FS KKR: A 15% Yield Trading 20% Below Book Value (NYSE:FSK)

Introduction

Receiving dividends is fun – and often necessary to retire (early).

However, when it comes to chasing yield, I’m extremely careful, as I believe the higher the yield, the higher the risk there’s something fundamentally wrong with the underlying investment.

That’s the so-called “sucker yield.”

Companies that fall under the “sucker-yield” definition typically have unpredictable and unreliable earnings histories with unsafe dividend payouts. – Forbes

After all, a very high yield often suggests a very low valuation.

If a stock is extremely popular, the market will never let its dividend yield get very high. Generally speaking, that is.

For example, Danaher (DHR), one of my largest investments in healthcare, has a five-year dividend CAGR of 12.1% and a yield of just 0.4%. The market never let the dividend yield get up because capital gains offset dividend growth.

That’s bad news for income-seeking investors looking to buy.

However, it’s great news for investors who bought it a few years ago, as they sit on a decent yield on cost and elevated capital gains.

That’s where FS KKR Capital Corp (NYSE:FSK) comes in. This business development company (“BDC”) is one of the few companies in its industry on my radar, as I am not usually a fan of companies that are mainly engaged in financing operations. I’m looking for moats, and I dislike the financial risks that come with the lending business.

My most recent article on this company was written on January 30, when I called the stock “cheap and reliable.”

Trading at a 20% discount to its book value, FSK stands out among Business Development Companies.

Despite a challenging economic environment, FSK’s robust portfolio and strategic initiatives contribute to its resilience.

With a 13.5% annualized yield and a solid credit rating, FSK presents an appealing opportunity for income-focused investors.

In this article, I’ll revisit my thesis, as the company just released its earnings, and because I want to re-assess the bigger picture, as the “higher-for-longer” economic environment comes with both tailwinds and headwinds for lenders.

So, let’s dive into the details!

FSK Stands Strong As Tailwinds Offset Headwinds

Generally speaking, higher rates are great news for business development companies.

If a BDC is able to carefully balance the duration of its investments and the balance between investments made and debt taken on to finance new investments, it generally benefits from a surge in interest rates.

FSK, for example, has 90.1% floating-rate debt.

This is what the company said in its 2023 10-K (emphasis added):

[…] because a rise in the general level of interest rates can be expected to lead to higher interest rates applicable to our debt investments, an increase in interest rates would make it easier for us to meet or exceed the incentive fee hurdle rate in the investment advisory agreement and may result in a substantial increase of the amount of incentive fees payable to the Adviser with respect to pre-incentive fee net investment income. – FSK 2023 10-K

Unfortunately, we’re at a point where, I believe, we need to be aware of the negative impact of higher interest rates on the economy.

While FSK benefits from higher rates due to floating rates, it knows that there are limits to these benefits. Quoting its 10-K again:

Rising interest rates could also cause portfolio companies to shift cash from other productive uses to the payment of interest, which may have a material adverse effect on their business and operations and could, over time, lead to increased defaults. – FSK 2023 10-K

In general, we are starting to see cracks in debt quality and financial health.

For example, according to Apollo, 41% of Russell 2000 companies have negative earnings. That’s the highest number outside of a recession since the start of Bloomberg data collection in 1995.

Moreover, more than 40% of small businesses have trouble paying rent on time.

Especially commercial real estate has turned into an issue, which is why I turned bearish on Ares Commercial Real Estate (ACRE), which had to cut its dividend to protect its liquidity.

The good news is that FSK is different – I didn’t call it “reliable” for nothing in my prior article.

For example, in its recently released first quarter, the company reported net investment income of $0.76 per share, along with adjusted net investment income of $0.73 per share.

This allowed the company to pay $0.75 per-share distributions, including a $0.05 special distribution, which is part of a previously declared $0.10 per-share special payout.

As FSK is currently trading at $19.87, it translates to an annualized yield of 15.1%. Excluding the special distribution, that yield drops to 14.1%.

These distributions were protected by a 104% coverage ratio, based on the aforementioned $0.76 in per-share net interest income.

On a full-year basis, the company aims to distribute $2.90 per share, which implies a current yield of 14.6%.

Please note that the dividend history below looks a bit “off” because automated data has issues incorporating special distributions. Every $0.05 special distribution looks like a divided cut compared to its regular distribution.

Going forward, the company is confident in its earnings power and what this may mean for shareholders, as it is seeing more tailwinds than headwinds in this market.

From a forward-looking perspective, we remain confident in the long-term earnings power of FSK, which enables us to continue paying an attractive distribution to our shareholders. We’re encouraged by the increased level of origination activity and the quality of the deal volume during the first quarter. The private credit markets continue to experience strong tailwinds and we believe we’re well positioned to take advantage of these opportunities. – FSK 1Q24 Earnings Call

Speaking of originations, the company originated $1.4 billion in new investments in the first quarter.

These investments were primarily focused on add-on financings to existing portfolio companies and long-term relationships.

To be a bit more specific, roughly 75% of new investments were directed towards add-on financings.

