Ares Capital: High Yield in a Big BDC

07/29/2019 5:00 am EST

Focus: FINANCIALS

John Freund

Income Specialist, Todd Shaver's Bull Market Report

Ares Capital Corporation (ARCC) — with a high yield of 8.8% — is the largest middle-market business development company (BDC), explains John Freund, contributing editor to BullMarket Report.

Ares is primed to benefit from the impending rate cut. The BDC sector has already received a boost from the implosion of the hedge fund world, which has led to large private equity companies raising record amounts of capital.

That in turn has created a gap for middle-market lenders like Ares to operate in, since the big boys are focusing more on larger deals and ignoring this end of the market.

And since Ares is the largest middle-market lender, the company secures favorable financing terms which help it dominate the space. Ares even has the size to dip its toe in larger waters — the company has issued several $500 million loans, which most middle-market lenders can’t possibly match.

Ares had a strong 1Q19. The company produced $375 million in revenue for a 10% YoY increase. Net income came in at $215 million, a 40% increase. The number of transactions also increased 10% during the quarter to 37, with gross fundings coming in at just under $2 billion, a 20% year-over-year increase. All of that came while interest rates were stabilized.

With the Fed on the cusp of cutting rates, expect to see a boost to Ares’ revenue haul as its portfolio companies improve their financial positions. Remember, a BDC like Ares is only as strong as the companies it invests in, so a booming economic climate is great for BDCs as it props up the underlying portfolio companies.

And speaking of portfolio companies, no one company makes up more than 6% of Ares’ total portfolio, so the BDC is well-diversified, which protects it in case any one of its portfolio companies goes under and doesn’t pay back the loan.

But that’s unlikely, given that Ares has a track record of picking companies with low default rates. Management guided the company through The Great Recession, so we have every reason to believe they will outperform during a positive economic cycle like the one we are currently in.

The company has increased its undistributed taxable income (UTI) as a percentage of shares outstanding by 20% over the last 12 months. This is significant because it underscores the stability of the dividend.

As the UTI grows in comparison to shares outstanding, the likelihood of covering the dividend remains extremely high, since the dividend is distributed according to the number of shares outstanding.

So even though Ares boasts a large 9% yield, its UTI-to-shares outstanding ratio is triple the industry average, which means the yield is safe.

The stock is nearing its all-time high of just above $20, set in 2007, and we are confident it will crack through that ceiling sooner rather than later. The stock has traded within a very tight range since 2011, but strong tailwinds generated by the boom in global private equity and the impending Fed rate cut are set to boost Ares above that $20 mark.

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