BDC Update: FS-KKR Capital

March 9, 2023

In Line

As we anticipated back in November 2022, FS-KKR Capital (FSK) performed well in IVQ 2022 from a recurring earnings standpoint. GAAP-blessed Net Investment Income Per Share (NIIPS) increased by 5.3% to $0.80. For the year, the large-cap BDC earned NIIPS of $3.05, up from $2.76 in 2021. NAV Per Share fell modestly by (1.6%) in the final quarter. The BDC announced an IQ 2023 payout scheme of $0.64 in a regular quarterly distribution and a $0.06 supplemental. Management indicated that the supplemental could be counted on for all of 2023, or "longer".

Realistic?

Our projection for 2023-2027 is for FSK to payout $3.0000 each year - an admittedly ambitious level given that the total payout in 2021 was $2.4700. This latest payout announcement annualizes at $2.80, already higher than in 2022. With higher rates on the way - and with the 2023 analyst earnings consensus at $2.9900 a share - our $3.0000 projection seems doable. Bolstering our confidence is the substantial level of undistributed taxable income left to pay out.

Valuation

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As result, we've left our projections alone where distributions are concerned and maintained the same terminal price-to-dividend multiple and a $30.25 Target Price. The current stock price is $18.96, implying a 60% price rise is projected. The pro-forma yield is 15.8% - the second highest of any BDC right now. The total return is 165% over 5 years or 33% per annum.

Eyes Open

The perennial challenge for FSK is credit. KKR continues to struggle with many troubled borrowers booked by the prior co-manager with FS Investments and a few new names. Underperforming assets account - by FSL's own count - to an unchanged 25% of the total portfolio. An economic recession might greatly increase the number of non-performing companies and materially impact both NAV Per Share and profitability, but the BDC continues to get the benefit of our doubts. Judging by FSK's current price-to-2023 earnings ratio of 6.3x investors are much warier.

November 20, 2022

Featured

We've heard from FS-KKR Capital (FSK), which materially improved its long-term valuation. Like ARCC and ORCC that we've discussed before, FSK operates in the very largest BDC market for lending. Higher interest rates pushed up "Core Net Investment Income Per Share" to $0.73, a 9% increase in 3 months. See the IIIQ 2022 earnings press release. This occurred even as two larger borrowers were placed on non-accrual.

High Side

We're projecting FSK's total payout will grow to $3.0000 a share from 2023 and stay there through 2027. We concede that's higher than the analyst EPS consensus of $2.9000 and better than the $2.7200 annual pace of regular and special distributions. However, we believe the analysts might be being too conservative given the potential 200 basis point increase, or more, yet to come from the average level achieved in the IIIQ 2022.

Major Worry

The biggest obstacle to reaching that profitability would be a good deal more loans going on non-accrual. KKR - as the BDC's manager - appears to have been a better underwriter than Blackstone, who operated the business previously. Many of the "legacy" loans have been settled out or effectively written off. We can't rule out, though, that FSK's total underperforming assets - already higher than its peers at 25% of the total portfolio - could yet increase with new additions, dragging down future earnings and distributions. We're monitoring credit performance carefully.

Big

Still, if FSK does increase earnings and distributions as we expect, the Target Price will be $35.25, versus only $19.36 currently. That's a prospective 88% price increase - twice the sector average, reflecting how much FSK has fallen from favor. While ARCC trades above net book value and repeatedly raises new equity, FSK trades at a (23%) discount to its latest net book value per share and only 6.7x projected 2023 EPS. (That's substantially below what ARCC and ORCC are valued at these days).

Valuation

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The result is a Total Return projection over 5 years of 160% - or 31.9% per annum - the best out there this week. The yield at our aggressive $3.0000 payout estimate is 15.5%. Obviously, that's a huge prospective return but even when we assume the dividend payout remains at $2.7200 over this whole period as higher income from rate increases is lost to credit mistakes, the annual Total Return is still 27%.

More Work Ahead

We'll be undertaking a full Credit Review shortly of FSK that might change our minds, but the current prospect is very intriguing. Too good to be true? The market certainly thinks so, but we wouldn't be in a hurry to discount KKR. In fact, on Monday we expect to add FSK to our growing model portfolio.