Ares Yields Over 8%, with More Ahead
Ares Capital Corp. (ARCC:NASDAQ, 18.92) has performed well, both as a company and a stock. In its latest results, net investment income (the critical metric for business development companies [BDCs], off which the dividend is based) was higher than estimated, boosted by origination fees for new loans—at record levels. Book value increased 3%, driven by portfolio gains and reduced loans on non-accrual (3.3% of the portfolio down from over 5% the prior quarter). It was a great quarter and end of the year, with income well above the current dividend. On a recent company update call, CEO Kipp Deveer said, "surprisingly to me, we are closer to pre-COVID levels than expected."
Strong loans and low debt
Over 80% of its loans are at floating rates, so if rates rise, Ares receives more. About the same number also have floors. Deveer noted that since BDC leverage is limited, the current level of interest rates is not as important to BDCs as to other finance companies.
For Ares (and many other BDCs), credit quality is more important than the interest rate of loans. So even as the environment has become more competitive, and with it, rates lower, one advantage is that the underwriting details of loans has improved. Deveer also noted that confidence in Ares has increased, because the company had proven that it was there for its portfolio companies during the lockdown and showed it had the capital and was reliable. He said the company has consequently gained market share.
Ares takes equity instead of cash
Unlike some BDCs that eschew so-called PIK (payment-in-kind) income, Deveer said Ares likes to have some PIK because it likes to have some equity. (The other BDC on our list, Gladstone Investment, takes equity kickers in addition to the interest on loans, but no PIK income.) He admitted that PIK income had doubled over the past year, as some companies were unable to pay cash on loans, "and some of this is not PIK we actually want, and we don't want the level to go any higher." However, over time, Ares had collected on about 90% of its PIK income.
Raised debt and equity, to improve liquidity
Because of the opportunities, Ares recently raised equity, something it had not done for years. It also took advantage of lower interest rates to "re-do" its debt—before the recent pickup in long-term rates—issuing debt at 2.15%, the lowest in its history. None of its debt is floating rate.
Although only a little over 3% of the loans are on non-accrual, the company is "still working on" about 15% of the portfolio, mostly in areas of the economy where recovery has been more difficult. It lends on cash flow, not on assets. Central to the Ares approach is that it lends to non-cyclical defensive businesses, and therefore is "very underweight" areas hit hardest by the lockdown. Deveer estimates that 80-90% of the portfolio is going to continue to do well and will be back to pre-COVID levels by the autumn.
Excess cash builds and can be distributed
Net operating income at $0.54 for the last quarter was well above the dividend at $0.40. In the second and third quarter it missed the dividend, each time by $0.01. The dividend was last raised at the beginning of 2019, though it has paid four small special dividends since then. Ares has accumulated significant undistributed income, so we expect some more special payments ahead, with a dividend increase probably waiting till the end of the year because of economic uncertainty.
Best in class, the largest BDC with the ability to raise money at very low rates, Ares currently yield 8.5%, fully covered by net income. Its solid balance sheet, strong originations and declining non-accruals all add to its appeal. Along with the BDC sector, boosted by high yields and a reopening economy, Ares stock has performed well, up from under $14 at the end of October. At the current level, we would hold, but wait for better opportunities to add to positions.
A Good Quarter for Gladstone, Also with a Strong Cash Position
Gladstone Investment Corp. (GAIN: NASDAQ, 12.52), our second, and far smaller BDC, also had a good quarter, despite ongoing economic lockdowns and restrictions. In the last quarter of the year, Gladstone earned net investment income of $0.24 per share, up from $0.15 in the previous quarter. The second and third quarter did not cover the dividend of $0.21 per quarter, so the latest results were good news. The company has $14 million of spillover income, sufficient for more than two whole quarters of dividend payments.
