Capital Southwest: Low operating costs support yields up to 9% (NASDAQ: CSWC) | Private Equity Weekly

Now is a great time to be an income investor, as investors can easily earn a +9% yield when the market is preoccupied with chasing growth. Such is the current situation in BDC, which brings me to the capital southwest (NASDAQ:CSWC), I finally cover in early January, highlighting its strong capital appreciation potential and low fee structure.

While the stock is almost flat since our last visit, it continues to generate good dividends, providing investors with a total return of 2.2% since the beginning of January. In this article, I’ll take a fresh look at CSWC, including its recent business performance, and discuss why it remains one of my top picks in the BDC space, so let’s get started!

Why choose CSWC?

Capital Southwest is one of the few companies with peer Main Street Capital (MAIN), Hercules Capital (high temperature gas chromatography) and Trinity Capital (TRIN). It provides financing solutions to the lower-middle market (i.e. companies with EBITDA between $30 million and $20 million) and the upper-middle market (i.e. companies with annual EBITDA in excess of $20 million).

As of the end of 2023, results will be announced on January 29^th, CSWC holds a $1.18 billion portfolio at fair value. This represents slight growth quarter-on-quarter and substantial growth over the past two-plus years, with the portfolio more than doubling in size.

Management has also taken meaningful steps to de-risk the portfolio, with 97% of its credit (income-generating) investments in first-lien debt, up from 90% in 2020. Additionally, new capital has been deployed to increase portfolio diversity, with average holding size now accounting for just 1.2% of the total portfolio, down from 2.3% in 2020, as shown below.

CSWC also has equity investments in 62 companies, accounting for 9.5% of the total portfolio, giving it upside potential in terms of NAV/share and additional distributions to shareholders. As shown below, its portfolio is well diversified, with healthcare, media and marketing, business and consumer services, and food and beverage accounting for more than half (53%) of the portfolio value.

Meanwhile, CSWC continued to show strong results in its fiscal third quarter results for the three months ended 12/31/23, released on 29 January. This includes a 1.9% sequential increase in net value per share, from $16.46 in the fiscal third quarter (the last time I visited the stock) to $16.77 by the end of 2023. As shown below, this was driven in part by retained earnings from net investment income after the payment of regular and special dividends, as well as accretion from equity issuances following the issuance of shares at a premium to net asset value, partly driven by the net increase in portfolio value. offset by depreciation.

Importantly for income investors, CSWC continues to earn more than its regular quarterly dividend, with NII per share of $0.72 in the fiscal third quarter, a whopping 20% ​​increase from $0.60 in the year-earlier period. The current dividend rate of $0.57 per share represents a 7.5% annual increase and a dividend coverage ratio of 126%, allowing CSWC to pay a special dividend of $0.06.

CSWC’s NII per share growth was driven by higher interest rates, 97% of its debt investments in floating-rate loans, and accretive growth in its portfolio as it was able to issue shares at a premium to NAV and use the proceeds to In terms of new investments, the fiscal third quarter alone included $116 million in new commitments.

As shown below, CSWC’s price to NAV has increased from approximately 1.1x to 1.47x over the past 12 months, representing a significant increase in equity capital from shareholders, including $66.5 million in equity in Q3’23, The weighted average is a premium of 1.33 times to NAV.

Also encouraging is CSWC’s third-quarter operating expense ratio of 1.8% (measured as operating expenses as a percentage of total assets), second-highest in the BDC industry behind Main Street Capital’s 1.3%. While the ratio was flat month-over-month, it was down 10 basis points year-over-year and 200 basis points down from 2.8% in 2020.

Going forward, CSWC has plenty of room to take advantage of continued high interest rates, as 53% of its debt is in unsecured, non-contracted bonds, with the earliest debt maturity being January 2026. It also has one of the best balance sheets in the world. BDC Industries’ debt-to-equity ratio is 0.77x and will be below 0.91x by the end of 2022, well below the regulatory cap of 2.0x. With ample balance sheet flexibility and the ability to raise equity at a higher premium to book value than in the fiscal third quarter, CSWC has ample leverage to grow its portfolio in an accretive manner.

Risks to CSWC include 3 non-accrual charges representing 2.2% of total portfolio fair value, which is higher than I’d like to see. Over time, I would like this ratio to ideally drop to 1.5% or lower. Other risks include the possibility of interest rate cuts, which could put pressure on investment spreads and net investment income. However, this may be offset by equity financing at an accretive valuation above NAV. Over the next few quarters and beyond, I will continue to monitor CSWC’s ATM (market) equity issuance and capital allocation levels, which may also reduce its non-accrual investment ratio through portfolio growth, if there are no new increases in non-accrual investments. Accruals.

When it comes to valuation, admittedly, CSWC’s price-to-earnings ratio isn’t cheap, with a price-to-book ratio of 1.47 times. However, it’s worth noting that CSWC’s efficient cost structure as an internally managed BDC allows it to pay a regular dividend yield of 9.3%, while still trading at a comparable premium to NAV. This is why I continue to believe that P/E (using NII to calculate earnings) is a better metric for evaluating well-run BDCs like CSWC.

From this perspective, CSWC, currently priced at $24.62 and trading at a forward price-to-earnings ratio of 9.2x, doesn’t seem expensive. With a regular dividend yield of 9.3%, the potential for special dividends along the way, an efficient capital structure, and the potential to grow the portfolio through equity financing, I continue to think CSWC is a good value at current prices.

Important points for investors

All in all, CSWC offers investors a well-managed, diversified income-generating portfolio with a strong balance sheet and additional upside potential through equity investments. It also has an efficient cost structure, allowing it to pay a large and well-covered dividend, although it trades at a considerable premium to NAV. With a strong balance sheet and multiple growth levers, I continue to believe CSWC is a value at current prices and yields and maintain a Buy rating on the stock.