Ares Capital Q4 Earnings: 2 Very Important Takeaways (NASDAQ:ARCC)

Ares Capital (NASDAQ:ARCC) just released Q4 and FY2022 results which only further strengthen its case for being a leading blue-chip Business Development Company (“BDC”) (BIZD). For those who wish to check out the headline numbers, you can view Seeking Alpha’s summary here.

Instead of boring you with a repetition of those numbers in this article, we will devote our focus to diving into two very important updates provided by Ares Capital management on the Q4 earnings call that significantly impact the investment thesis. In this article, we discuss these in detail and offer our updated outlook on Ares Capital.

Important ARCC Update No. 1: We Expect Another Meaningful Equity Raise Soon

Probably the most important near-term development for the thesis were the numerous clues dropped throughout the earnings call that it will likely issue equity in the near future.

First and foremost, the leverage ratio crept up to 1.26x, slightly above the upper limit of the company’s target leverage range. Issuing new equity would help to immediately reduce the leverage ratio. Management even acknowledged this in the context of weighing if and when to do another equity raise, stating:

we try to maintain a leverage ratio somewhere between 0.9 and 1.25x our equity capital base, and we’re at the upper end of that.

Second, management clearly believes that the current investment environment is very attractive, stating:

Market spreads on new deals are at least 100 to 150 basis points higher than at year-end 2021, and we believe that the total return opportunity afforded by the higher base rate in addition to the spread expansion is very compelling. These enhanced economics are being achieved in transactions that also have reduced leverage and meaningfully better documentation. We think this is an exciting development for our new investment business, and we remain active in the market.

Their fourth quarter originated senior loans had a weighted average interest rate of over 10.5% with weighted average leverage under 5x on a debt to EBITDA basis. Furthermore, the weighted average EBITDA generation of these businesses is greater than $500 million. With these attractive terms, management is incentivized to invest aggressively to capitalize on this opportunity to improve the overall portfolio profitability and quality. In order to do this effectively – especially given where their leverage ratio is – they will need to raise equity.

Third, the company is also taking a more cautious approach to paying out dividends on both a regular quarterly basis as well as via special dividends. While this is largely being governed by conservatism about where interest rates are headed moving forward as well as the broader health of the economy, it also makes sense that they are being a bit cautious about growing the dividend if they are about to issue a bunch more equity as this would bleed their balance sheet even more if they issued equity and then had to pay substantial dividends on it.

The impact that another meaningful equity raise has on the thesis is two-fold:

1. Generally in the immediate aftermath of such an equity raise, shares tend to drop by a percentage point or two. This is due to dilution of shareholders in the near-term due to an increase in the supply of shares on the open market and the earnings per share drag that comes with the time gap between when shares are issued and when the proceeds are eventually reinvested.
2. The medium to longer term impact of such an equity raise is generally very positive, especially in the case of ARCC at the moment. While its NAV per share is $18.40, its share price is $20.04 as of this writing, representing an 8.9% premium. As a result, by issuing equity at a meaningful premium, ARCC increases book value per share, effectively monetizing the favorable current market conditions and creating long-term value for shareholders. Additionally, ARCC has a proven track record of reinvesting these proceeds effectively, driving additional earnings per share and eventually dividend per share growth for shareholders.

Overall, we would view an additional equity raise as a positive development given that we are long-term investors. However, investors looking to add shares in the near future may want to wait for the equity raise announcement to buy given that there will very likely be a temporary pullback in the share price that comes along with it.

Important ARCC Update #2: The Dividend Looks Quite Safe

Despite Ares Capital growing its dividend so aggressively last year and currently offering a juicy 9.8% forward dividend yield, the company’s dividend looks quite safe at the moment. Management made several points on the earnings call that should enable investors who depend on ARCC’s dividends for income sleep better at night.

First of all, Net Investment Income came in at $0.68, up an incredible 30.8% year-over-year and 19.3% sequentially. Relative to the quarterly dividend of $0.48, the dividend coverage is a very strong 1.42x. This level of coverage for a BDC is nearly unheard of given the requirement that BDCs pay out at least 90% of taxable income as dividends. The reason management could get away with this extremely high dividend coverage ratio is simply that they had a tax deduction related to a legacy Allied Capital investment which reduced its total taxable income for the year. That said, its spillover income remains at over 2.5x its current regular quarterly dividend rate, giving it a substantial cushion to support the current dividend even if the economy were to enter a serious recession.

While interest rate uncertainty could also impact the company’s earnings profile moving forward (too dramatic of an increase in interest rates could cause some of its counterparties to default on their loans, while too dramatic of a decline in interest rates could cause their interest income from floating rate loans to plummet, thereby hurting their earnings), management is taking a conservative approach to the dividend, leaving significant current earnings and spillover income coverage in the event that a negative scenario were to play out.

Another reason to be confident in the safety of the dividend is the fact that the investment portfolio continues to improve in quality. For example, the average size of ARCC’s counterparty improved substantially during 2022, especially in Q4. As management pointed out on the earnings call:

At year-end 2022, the weighted average EBITDA of our portfolio companies reached $275 million, an increase from $162 million at the end of 2021 and meaningfully above the weighted average from 5 years ago of $62 million. We believe this offers significant benefits to Ares Capital as we grow as larger companies generally have stronger credit profiles as a result of more diverse revenue streams, broader customer bases and more experienced management teams.

The nonaccrual rate also remains very low at 1.7% of cost as compared to ARCC’s 10-year average of 2.4%.

Management is also improving its investment team in order to improve deal flow and net recoveries. As ARCC announced on the earnings call:

Today, we believe we employ the largest direct lending team in the United States with approximately 170 dedicated investment professionals. We believe that the scale of our team enables us to have complete market coverage by industry and by geography and to drive compelling opportunities in every channel that we target.

An example of their excellence at managing distressed investments in their portfolio is the fact that they have achieved a ~0.9x multiple on invested capital on all their loans that have gone on nonaccrual since inception. Furthermore, their counterparty’s overall weighted average interest coverage ratio is a pretty strong 1.8x, and the weighted average loan-to-value in the portfolio is ~45%, giving them significant downside protection from here.

Investor Takeaway

ARCC management have been very disciplined and successful at issuing equity at premiums to NAV and then reinvesting the proceeds in accretive fashion in order to drive long-term growth and outperformance for investors. This is evidenced by the fact that they have paid out stable or increasing dividends for 13 consecutive years (alongside substantial supplementary dividends) despite operating in an industry where 90% of taxable income must be distributed to shareholders each year. Last year alone, they increased their dividend payouts by 15%

Moving forward, while dividend per share growth is very likely to slow down, investors should be able to sleep well knowing that the dividend is on very solid footing right now and the company should be able to continue growing earnings and book value per share.

Ares Capital continues to grind out solid results quarter after quarter like clockwork, making it arguably the most dependable publicly traded BDCs today. Ares Capital is one of our top picks in the sector at the moment.