Part of the reason for the large jump in NOI was "other income," which includes exit fees on companies that repaid their loans early, as well as dividends on preferred stock investments. The baseline of interest income on loans was pretty steady. Such "other income" can vary considerably from quarter to quarter, so it may be too early to say the company is out of the woods yet. Gladstone noted that during 2020 it did not pressure its portfolio companies to pay on their loans if that would have hurt the businesses, but they did not have to provide much additional financial support all year, and at this point, none of the companies needs additional funding.
Portfolio valuations are stabilizing, with an increase at the end of the year. Gladstone noted the very competitive environment for new deals, though they hope to close some in coming months. The company has sufficient liquidity after raising nearly $13 million in equity on its ATM (at-the-market) program, and nearly $100 million available on its credit facility. The net asset value (NAV) increased to $11.11 mainly from net realized gains.
Stock up above asset value
Like many of the BDCs, the stock has performed well in recent months, after sliding from last spring through to the end of October. GAIN is up over 50% since then, back to where it stood before COVID, if not yet back to all-time highs. The yield is 6.7%, assuming no special dividends, at its decade-long lows, but we expect bonus distributions, which the company typically pays from realized gains, while regular interest income pays the month dividend. It is trading a little over NAV (1.13x) indicating there may be ongoing ATM equity sales, though there is no need for a major equity financing. We will continue to hold though look for better opportunities to buy.
Nestle Continues Its Long-Term Growth Trend
Nestle SA (NESN:VX; NSRGY:OTC, US$105.52) had a good year despite the pandemic and despite top-lines sales down nearly 9% mostly because of the strength in the Swiss franc.
Organic growth was an acceptable 3.6%, though not at the company's long-term target. It was driven by growth momentum in the Americas, especially in pet foods and health sciences. Growth in China stalled. The operating margin was up to nearly 18% as cost- saving initiatives continue to kick in.
Nestle said it was confident about the growth rate moving higher, above 4%, despite a lower outlook for China; it also said that operating margin increases would slow. The return on invested capital would likely remain about a very solid 15%.
M&A in its future
Nestle said it is interested in major acquisition; it is still sitting on the $10 billion from the sale of its skincare unit in October. The company has been very active in recent years on dispositions, large and small, and mostly bolt-on acquisitions. Since 2017, there has been portfolio rotation of about 18% based on 2017 sales. It has generally achieved sales prices above expectations.
Its largest recent sale is that of the North American water brands for $4.3 billion. Following that, it acquired Essentia Water, which pioneered ionized alkaline water more than 20 years ago and is the leading brand in that space in the U.S. This pair of transactions is a good example of Nestle exiting mature competitive businesses and buying high-margin and growth businesses.
The company continues to put significant emphasis on global warming and sustainability. There are constant innovations, such as a recyclable KitKat wrapper, and bio-based lids. These are low-cost changes that do not affect the consumer but emphasize a commitment to the environment. Less successful may be some of the changes in its actual products, some of which, including sugar-free chocolate bars, faced consumer revolt in England. Plant-based coffees and vegan chocolate bars may, at best, be niche products.
Food costs going up
Nestle, like other food companies, faces the prospect of higher input costs, which has already caused some other consumer companies to raise prices across the board.
The company increased its dividend, for the 26th consecutive year, though at 2.85%, the yield has declined steadily over the past decade as the stock has moved up faster than the dividend. The stock declined steadily from the middle of last year, culminating in a drop in February to Sfr 95. Since then, it has recovered two-thirds of its long slide and currently trades at a rich price-to-earnings in the mid-20s. The balance sheet remains rock solid. Long-term investors can continue to hold, though we will look for better opportunities to buy.
TOP BUYS now include Midland Exploration Inc. (MD:TSX.V, 0.82 x 0.88); Lara Exploration Ltd. (LRA:TSX.V, 0.70); Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE, US$6.75); and Barrick Gold Corp. (ABX:TSX; GOLD:NYSE, US$20.37).
Originally posted on April 4, 2021.
Adrian Day, London-born and a graduate of the London School of Economics, heads the money management firm Adrian Day Asset Management, where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX). His latest book is "Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks."
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