FS KKR: Recovering From The Drop And Generating Large Income Yielding 13.35% (FSK)

Shares of FS KKR Capital Corp (NYSE:FSK) were declining into their Q4 2023 earnings report and dramatically sold off after they Q4 numbers were published. Shares of FSK had declined by -$1.14 (-5.49%) from January 4^th through February 26^th, then immediately after their Q4 earnings hit the street, shares declined another -$1.15 (-5.86%) over the next two days to $18.48. Shares tried to rebound, then retraced back to the mid $18s over the next two weeks, and since then, have rebounded past the $19 level. It looks like the market wasn’t thrilled with the declining net investment income (NII) especially since we’re in a high interest-rate environment. After going through the numbers and looking at many of the larger business development corporations (BDC) results for the 2023 fiscal year, I am still bullish on FSK. The dividend looks well covered and after looking at my personal investment, I plan on adding to my position. I started acquiring shares in April of 2023, and my price per share is $19.24. I made seven purchases since April of 2023 and have already generated 11.97% of my initial investment from their distributed income. I believe FSK represents an opportunity for income investors, as the underlying assets with FSK’s portfolio are trading at a discount. I plan on adding to my position in FSK before their Q1 earnings because I feel there is an opportunity for capital appreciation and large amounts of income to be generated.

Following up on my previous article about FSK

In my previous article, which was published on January 29^th, 2024 (can be read here) I had discussed why I felt shares looked undervalued going into their Q4 earnings report. Since then, shares of FSK have declined by -6.87% compared to the S&P 500, which has appreciated by 6.36%. When the distribution is taken into account, shares of FSK have declined by -3.67% since January 29^th. I am not a trader or a short-term investor, so watching shares decline after an earnings report doesn’t bother me if I feel the investment thesis is still intact. While shares of FSK have been in the black over the past year, they have not reached their pre-pandemic levels and have declined by -3.42% in 2024. I wanted to follow up on my previous article to discuss why I believe shares sold off after the Q4 report and provide an update to my investment thesis regarding why I am still bullish and plan on adding to my current position.

What went wrong in Q4 and the risks to my investment thesis regarding FSK

NII is one of the most critical numbers when it comes to BDCs because this is the profits generated from their investments after deducting expenses. NII can include interest collected, dividends or distributions paid to the corporation, rental income, and capital gains. In Q4, FSK’s NII declined by -11.25% YoY to $0.71 per share. This was also a decline of -15.48% QoQ as FSK generated $0.84 of NII per share in Q3 2023. On the Q4 conference call, Brian Gerson (FSK Co-President) discussed how FSK placed five investments on non-accrual, which had a combined cost of $654 million and a fair value of $422 million. When a company classifies a loan as non-accrual it’s because the entity that was issued capital as debt hasn’t made a payment for at least 90 days. This can negatively impact short-term results and the lender’s longer-term financials because their investment isn’t generating the agreed-upon interest. Non-accrual loans are often unsecured, and when payments aren’t made, they become non-performing. Non-accrual loans can stay on the books on a cash basis, and the lender in this case, FSK, the lender will normally adjust its allowance for potential losses regarding the loan that has gone bad. When these situations occur, the lender will typically work with the borrower because it’s in their best interest to agree on a plan to meet the financial obligations. For a non-accrual loan to return to an accrual status, the principal that is in arrears will be paid back with interest and fees, and then the regular payments will resume.

This spooked the market a bit because a correlation between 5 investments going on non-accrual status and a decline in NII during a high-rate environment can’t be ignored. The Fed certainly didn’t help matters by closing the door on a March rate cut. At the recent FOMC press conference, Fed Chair Powell left indicated that a higher for longer rate environment was entirely possible, and while the dot plot reaffirmed that the median points were 4.6% in 2024, 3.6% in 2025 and 3.1% in 2026, there is no guarantee that the Fed will cut rates on this timeline. Personal spending in the U.S. increased by 0.8% MoM in February, while the U.S. personal consumption expenditure price index (PCE) increased by 0.3% MoM in February. The economy is still running hot, and the Fed has less reason to cut rates in the first half of 2023. The CME Group’s Fed Watch Tool is now indicating that there is a 95.2% chance that rates will remain unchanged at the May meeting, while there is a 46.8% chance that rates will also remain unchanged at the June meeting. The Fed runs the risk of inflation creeping back up if they cut rates while the economy is hot, and that is the last thing the Fed wants to occur as it would most likely lead to a reversal in Fed policy that ends with rates going higher.

This is negative for FSK because its business model revolves around lending and taking equity stakes in smaller companies that typically operate in lower to middle markets. While higher rates can act as a catalyst for higher-interest loans to be issued and larger amounts of interest to be collected, it also creates a tougher operating environment for businesses, and as we are now seeing, some of the companies that took loans from FSK are having trouble repaying their obligations. This presents a significant risk to my investment thesis because if more companies that FSK issued loans to get placed on a non-accrual basis, the quarterly NII could deteriorate further, and a larger portion of the portfolio will have an enhanced probability of defaulting. This could put FSKs distribution at risk, and if loans start to default, it would probably correlate to a lower net asset value (NAV) which would likely lead to lower share prices.

