Chip Somodevilla
Investors in the leading business development company FS KKR Capital (NYSE:FSK) have experienced a resurgence over the past two months since my previous update. I reminded investors that the undervaluation gap shouldn’t be expected to “last for long,” as the market realizes it could have been too pessimistic. Despite that, FSK continues to trade at a steep discount (“A+” valuation grade) against its financial sector (XLF) and BDC peers. Moreover, FSK has underperformed against the VanEck Vectors BDC Income ETF (BIZD) since FSK/BIZD topped out in mid-September 2023 (adjusted for dividends).
Accordingly, FSK is valued at a forward NII per share multiple of 6.7x, well below its BDC peers’ median of 8.33x (according to S&P Cap IQ data). As a result, the market remains relatively cautious over FSK’s execution risks, notwithstanding its robust “B+ earnings revisions grade. While we can discuss why the market seems to have “mispriced” FSK relative to its industry peers, I prefer to focus my attention on its fundamental thesis and price action. I find little value in trying to argue against the market’s perception. Instead, we should try to ascertain whether the potential for a further valuation re-rating could pan out. In this update, I attempt to help investors assess the risk/reward profile of the current opportunity, given the recent upside in FSK and its BDC peers, as I had anticipated.
The leading BDC is scheduled to report its fourth-quarter or FQ4’23 earnings release on February 27. It’s slated to occur after the FOMC’s January meeting this week (January 30-31) as we gain more insights into the Fed’s rate cuts cadence in 2024. With the 10Y (US10Y) down steeply from its October 2023 highs of above 5%, we can justifiably argue that the market has likely priced in the Fed’s rate cuts ahead of it even happening.
With the 10Y hovering over the 4.12% level this week, above its December 2023 lows of 3.78%, bond sellers have regained the initiative lately. As a result, we could be in extended consolidation as the market assesses how aggressive the Fed could get in 2024. Investors will likely pay close attention to Fed Chair Jerome Powell’s commentary, as it could impact the NII per share growth metrics for FS KKR over the next two years. Given its mostly floating rate portfolio (89% as of Q3), I expect the company’s NII per share growth could have topped out in 2023. Notwithstanding the cautious assessment, FSK could also refinance its relatively robust debt portfolio (debt-equity ratio of 1.1x as of Q3) at potentially lower rates.
Accordingly, FS KKR reported a weighted average effective borrowing rate of 5.31% in Q3. Coupled with its weighted average maturity of 3.2 years, a less hawkish Fed will be constructive for the company to refinance through 2025. Therefore, investors must assess whether the growth normalization in its NII per share in 2024-25 could be better than anticipated, bolstering a possible valuation re-rating.
I gleaned that analysts’ estimates on FS KKR have likely reflected some downside risks, but not substantial enough to warrant investors bailing out in droves. Accordingly, the BDC is expected to post an NII per share of $3.04 in 2024, down about 3.6% from FY23’s estimates. However, it’s still in line with FY22’s $3.05 metric, suggesting a relatively resilient earnings profile.
Despite that, the market’s focus will likely also turn to the success of the Fed’s monetary policy through 2025 as we assess the impact on inflation data. Since such information is expected to be backward-looking, FSK investors must anticipate (maintain a forward-looking posture) whether potentially more aggressive rate cuts in 2025 could affect its NII per share markedly. While a lower implied recession risk is expected to bolster the appeal of BDCs (given their middle market focus), the expected earnings peak in 2023 could also hurt buying sentiments. Therefore, I urge investors to pay close attention to FSK’s price action, providing vital clues on whether buying sentiments are still constructive or could have reached a peak preceding a steep reversal.
FSK price chart (weekly, medium-term, adjusted for dividends) (TradingView)
To be clear, I have not assessed red flags on FSK’s price action, suggesting we need to be highly cautious. In addition, when adjusted for dividends (forward yield of 14.1%), FSK’s appeal can be observed in its uptrend bias, underpinning its robust buying sentiments.
As a result, FSK investors looking to buy the dips would likely find FSK attractive. With the economy not expected to fall into a recession, I see BDCs continuing to find strong buying support from investors, given the secular growth in private credit. Moreover, income investors looking for high-quality exposure could find FSK attractive as they potentially reallocate from other fixed-income products.
While FSK could take a near-term tumble (not surprising) following a remarkable rally from its October 2023 lows, I view such pullbacks as solid buying opportunities.
Consequently, I’m prepared to maintain my bullish bias on FSK, as the market environment, price action, and valuation undergird my optimism.
Rating: Maintain Buy.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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