Best Idea: Golub Capital BDC
August 18, 2022
For many years Golub Capital BDC (GBDC) was regarded by many investors as the "safe" BDC. For years after going public in 2010 at $14.50 a share, GBDC reliably paid the same quarterly distribution of $0.32 for 8 years. (That's not the longest streak in the BDC sector history, but still impressive). In 2019, the dividend was raised to $0.33, setting up the prospect of more years of unbroken quarterly payouts. No wonder GBDC was an investor favorite whose stock price perpetually traded at a premium and at a multiple of earnings that most other BDCs could only dream of.
Suddenly, though, the pandemic broke out in 2020 and GBDC was caught flat footed, and was one of a few players who needed to undertake a dilutive Rights Offering to right its balance sheet. The quarterly distribution was dropped to $0.29. GBDC's stock price fell out of bed, dropping by nearly 50% in a few weeks.
Of course, the whole sector was down and then up, but as this chart shows GBDC has never reverted to its February 2020 pre-pandemic level or its salad days in 2017 when the stock traded briefly over $20, even though the quarterly distribution has been increased recently to $0.30.
Here's the good news: we have reason to believe GBDC's fundamentals are improving in such a way that its regular distribution may shortly exceed the prior $0.33 level and its stock price break through to a new high. Our Target Price for GBDC is $21.00, 5% above the record and 50% over the current price level.
That's the conclusion we drew after the BDC Reporter undertook its quarterly review of GBDC's IIQ 2022 results; dissected the earnings call transcript and looked at the latest 10-Q. GBDC is about to become another beneficiary of the Fed's campaign of higher rates, which we expect to be the gift that keeps on giving into 2024, and even beyond. For a long term investor this is good news as the numbers suggest GBDC's "Adjusted Net Investment Income Per Share", which was already at $0.34 in the first two quarters of 2022 could go substantially higher.
That's because almost all of GBDC's $5.4bn loan portfolio (valued at cost) and $1.7bn worth of its debt obligations are priced on a floating rate basis. Or, in other words, as rates rise investment income will be increasing much higher than interest expense. Furthermore, as the Carpenters would says, we've only just begun. GBDC's portfolio yield increased by just 0.20% in the IIQ 2022 even though the Fed raised its target by 1.25% in the period, and has since gone 0.75% higher in this current quarter. And there's more to come.
Like with many BDCs, borrowers are given the option to fix in their rates for periods that range between 1 and 3 months. You can imagine what every CFO chose the last time they had a choice, but now those 3 month fixes are coming to an end and borrowers will be paying a great deal more. Three months from now, and - probably - three months after that this process will be repeated as the Fed tries to wring inflation out of the economy by making everybody pay more for borrowing.
Then there's that other benefit: higher spreads. With the economic outlook dark, many lenders have pulled back from leveraged lending, or - like GBDC - are demanding wider spreads from borrowers and better terms and being more picky about saying yes to new transactions. As long as these conditions persist, GBDC's Return On Assets (ROA) will - in a drip drip fashion - improve even if the Fed wasn't raising rates. Furthermore, if past is prologue, those wider spread loans will benefit GBDC for the next 3-5 years.
Just how much GBDC will benefit from these conditions is very hard to say. Management avoids offering much in the way of specific quantitative guidance or any sort of timeline. In its 10-Q, though, GBDC calculates the incremental net investment income - after factoring in higher interest expense - comes to $75mn annually if interest rates increase by 200 basis points over the mid-year 2022 level. In per share terms that $0.44 ! Even if you lop some of those gains off for the manager's incentive fee, or make provisions for higher credit losses than in the past from the process of stressing so many borrowers with higher rates, the prospective gain in EPS should be substantial.
Where earnings go, dividends will follow. Here's our educated guess which we've input into our 5 year model: Starting in 2023 we expect the annual GBDC payout to jump to $1.4000, or $0.35 per quarter. (In reality, some of the dividends may be paid as "specials" - something GBDC has done in the past). Controversially, we expect GBDC will be able to maintain that 17% increase in its payout through 2026. Even when the Fed dials down rates, as we expect them to begin to do in 2024, GBDC will have both the benefit of higher spreads and the accretion from selling new shares at a premium, which we expect to occur. Also, it's likely that EPS will be high in 2023-2024 and doled out in future years as distributions.
We are maintaining a terminal multiple of 15.0x the 2026 distribution. Back in 2017, GBDC traded at almost that multiple and may do so again. If so - as we mentioned - the Target Price would be $21.00 as investors fervor - which has cooled in recent years - is renewed. The result is an investment that our model indicates will earn 99%, or 19.8% over a 5 year period. About half the gain will come from distributions and half from price appreciation.
Admittedly a 15x price to dividend multiple is high. We re-calculated our return using a more modest 12.5x multiple and came away with a still generous return of 74% over 5 years - two thirds of which to come from payouts. Either scenario compares favorably with GBDC's total return of just 12% over the past 5 years. Back then , after all, the BDC's stock was trading over $18 and was headed much lower, eating away at the return afforded by quarter after quarter of pretty stable distributions.
Buying And Selling
We know it's not easy, but getting the timing of buying AND selling is critical to getting full value out of these Best Ideas. At the moment, GBDC and most every BDC out there, is oversold, much as you might expect with so much gloom, doom and uncertainty in the air. GBDC, for example, is trading (14%) below its 52 week high and more than (30%) below that 2017 all-time peak. One day - and we can't say when - GBDC and the sector will become "overbought", which will represent an opportunity for the patient long term investor willing to say good-bye at the right time.
In any case, based on our expectations of higher earnings and distributions - and only modest damage from any potential recession thanks to the diversified and first lien nature of the portfolio and management's excellent underwriting track record - GBDC is our latest Best Idea. We bought the stock today for $14.00 for our Best Ideas portfolio. Now, we wait to see if those payouts begin to rise...The current yield is 8.6%, but should jump to 10.0% if we're right that GBDC is going to reclaim its crown as the "safe", popular BDC.