Ares Capital Stock: A more aggressive Fed is good for its profits

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Thesis

Ares Capital, a leading mid-market business development company (NASDAQ: ARCC) has seen its stock take a beating from its February highs, although it continues to benefit from a hawkish Fed.

As a result, the ARCC is down nearly 25% from its recent lows, as the market downgraded it to reflect value compression within its portfolio companies.

Management is confident that its relatively low leverage (debt/equity target: 0.9x to 1.25x) and ample liquidity of $4.7 billion should provide it with more opportunities in the dislocated funding market by loan. As a result, the company continues to expect strong opportunities in the private lending market, despite the looming global recession.

Additionally, its focus on primarily less cyclical higher quality companies that have demonstrated robust EBITDA growth should help secure the market for its value proposition through the cycle.

Given the sharp collapse from its recent lows, we believe its valuation has also been de-risked. Moreover, its price action is also constructive, which could help ARCC form a consolidation zone at current levels.

However, we believe caution remains warranted as a worse-than-expected global recession could further depreciate its valuation multiples, in line with its historical averages. Therefore, investors considering increasing their exposure are encouraged to layer over time.

With management committed to executing on their dividend strategy, we see an attractive risk-reward profile with an NTM dividend yield of 10%. Accordingly, we rate ARCC as a buy.

Owning the ARCC thanks to the Fed’s hawkish posture

With the release of the closely watched Nonfarm Payrolls report on Oct. 7, the market priced in a much higher probability (81.6%) of a 75 basis point rate hike at the next FOMC meeting. in November.

Therefore, it should provide more clarity on Ares Capital’s core EPS track through at least H123 (the Fed’s current median terminal rate is 4.6%) as it benefits from l increase in the base rate adjustment on its floating rate debt portfolio. Investors should note that its floating-rate share was 74% in the second quarter, funded mostly by lower-cost, fixed-rate funding sources.

Ares Capital Core EPS change % consensus estimates

Ares Capital Core EPS change % consensus estimates (S&P Cap IQ)

However, there is a bit of a delay in resetting its base rate on its debt portfolio. Management emphasized:

We expect continued increases in short-term rates to have a positive impact on the company’s net interest income performance. Given that approximately 60% of our variable rate loan base rates are currently reset every 3 months and the increase in base rates through these resets has typically occurred in the latter part of the quarter , our second quarter earnings did not fully benefit from the increase in market prices. rates reflected in our returns at the end of the quarter. (Ares Capital FQ2’22 earnings call)

We believe visibility through 2023 should help mitigate potential earnings volatility during the coming recession. Therefore, he should bring more confidence in the earnings quality of Ares Capital thanks to his well-diversified portfolio. Therefore, we are confident that this could reduce the ARCC’s potential volatility from current levels.

Ares Capital NAV per share change % consensus estimates

Ares Capital NAV per share change % consensus estimates (S&P Cap IQ)

Despite this, we think the market rightly downgraded the ARCC in anticipation of the impact on the net asset value (NAV) per share of its portfolio.

As seen above, Ares Capital’s net asset value per share growth is only expected to bottom out in the first quarter of 2023, with the (very bullish) street likely modeling a less severe economic downturn.

Accordingly, the risks of a significant economic downturn could materially affect the recovery of its net asset value per share, further compressing the value of its portfolio companies and ARCC’s valuations.

But ARCC’s assessment seems reasonable

Valuation trend of ARCC NTM Core EPS multiples

Valuation trend of ARCC NTM Core EPS multiples (koyfin)

We understood that the market had already downgraded the ARCC, sending its NTM base EPS multiples spiraling down to the area of ​​two standard deviations below its 10-year average.

However, we believe the company’s earnings visibility through the cycle, supported by the Fed’s hawkish stance, should support its valuation at current levels.

ARCC TTM P/TBV valuation trend

ARCC TTM P/TBV valuation trend (koyfin)

However, ARCC’s TTM tangible book value (TBV) multiples are still above the two standard deviation zones on its 10-year average. Therefore, we postulate that the market probably anticipated a less severe recession at current levels, with a TTM P/TBV of 0.9x.

A worse than expected economic downturn could cause its TBV multiples to drop towards its 0.8x zone. Therefore, we urge investors to consider spreading their exposure over time, taking advantage of unexpected downside volatility.

Is ARCC stock a buy, sell or hold?

ARCC Price Chart (Weekly)

ARCC Price Chart (Weekly) (TradingView)

We understood that the ARCC held its recent lows with resilience after breaking through its previous lows in June. As long as these lows hold solidly (in our current view), the ARCC should be able to consolidate at these levels.

Additionally, the rapid sell off from its August highs is constructive for its bottoming process as the market has shrewdly digested the gains from the summer rally.

However, we encourage investors to consider its intermediate support as the next potential re-test zone if the market anticipates a more severe global recession, leading to a further downgrade.

We rate ARCC as a buy.

Sallie R. Loera