Why I am bullish on FSK in 2024

FSK’s management team showed that they are able to adapt to undesirable situations. The non-accruals that occurred aren’t optimal for FSK, and how a management team triages them is critical. FSK restructured its $125 million first lien term loan with Reliant into a $62.5 million cash pay first out term loan with a $62.5 million second out term loan that was placed on non-accrual. KBS is a facility maintenance business that had a $366 million first-lien loan with FSK. This has been restructured into a $166 million first-out and a $200 million second-out term loan. The $200 million loan was placed in non-accrual. While the five investments that went into non-accrual basis attributed to FSK’s investment income decreasing by -$18 million QoQ, this is a testament to management’s ability to navigate difficult business environments and work with operators to find a solution to mutual problems.

FSK is still operating at an enticing level despite the hiccup in Q4. Throughout 2023, FSK generated $3.18 of NII per share and distributed $2.95 of it to shareholders through normal and special distributions. Management has projected that on a per share basis, FSK’s NII will increase to $0.73 in Q1 2024 as they expect to generate $348 million in recurring interest income, $51 million in recurring dividend income, and $30 million from other fees and dividend income. Management is confident that they will distribute $2.90 in income per share during 2024, which is comprised of $2.80 from the normal distributions and $0.10 of special distributions in the first half of 2024. This would be a 15.12% forward yield on FSK’s current share price of 19.18.

There is $6.36 trillion sitting on the sidelines in money market accounts, which can still yield up to 5.3%. While Fed Chair Powell left the door open for a higher for longer rate environment, I think we will see the first rate cut in June. While the Fed doesn’t want inflation to creep up, they also don’t want massive defaults on loans because it has the potential to cripple the regional banking industry. After what occurred in March of 2023, I don’t believe they are going to risk it. I think the Fed is preparing us for a slow decline in rates, so the refinancing market works for both sides in 2025. While FSK was able to write loans with higher interest rates, the lending markets have tightened as the cost of capital isn’t as enticing as it once was for companies to expand. Based on the Fed’s projections, I think we will get to a point where the risk of defaults and issued debt going into a non-accrual basis will decline while the appetite for taking on debt increases because the ability to finance debt will be stronger. Rates aren’t going to 2% or lower anytime soon, and FSK will be able to write new loans at enticing rates even in an environment where the terminal rate is between 3.5% – 4.5%. FSK may actually do better because the volume of loans they may be able to write could exceed the amount of interest generated from fewer loans at higher rates.

When I compare FSK to their peer group, making new investments in FSK is still attractive to me. The peer group I compare FSK to is:

• Ares Capital (ARCC)
• Main Street Capital (MAIN)
• Prospect 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)
• Gladstone Capital (GLAD)
• Sixth Street Specialty Lending (TSLX)

I always want to pay a fair price for a BDCs NII, and if I can get it at a discount, that’s even better. FSK is trading at 6.02x its NII, while the peer group trades at 8.17x. FSK is being significantly discounted, especially as its NII is expected to grow QoQ in Q1. FSK also generates the 2^nd largest amount of NII from its peers on an annualized basis, and paying 6.02x is cheap in my opinion.

While there is some pressure on FSKs NAV, the fact is that it’s still valued at $24.45 per share. This means that FSK is trading at a -21.55% discount to its NAV. Even in a bad scenario where some of the loans placed on non-accrual status actually default, there is protection between the NAV and FSKs’ share price. Provided that management is working on solutions with these companies that have gone into non-accrual status, I feel confident that the discount between FSK’s share price and NAV will tighten over the next several quarters if we don’t see a significant decline in FSK’s NAV. This could be a solid arbitrage opportunity, considering the peer group trades at a premium of 9.79% to NAV.

FSK, for me is an income investment first and a capital appreciation investment second. Based on the normal distribution from 2023, FSK has a yield of 13.35% compared to the peer group average of 10.02%. When I use the figures that were discussed on the Q4 conference call, FSK is expected to generate a distribution yield of 15.12% based on the current share price. This is a significant yield that is roughly 50% higher than the peer group average. From an income perspective I am excited to add to my position in FSK, considering I am being paid a large amount of income compared to its peers.

Conclusion

I think FSK represents an opportunity coming off the lowered NII in Q4 2023. While FSK had some hiccups, they are working on rectifying the issues and have indicated that it’s NII will grow and that it will be able to distribute $2.90 per share to its investors during 2024. I think the Fed will start rate cuts in June, and we’re going to have a solid environment in the back half of 2024 and throughout 2025 for BDCs to write loans and drive larger amounts of NII. FSK is one of the largest BDCs as it generates the 2^nd largest amount of NII and has the largest distribution yield from the ones I track. I think investing in FSK has the potential to generate large amounts of income and modest capital appreciation going forward. I plan on adding to my investment in FSK going into Q1 earnings.