower than their current level. I am very interested in what Jerome Powell says at the upcoming meeting on Wednesday because the market seems to be front-running his previous message. When I look out to the December projection from CME Group, there is a 100% chance that rates are lower than 500 bps, with a 34% chance the target rate resides between 375-400 bps and a 33.2% chance the target rate is between 400-425 bps.

At the December 13^th, 2023 Fed press conference, Jerome Powell provided clear explanations for forward monetary policy (transcript can be read here). The Fed has tightened rates by 525 bps since early 2022, which has put pressure on economic activity and inflation. Jerome Powell made it clear that the economy has unpredictable surprises, and if needed, the Fed is prepared to increase rates if that is what the data calls for. We just got the GDP data, and the economy was red hot in Q4 2023 as it expanded at an annualized rate of 3.3% compared to the estimated rate of 2%. A reduction in rates typically occurs when the Fed wants to stimulate the economy and increase economic activity, not when GDP is expanding significantly more than what is forecasted. Jerome Powell also made it clear that the median rate based on the individual assessments all Fed members took would be finishing 2024 at 4.6% and 2025 at 3.6%. The market is currently pulling rate cuts forward despite the warning about going higher if needed and the commentary on the median rate for the end of 2024 and 2025.

Rates have been higher for a longer time, and after the GDP data that was just released, I am surprised that CME Group is still factoring in aggressive rate cutting throughout 2024. Ultimately, the Fed meeting on Wednesday will be interesting, and all we can do at this moment in time is speculate. I think that the Fed will leave rates unchanged and be a bit hawkish due to the increased GDP activity and signal that while they are at the end of their tightening cycle, rates are not going to come down as quickly as they increased.

The rising rate environment has been a net positive for FSK, and I believe that the economic benefits will be felt for years to come. As a BDC FSK generates most of their income through originating loans. FSK has $14.67 billion in investments comprised of 59.8% in First Lien Senior Secured Loans, and 7.5% in Second Lien Senior Secured Loans. Only 11.5% of the debt they have issued is at a fixed rate, while 88.5% is floating rate debt. Over the past year, the weighted average annual yield on their accruing dent investments has increased from 10.4% to 12.2%. This has favored FSK as they have grown the amount of net investment income (NII) they have produced. In Q3 of 2022, FSK generated $0.76 of NII per share, and over the past year, this has increased to $0.84 in Q3 of 2023.

The higher rate environment has allowed FSK to originate debt investments at higher yields, which has driven increased NII to the bottom line. The Fed did FSK a favor by not cutting rate in 2023 as they have been able to grow their loan book, lock in higher fixed rates, and reap the benefits of floating rate debt generating elevated amounts of interest compared to previous years. If the Fed doesn’t cut rates until the spring, this would allow FSK to have several additional months to generate more debt while rates are at the highest levels in decades. As rates decline, the fixed interest rates at which FSK issues debt will remain unchanged, and the floating rate debt will still generate a significant spread from the Fed base rate. I am not making any assumptions on what the Fed will do, I am just looking at what they are saying they will do. A rate environment that is projected to end 2024 at 4.6% and 2025 at 3.6% is still very favorable for FSK from an originating debt perspective. This should give FSK a significant amount of time to benefit from higher rates, especially since GDP is expanding and the Fed may be less inclined to cut rates as much as the projections from CME Group are showing.

FSK has been an income investors dream throughout 2023 and the trend is already continuing in 2024

Throughout 2023, FSK has paid $2.56 through 4 quarterly distributions per share and an additional $0.39 through 7 special distributions. FSK’s board declared that they will pay shareholders $0.10 per share in special distributions in the 1^st half of 2024. The first special distribution will be paid on February 28^th, while the second special distribution will be paid on May 29^th, 2024. FSK has been vocal on their conference calls about rewarding shareholders above and beyond the quarterly distribution when they are in a position to do so. It looks like 2024 is starting out very similar to how 2023 began, and with rates still at the highest levels they have been in decades, FSK could be in a position to distribute additional income to shareholders in the back half of 2024.