The portfolio currently includes 205 portfolio companies in 24 industries, with the top 10 accounting for roughly 20% of the total volume. The weighted average yield on debt investments was 12.1%, with 57% of all investments being senior-secured first-lien loans.

These deals came with great conditions, including a 570 basis points spread over SOFR (the short-term interbank lending benchmark).

We also continue to be pleased with the quality of the new deals. During the first quarter, our new direct lending investments had a weighted average EBITDA of approximately $243 million, 5.7x leverage through our security and a 47% equity contribution, all with a weighted average coupon of approximately SOFR plus 570 basis points. – FSK 1Q24 Earnings Call

The SOFR moves in lockstep with the effective Federal funds rate, which means a “higher-for-longer” scenario bodes well for interest income (as long as portfolio companies remain healthy and FSK manages its own debt portfolio in a sustainable manner).

Going back to portfolio investments, the portfolio saw a net decrease of $221 million due to sales and repayments, including those to its joint venture (Credit Opportunity Partners – COPJV).

69% of new loans were made in the first-lien senior secure segment.

With regard to the net asset value of FSK shares, the company ended the first quarter with a 0.7% lower “NAV,” mainly due to its (special) distributions and some unrealized losses, which offset the $0.76 gain in NII.

With that said, despite challenges like sticky inflation and elevated rates, portfolio holdings continued to perform well.

According to the company, it saw high-single-digit EBITDA growth among its portfolio companies, with “modest margin pressure” due to inflation. Core companies, which have been part of the portfolio since April 2018, saw 7% year-over-year EBITDA growth.

In the quarters ahead, the company expects the revenue of portfolio companies to slow in line with an overall weaker economy.

The good news is that despite increasing stress on companies, portfolio companies have seen stable leverage and a bottoming interest coverage ratio, which instills some confidence that we’re dealing with a high-quality portfolio here.

This brings me to the next part of this article.

Balance Sheet Strength & Valuation

The company itself also maintains a healthy balance sheet.

In fact, it’s one of the few BDCs that holds an investment-grade credit rating. In this case, it has a BBB- (or equivalent) rating from Fitch and Moody’s.

It also has a net leverage ratio of just 1.09x, $4.2 billion in liquidity, and well-laddered debt maturities, with more than 80% of its debt maturing after 2026.

With regard to my earlier interest rate risk comments, the company is in a great spot to benefit from elevated interest rates without incurring many of the headwinds of more expensive debt on its own balance sheet.

When it comes to the company’s valuation, it continues to trade at a discount compared to its book value. Since the 2021 merger between FS and KKR, the BDC has consistently traded at a 20% book-value discount.

While I would not make the case that the stock will trade at a premium anytime soon – like some super-high quality BDCs that include Main Street Capital (MAIN) – I believe FSK should not trade below its book value.

This is what I wrote in my prior article:

Including its dividend, the company could return close to 15% per year if it reaches its target price (without including a higher book value) over the next three to four years.

Needless to say, this is only possible if the Fed maintains a healthy balance between supporting economic growth and fighting inflation.

I stick to what I wrote back then.

Having said all of this, FSK remains one of my favorite BDCs. If I were running an income-focused portfolio, I would own some FSK exposure.

However, I urge investors interested in FSK or any of its peers to be careful.

While FSK may be strong, please be aware of the cyclical risks that come with these companies.

If we run into a scenario where the Fed is forced to cut rates due to overwhelming economic weakness, BDCs could see steep declines in the stock market.

While this is a low-probability scenario – for now – it’s something investors need to be aware of.

If I were a buyer of BDCs, I would do it gradually. If we run into trouble, I can average down. If the Fed manages a soft landing, I have a foot in the door.

Takeaway

FS KKR has emerged as a beacon of stability and opportunity in an increasingly tricky industry.

Despite economic challenges, FSK’s recent earnings report underscores its strength, with impressive net investment income and robust dividend distributions.

Positioned at a discount to book value and boasting investment-grade credit ratings, FSK presents an enticing proposition for income-oriented investors.

While we need to keep an eye on rate-related risks, FSK’s prudent management and promising forward-looking comments make it a compelling choice for investors seeking elevated returns in the financial sector.

Pros & Cons

Pros:

• Resilient Performance: FSK has shown resilience in light of economic challenges, with a solid track record of net investment income and juicy capital distributions.
• Value Opportunity: Trading at a discount to book value since its 2021 merger, FSK offers investors a chance to acquire quality assets at a favorable price.
• Investment-Grade Rating: FSK holds an investment-grade credit rating and a healthy balance sheet, providing stability when it matters most.
• Strong Portfolio: With a diverse portfolio of investments and a focus on quality deals, FSK mitigates risk and improves potential returns for shareholders.

Cons:

• Cyclical Risks: While FSK has weathered economic headwinds so far, investors should remain cautious of cyclical risks.
• Market Volatility: Fluctuations in interest rates and market conditions could impact FSK’s performance and stock price, potentially leading to short-term volatility for investors.
• Dependency on Economic Outlook: FSK’s success is closely tied to broader economic trends, meaning changes in economic conditions could affect its profitability and distributions.