BDC Update: Golub Capital BDC

October 19, 2023

If Wishes Came True

Ideally, when Best Ideas makes its 5-year projections about future dividend payouts of the BDCs we track and fixes a target price, we could just walk away and see everything pan out as hoped. However, we often find ourselves fiddling with both the projections and the assumptions in our Expected Return model, which results in a fresh Update. In the case of Golub Capital (GBDC), though, the estimates we came to in August of last year have held up very well. (See what we wrote below). Only now do we feel compelled to amend our outlook.

Steady

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).

That's what we wrote last year and that has come to pass, and more. Through the first 9 months of the year, the BDC has paid out $1.07, and thanks to a IIIQ 2023 increase to the regular dividend to $0.37 per share, the likely full-year payout will be (at least) $1.4200. Earlier we projected GBDC would be able to maintain that $1.4000 distribution through the years ahead. Now we've upped the outlook for 2024 to $1.60 a share, falling back to $1.50 from 2025-2027. The change has to do with the impact of higher rates, which are expected to remain at their elevated levels through next year and gradually decrease thereafter. We've used the disclosures in GBDC's 10-Q to estimate the impact.

Net Asset Value

Another key assumption - a new feature of the Expected Return model since last we wrote - is what will happen to net book value per share over the five year period from 2022-2027. Over the past 5 years, GBDC's NAVPS has dropped (7%). However, much of that was related to the one-time dilution caused by the BDC's emergency Rights Offering that occurred in 2020, and discussed in our earlier update. More recently GBDC's net book value has remained very stable and we're projecting that will continue through 2027.

Terminal Multiple

To be consistent with the assumptions we've made for other BDCs with stable NAVPS, we're assuming GBDC will eventually trade at 12.5x its annual dividend. For our purposes this gives us a Target Price of $18.75. That's lower than what we assumed before ($21.00), which was based more on historical trading performance.

Valuation

Investment Recommendation

August 18, 2022

Dependable

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.

Banana Peel

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.

Never Again

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.

Comeback

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.

Good News

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.

Beneficiary

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.

Temporary Delay

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.

Lender Friendly

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 the past is prologue, those wider-spread loans will benefit GBDC for the next 3-5 years.

Shy

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 is $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.

Bigger

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.

High Expectations

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.

Less

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 came 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 goodbye at the right time.

Chosen

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.