Going back 3 years, shares of FSK were trading for $16.79 on January 27^th, 2021. Since then, shares of FSK have distributed 48.12% of their value from January 27^th through $8.08 of distributions. The base distributions since 2021 have amounted to $7.56, while FSK distributed an additional $1.72 of income through special distributions. Shares have also appreciated by 23.17% in value. This has been an income investor’s dream as the original investment has appreciated in value rather than declining due to rates, and has consistently distributed double-digit yields over the past 3 years. I think the higher for longer rate environment has put FSK in a position where they can continue to deliver double-digit yields for quite some time.

FSK still looks undervalued going into Q4, and their 2023 fiscal year earnings

When I look for value in the BDC sector, I compared the largest BDCs among several metrics. The peer group consists of the largest BDCs by market cap and net assets. The companies I compare FSK to are:

• Main Street Capital (MAIN)
• Prospect Capital Corp (PSEC)
• PSEC Capital Corp (PSEC)
• Barings BDC (BBDC)
• Blue Owl Capital Corporation (OBDC)
• MidCap Financial Investment Corporation (MFIC)
• Goldman Sachs BDC (GSBD)
• Oaktree Specialty Lending Corporation (OCSL)
• Golub Capital BDC (GBDC)
• Ares Capital (ARCC)
• Gladstone Investment (GLAD)
• Sixth Street Specialty Lending (TSLX)

The first thing I look at is the market cap to NII multiple that BDCs are trading at. Since I typically look for value, I want to pay the best price for a BDCs NII that I can. FSK is trading at 6.6 times its annualized NII compared to the peer group average of 8.8x. This is an indication that FSK is undervalued, especially since FSK has generated the second-largest amount of NII at $877 million in the peer group over the trailing twelve months (TTM).

The next thing I want to look at is how each BDC is trading compared to the net asset value (NAV). I don’t mind paying a premium for a great BDC’s book, but I would rather get everything at a discount. Today, FSK is trading at a -16.91% discount to its NAV, which means you’re able to purchase its assets for less than 90% of their fair value. FSK is producing $877 million annually in NII, and having an opportunity to purchase shares at this big of a discount is enticing to me. The peer group trades at a 1.5% premium to NAV, so this is another indication that FSK is undervalued.

I am not including the special distributions for FSK, as I am only looking at the current base distribution of $2.56. Today, shares of FSK support the largest yield in the peer group at 12.38%, while the peer group average is 9.86%. I think that there is a compelling case for FSK when looking at these stats because they generate the second largest amount of NII, trade at the second lowest NII multiple, and have the third lowest discount to NAV while having the largest yield.

Risks to my investment thesis

Just because FSK has constantly paid a special distribution throughout 2023 and is producing more NII doesn’t mean there aren’t risks to my investment thesis. FSK generates its NII by originating loans and taking equity stakes in companies. While the rising rate environment has been good for FSK, there could be a possibility that it has put unmanageable pressure on the companies they do business with. By investing in FSK, you’re investing in their management team’s ability to navigate the debt markets. If rates stay higher for longer, or economic activity starts to decline, and we’re pushed into a recession, it could create a negative operating environment for FSK’s underlying portfolio companies, causing some to default on their loans. If this occurs, it could severely impact the amount of NII FSK is generating, their ability to pay the distribution at the current level, and decrease the value of their investment portfolio, which would negatively impact their NAV.

Conclusion

BDCs are complicated investments, and investors should understand how they work and the risks rather than invest in them because of the yield. FSK has done well over the past several years and generated a significant return for investors. I am bullish on 2024 as 2 special distributions have already been declared, and FSK continues to trade at a discount to its peer group. I think that FSK will produce strong NII in 2024, and even though shares are on the upswing, I feel they are undervalued. I will be looking to add to my position going into Q4 earnings as shares still trade at a -16.91% to its NAV while yielding 12.38% prior to the special distributions.