Capital Southwest Q4: Quality BDC, But Valuation Is Too Rich Here (NASDAQ: CSWC )

Introduction

Southwest capital (NASDAQ: CSWC) has been the highest performer in my dividend portfolio at present, up greater than 50% over the previous 12 months. I’ve been a fan and shareholder of this BDC for fairly a while, however with a current surge by way of share value, I imagine CSWC’s premium is simply too excessive at present ranges.

I’m very aware of paying for high quality and think about CSWC to be one of many highest high quality BDCs within the sector, if not the best in the intervening time. And their share value and efficiency because the fee hike started exhibits that.

However I did not add final 12 months and I believe prepared traders ought to anticipate a pullback. On this article, I talk about current BDC quarterly earnings by way of the year-end and why traders might even see costs fall in subsequent 4-6 months.

Preliminary thesis

Again in early February, in an article entitled: Capital Southwest This fall: Essential for traders, however anticipate the pullback, I fee the inventory as a maintain because of its premium. The inventory traded round $24 a share and continued its upward trajectory as profit-oriented traders pushed the inventory value above $26, the place it’s at present buying and selling.

The corporate reported a robust Q3 with a beat in each web funding and complete funding returns. As well as, they continued to develop their portfolio by including 4 new portfolio corporations. This was along with investments in 12 current ones throughout the quarter. They’ve additionally proven robust NAV progress with worth positive aspects of $0.31 to $16.77, which is one other indicator of their high quality and why they seem to be a must-have for income-oriented traders.

One other robust quarter

Capital Southwest reported This fall earnings final week on Could 15 with one other robust exhibiting on each the highest and backside strains. Web funding revenue beat analysts’ estimates by $0.23 and closed the fiscal 12 months with a pre-tax Nll of $2.72 for the complete 12 months.

That is a formidable double-digit enhance from $2.30 final 12 months, one other testomony to its high quality and why this BDC deserves a premium for its NAV. Wanting on the​​​​chart beneath, you’ll be able to see that CSWC has outperformed its largest peer Ares Capital (ARCC) and different high BDCs by a big margin over the previous 12 months. The following BDC in comparison with them is Blue Owl Capital Corp (OBDC) and even the primary one outperforms them by greater than 20%.

For the quarter, web funding revenue earlier than taxes was $0.68, which coated the common dividend by 147%, though it was down from $0.70 within the third quarter. Even factoring within the $0.57 and the extra $0.06 due subsequent month, Nll CSWC covers that greater than 100%. NAV was flat at $16.77 from the earlier quarter, however up from $16.46 within the second quarter and $16.37 for the 12 months.

Whole funding revenue additionally rose impressively year-over-year to $178.14 million, however was down sequentially from $48.6 million to $46.4 million. Administration attributed this to decrease dividend revenue and decrease distributions. However that is up practically 25% from about $37.2 million from This fall 2023.

Efficiency pushed by robust portfolio progress

So, general, a stellar efficiency by CSWC to finish the monetary 12 months. As well as, BDC continued to develop its portfolio, which totaled $1.5 billion in complete honest worth, up from $1.4 billion within the prior quarter and $1.2 billion year-over-year.

This was pushed by new commitments of $157.5 million to 6 new corporations throughout the quarter, in comparison with 4 in 3Q. Of that, $123.5 million went to loans primarily from $2.8 million in fairness. Moreover, they made additions to five current portfolio corporations, however this was offset by $13.7 million in proceeds from two mortgage advances.

On the finish of the quarter, CSWC’s first mortgage ratio was 88.7%, placing the BDC in a robust place to climate financial downturns. On this approach, they not solely enhance their portfolio, but additionally enhance their publicity to loans within the first place. And whereas that is nonetheless properly beneath Blackstone Secured Lending’s (BXSL) 98.5%, it is properly above ARCC’s 64.8%.

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Why a rollback would possibly occur

Although the corporate was a lot smaller again then, and it was throughout the recession, you’ll be able to see that its inventory value elevated considerably throughout the rate of interest hike from June 2004 to June 2006. CSWC’s inventory value greater than doubled from about $6 to just about $13 by the point the charges had been minimize in September 2007. Then you definately see that by February 2009, the inventory was down greater than 50%. I believe traders will get a greater entry value earlier than the tip of the 12 months, particularly in 2025.

In keeping with the CME FED Watch Instrument, greater than 50% imagine that the primary fee minimize will happen in September. If that’s the case, I anticipate BDC costs to fall within the coming months. Additionally, because of their predominantly floating fee portfolios, many are more likely to minimize their particular and extra dividends to shareholders, another excuse many are more likely to see costs fall.

Dividend protection

As you’ll be able to see from the chart beneath, CSWC has rewarded shareholders with extra dividends because the begin of fee hikes in 2022, a tribute not solely to their high quality but additionally to their inner governance construction. Exterior-managed friends like ARCC hold their dividends regular and are much less shareholder-friendly. In flip, this has led to raised efficiency and fairness issuance alternatives as many are buying and selling properly above NAV.

Overrated

It appears I am not the one one who thinks Capital Southwest has gotten forward of itself with its metrics. On account of the evaluation, BDC was lately downgraded to market carry out from outperform. Their outperformance has seen them commerce at 1.61x e-book worth, above the 1-year common of 1.40x.

On the time of my final thesis, CSWC had a P/NAV ratio of 1.44x and was buying and selling at 1.31x on the finish of 2023. It at present stands at 1.57x, which is considerably increased than ARCC’s friends’ 1.08x. Even accounting for OBDC’s efficiency over the previous 12 months, which is up greater than 28%, that is nonetheless properly above their P/NAV ratio of 1.07x.

Moreover, the inventory is buying and selling close to its 52-week excessive of $27.22 and poses some draw back threat, in keeping with Wall Avenue analysts. Whereas I do not know if the inventory will commerce close to its value earlier than the speed hikes start, I believe they provide a greater entry for these with endurance.

Dangers

One of many enormous dangers in my opinion for CSWC and its BDC friends is a drop in web funding revenue if rates of interest decline within the subsequent 4-6 months. Most of them have primarily floating fee portfolios and get further revenue due to increased rates of interest. And that is another excuse why I believe their inventory costs will fall as a result of they will not be as engaging to traders.

To be honest, these with good stability sheets and portfolio high quality might be high-quality, but it surely’s nonetheless a threat and traders ought to concentrate on it going ahead. One other threat is that if the financial system falls into recession. BDCs might even see their lenders goal non-accrual or progress PIK revenue. CSWC noticed its PIK income fall quarter-on-quarter, however administration stated it expects extra progress throughout a time of excessive rates of interest. If a recession hits, this might enhance once more and is one thing to be careful for within the coming months.

Backside line

CSWC has carried out exceptionally properly, growing practically 49% over the previous 12 months, which is a testomony to their creditworthiness and shareholder-friendly construction. Nonetheless, with BDC lately hitting a brand new 52-week excessive earlier this month, I believe the inventory has gotten forward of itself and traders seeking to open a place ought to anticipate decrease rates of interest.

With the primary minimize anticipated in 4 quick months, CSWC will possible be a greater entry level than their present stage. The shares proceed to ship robust numbers and portfolio progress, which is a consequence not solely of their creditworthiness, but additionally of an skilled administration group. But when rates of interest are near falling, I fee Capital Southwest as sustainable.