BUY (CSWC, $16.31)
Diamond in the Rough: Internally Managed BDC at Discount to NAV/share, Further Dividend Increases Likely with Expectations of Strong Portfolio Growth Ahead, Portfolio with Both Lower and Upper Middle Market Investments Enables Versatility in a Challenging Market - Initiating with a BUY Rating And $22 Price Target.
June 27, 2017
Christopher R. Testa
Investment Conclusion . We are initiating coverage of Capital Southwest Corp. (CSWC) with a BUY rating and $22 price target. CSWC is an internally managed BDC, founded in 1961 and converted into a BDC in 1988. The company was, for many years, largely an equity investor with a small debt portfolio. As a result of this, distributions were lumpy and the stock consistently traded at a significant NAV discount. In the quarter ended 9/30/15, however, the company spun off its industrial equities portfolio into a separate entity with the remaining CSWC entity moving towards a more traditional debt-focused BDC model. As a result, the NAV discount has narrowed significantly but the stock remains largely unnoticed and under the radar, trading cheaper on a NAV basis than externally managed peers. Management’s extensive experience at ACAS should benefit growth in the LMM (lower middle market) portfolio and we expect that the company will continue to opportunistically utilize its I-45 SLF JV with Main Street Capital Corp. (NYSE: MAIN – SELL - $38.93) to take advantage of UMM opportunities. The company underwrites each investment assuming the financial crisis recurs, which is very cautious but we think is refreshing given how frothy loan markets have become and the increased occurrence of credit issues at BDCs.
* Core net investment income = net investment income + excise taxes + spin-off professional fees + other Source: S&P Capital IQ, National Securities Corporation Estimates
CSWC should have increased all-in effective yields but a relatively flat NIM as a result of the company utilizing more debt funding as the previously high cash balances have been drawn down. In fiscal 2Q16, the post-spin off quarter, CSWC had $184.1 million of cash compared with $93.3 million of investments at fair value. This drew down to $22.4 million in fiscal 4Q17 with an investment portfolio at fair value of $286.9 million, with the two most recent quarters involving modest draws on the revolver. We expect more debt to fund investments going forward and thus we expect NIM to remain relatively flat despite our expectations of all-in effective yields increasing. NIM was 9.29% in fiscal 2017 and we project this to be 9.31% for fiscal 2018 and 9.19% for fiscal 2019. We model all-in effective yield to improve to 10.48% and 11.19% in fiscal 2018 and 2019, respectively, from 9.70% in fiscal 2017.
We expect very robust portfolio growth in fiscal 2018 and fiscal 2019. CSWC’s portfolio at fair value finished fiscal 2017 at $286.9 million and we project this will increase to $389.5 million and $550.0 million at fiscal year-end 2018 and 2019, respectively. We expect CSWC to trade at a sizable premium to NAV/share, permitting accretive equity issuance when needed. However, we note that we do not expect the company to require a secondary equity offering until fiscal 3Q19. As a reminder, the company makes direct and club deals in the LMM but also has the flexibility to make lower yielding, UMM loans in its I-45 JV which should serve to augment deal flow and enable the company to put capital to work quickly without skimping on due diligence.
CSWC has excellent asset quality and we expect this to continue. CSWC had one legacy investment go on non-accrual in fiscal 2Q17 with a cost of $2.7 million or 1.3% of the portfolio at amortized cost which was restructured in the subsequent quarter with the subordinated debt being converted into preferred equity. The company underwrites each investment as if the financial crisis will occur again and they typically lend to companies that cycled very well through the crisis. Additionally, the UMM JV investments typically have lower risk given the staying power of larger, established companies with greater market share to weather adverse economic conditions.
We model steady dividend increases going forward as the company continues to ramp its balance sheet leverage and thus portfolio growth with a relatively low cost of capital. As CSWC continues to deploy capital in an accretive manner we expect core NII/share to increase steadily leading to further step-ups in the quarterly dividend. The quarterly dividend was $0.21/share for the 6/30/17 quarter as project it will be $0.24/share in fiscal 4Q18 and will be $0.28/share in fiscal 4Q19.
Shares remain materially undervalued, as we see it. CSWC remains at a decent discount to NAV/share despite being internally managed with a management team that is well-established in middle market lending from their tenures at ACAS. With a great runway for growth in the portfolio and core NII/share, likely steady dividend increases, and a very conservative underwriting approach with the optionality to rotate between LMM and UMM we fail to see why CSWC trades the way it does. We expect as the company gets more buy side attention the valuation should increase.
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