NEUTRAL (SAR, $21.26)
Lower Middle Market Focused BDC with Ample Dry Powder to Drive Strong Portfolio Growth with Minimal Equity Issuance, Significant Non- Sponsor and Second Lien Composition Keep Us On the Sidelines For Now - Initiating With a NEUTRAL Rating And $23 Price Target.
August 29, 2017
Christopher R. Testa
Investment Conclusion . We are initiating coverage of Saratoga Investment Corp. (SAR) with a NEUTRAL rating and $23 price target. Saratoga is a lower middle market (LMM) focused company, making loans to companies with EBITDA between $2 - $50 million. The company commenced operations in March 2007 but was known as GSC Investment Corp. and was externally managed by GSCP, LP. In July 2010 the company recapitalized and Saratoga Investment Advisors became the new external manager of the company. SAR did not begin to pay regular cash dividends until fiscal 2Q15 and since then it has increased its quarterly dividend every quarter. The company recently had a couple non-accruals pop up totaling $20.1 million or 5.9% of the portfolio at amortized cost. We expect portfolio growth to offset the pressure on earnings that the non-accruals would otherwise cause. However, we note that we do model NAV to decrease the next fiscal quarter before stabilizing. Ample dry powder with increased first tier sponsor relationships should drive good volume for Saratoga, helping NII to overcome the anticipated earnings drag from non-accruals. Additionally, we expect the company to have to issue minimal equity on a flow basis through its ATM program given the reasonable regulatory leverage on the balance sheet.
* Adjusted net investment income = net investment income + losses on debt extinguishment + interest on 2020 notes during call period + changes in accrued capital gains incentive fee expense/reversal Source: S&P Capital IQ, National Securities Corporation Estimates
Saratoga’s portfolio composition will likely mute the NAV multiple shares trade at. Despite being a generally good lender, especially since Saratoga took over external management in 2010, we note that the composition of the portfolio will likely weigh on the multiple that SAR trades at. Saratoga is a LMM lender and roughly half of the portfolio is non-sponsor, even if no further non-accruals were to spring up, we expect as the credit cycle continues to age that this should warrant more of a discounted valuation. Non-sponsor, LMM companies already have low recovery prospects should an investment go sour and SAR has a second lien portfolio that was 30.8% of the portfolio by amortized cost of 5/31/17.
All-in effective yield and NIM (net investment margin) should be under pressure in fiscal 2018 before improving modestly in fiscal 2019, as we see it. We expect non-accruals and general broader market competition will likely weigh on all-in effective yields and thus NIM in fiscal 2018, before we expect non-accruals to be less of a drag as the portfolio grows and leads to improvement in yields and NIM in fiscal 2019. All-in effective yield and NIM were 11.98% and 8.40%, respectively, in fiscal 2017 and we project that they will be 10.94% and 7.62%, respectively, for fiscal 2018. For fiscal 2019 we model all-in effective yield and NIM to be 11.10% and 7.81%, respectively.
SAR’s portfolio should grow through fiscal 2018 and 2019. As of 5/31/17, SAR’s portfolio at fair value was $329.7 million and we model this to increase to $357.3 million at the end of fiscal 2018 and $387.7 million at the end of fiscal 2019. The company finished 5/31/17 with regulatory D/E (excluding SBA debentures) of 0.78x and 1.83x including the SBA debt. We expect that the company will continue to issue equity through its ATM program on a flow basis and draw upon its revolver and some additional SBA debentures to generate the portfolio growth we model.
Further dividend increases are likely although we do not expect step-ups each quarter. Saratoga has been increasing its quarterly dividend each quarter since fiscal 2Q15. We anticipate that the quarterly dividend will be increased Q/Q to $0.49/share in fiscal 4Q18 from our estimate of $0.48/share in fiscal 3Q18. We then expect the quarterly dividend to be increased to $0.51/share in fiscal 3Q19. We model the company to pay out 93% of adjusted NII in fiscal 2018 and 96% in fiscal 2019, from 99% in fiscal 2017.
Currently, shares are at a 6% discount to NAV compared the average 5% discount in the BDC space. We think Saratoga should trade largely in-line with peers as it has a decent origination platform and asset quality with the potential to grow dividends. However, we note that the company’s portfolio will likely be discounted, especially if and when the credit cycle shows more signs of turning, given the large second lien composition and non-sponsor investments. Additionally, the lack of private AUM takes away from the potential to co-invest, win deals courtesy of providing certainty of closing, and increases concentration risk.
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