Solar Capital (SLRC) showed resilience during the pandemic. The company’s portfolio had ZERO non-performing loans in FQ2.
The quality of SLRC’s portfolio will enable the company to maintain its dividend distributions, which currently yield an eye-watering 9.5%.
SLRC is trading at a 19% discount on NAV, opening an opportunity for 17% capital appreciation, augmenting the 9.5% annual dividend yield.
SLRC portfolio performed well during the pandemic. The company had ZERO non-performing loans as of June 30th, 2020. This is a result of a careful approach to investing that won Wall Street admiration. Wall Street analysts have a very bullish rating for the stock and a price target of $18.22 per share.
SLRC’s $1.4 billion investment portfolio is composed of 108 companies in 27 different industries, providing valued diversification. Almost all of SLRC’s debt investments are senior secured loans, enhancing portfolio quality.
Moody’s rating maintained its investment grade rating for the company during lockdown, which is a testimony on management prowess and portfolio quality.
SLRC has an uninterrupted record of dividend hikes since 2014. SLRC’s management stated last month that it plans to maintain its dividend payments at current levels. The outstanding investment portfolio will enable the company to achieve its dividend distribution plans.
Having said that, temporary disruptions in earnings pushed SLRC’s payout ratio above 100%, driving some investors to question the sustainability of future distributions. Below is an analysis of these factors to assess the risks related to dividend continuity.
Reasons for lower revenue in Q2
- Smaller investment portfolio
- Lower interest rates on debt securities
- Lower dividend yields on equity securities
Smaller Investment Portfolio: SLRC’s portfolio shrank $105 million at cost ($135 million at fair value) in the six months ending June 30th, 2020. This was a result debt pre-payments on behalf of some portfolio companies looking to refinance their debt. SLRC is gradually restoring its investment portfolio by new investment originations. In the three months ending June 2020, SLRC invested $61 million in 14 new portfolio companies. With almost half a billion in cash, the company will have no problem replacing investments it lost recently.
Source: SLRC financial statements
Lower interest rates on debt securities: 77% of SLRC’s debt investments are tied to LIBOR. In response to the COVID pandemic, the Fed ventured on a wide scale monetary stimulus that lowered interest rates. Last week, the Fed chairman signaled that interest rates will remain close to the zero bound until 2023.
While these developments are recent, the low interest rate environment is yesterday’s news. Historically, the effect of low Fed rates on the US middle market rates has been soft. SLRC’s weighted average yield in Q2 was 9.9%, compared to 10.6% in Q1.
Moreover, many of SLRC debt securities have interest floors, thus minimizing the impact of lower LIBOR.
Lower yields on equity investments: SLRC holds 23% of its investments in the form of equity securities. Dividend on these equity securities decreased by 30% in Q2, compared to the same quarter last year.
As economic activity returns to normal, SLRC’s portfolio companies will bring their dividend distribution up closer to their pre-pandemic levels.
Currently, SLRC insiders own 7% of the shares outstanding. The management team increased buying at the start of the market rout in March. This demonstrates the management’s confidence in the company.
Discount on NAV
Reported NAV as of June 30th, 2020 is $20.11 per share. The stock is trading at a 19% discount of NAV ( price $16.37). Below is the historical NAV-Price gap. If NAV-GAP returns to normal levels of 4.5%, then the price will be 19.2, opening an opportunity for 17% capital appreciation.
Source: Author’s estimates. Data from SLRC financial statements
SLRC has about half a billion in cash. While this cash will help the company grow its portfolio, the company faces competition from other lenders in the US middle market. This might make it difficult for the company to deploy its capital in investments that meet the management’s criteria.
Moreover, SLRC’s investments are non-investment grade and carry a significant amount of risks. The company implements covenants, collateral, and stringent due diligence in choosing its investments to minimize these risks. Still, the risks inherent in the company’s operations can’t be ignored.
Temporary disruptions in earnings are spooking investors, pushing SLRC below its average NAV/Price, and opening an opportunity for long-term investors to lock in a 9.5% dividend yield with 17% capital gain potential.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is not investment advice. Please consult an investment advisor before trading in the stock market.