NEUTRAL (ARCC $13.87)
Strong Origination Platform and NAV Stability, Although The Portfolio Shift Away From First Lien is Unfavorable and Likely to Weigh on Valuation - Initiating With A NEUTRAL Rating And $16 Price Target.
June 28, 2016
Christopher R. Testa
Investment Conclusion. We are initiating coverage of Ares Capital Corp. (ARCC) with a NEUTRAL rating and $16 price target. Ares is the largest publicly traded BDC by asset size and market capitalization. ARCC has regional offices in New York, Chicago, Dallas, and Atlanta with about 100 investment professionals. The company has good asset quality with non-accruals at cost averaging 2.3% of the portfolio since 1Q12. While this is higher than we would like, ARCC has a good track record of recoveries as indicated by its decreasing net realized losses and stable NAV (net asset value). Ares recently announced that it reached an agreement with American Capital Ltd. (NYSE: ACAS- $15.57-NR) to acquire the company for a combination of both cash and stock, with some financial support from ARCC’s external manager. The acquisition, which we assume will close at the end of 2016, will likely be dilutive to NAV/share initially although core NII should be supported by the up to $10 million/quarter of incentive fee waivers the manager is prepared to give to ARCC as it digests the acquisition. The break-up of GE Capital and sale of the Antares sponsor finance unit in 2015 presents a challenge for Ares due to the large size of the joint venture (JV) with the company (20.8% of the portfolio’s fair value as of 1Q16). As this JV winds down, the company is beginning a new one with Varagon although the size and economics will not be comparable to the one with GE. ARCC has decreased its first lien exposure and increased its second lien and subordinated exposure and in turn attachment points have steadily increased which are trends that we find worrisome. Our $16 price target implies an estimated 2017 P/NII of 9.8x, dividend yield of 9.5%, and P/NAV of 0.97x compared to the BDC sector averages of 7.4x, 11.2%, and 0.81x, respectively.
* Core NII = NII + capital gains incentive fee (reversal) + income tax expense for gains/losses
Source: S&P Capital IQ, National Securities Corporation Estimates
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