Description

FS KKR Capital Corp (“FSK”) represents an opportunity to collect a 12.7% dividend yield plus potential 20-30% capital appreciation over the next 12-24 months.

FSK is a BDC providing credit to upper middle market (EBITDA $50-100m) private equity backed companies. 74% of FSK’s portfolio is senior secured debt and the median EBITDA is $54m with an attachment point of 5.1x. FSK is the product of the merger of FSIC (a BDC which was a JV between FS Investments and GSO, the credit arm of Blackstone) and CCT (a BDC that was backed by KKR). After the merger, FSK became the second largest publicly traded BDC (largest is ARCC, sponsored by Ares). Under the new JV arrangement, FSK will benefit by leveraging the 120 KKR investment professionals who are focused on originating and underwriting credit investments. One of the issues with FSIC’s prior relationship with GSO was that GSO was a huge operation relative to FSIC and GSO operates many different credit funds. Thus, as a relatively minor JV partner, FSIC didn’t get a look at all deals, and I suspect GSO directed the best deals towards its other (non-JV) funds. The new FS-KKR relationship is more balanced towards FSK, and will allow FSK to share in all deals originated by KKR’s credit team.

In addition, the larger size of the combined FSK provides a couple benefits. First, the portfolio is more diversified as top 10 issuers combined are 20% of the total portfolio vs 35% for FSIC pre-merger. Secondly, FSK (as part of the larger KKR credit platform) is able to lead deals and control documentation which leads to better lender terms compared to being a syndicate participant. As of 3/31/19, 85% of portfolio loans were ones where FSK was lead, co-lead or sole lender.

FSK has NAV/share of $7.86 as of 3/31/19. Based on the current stock price of $5.97, FSK trades at 76% of NAV. FSK trades below NAV due to credit mark-downs in the back half of 2018 which resulted in a decline in NAV/share from $8.87 in Q2 18 to $7.84 in Q4 18. Much of the deterioration was due to specific credits that went bad, for example one restructuring (Thermasys) accounted for 13c/share of NAV decline in Q4 18. Q4 18 was also a period of turmoil in credit markets, so spread-widening accounted for another 17c/share of NAV declines in Q4 18. In addition to credit-specific and market conditions, I also believe the merger gave management reason to mark the loan book conservatively. Because the management team of FSK was incentivized to place as much blame as possible on the former GSO-FS JV (and set themselves up for success), I believe the loan book was heavily scrutinized and now reflects conservative marks. The merger was announced 7/23/18 and closed on 12/19/18. It’s notable that FSK’s non-accrurals spiked in the Sept quarter (prior to merger close) and have come down in the following two quarters. Below is a chart of FSK’s non-accrurals (at fair value) as % of overall portfolio.

While my belief that management had incentives to mark its balance sheet conservatively is hard to prove, the large amount of management stock purchases and company share repurchases since the merger close lends credence to this part of the thesis. Year to date through May, named officers of FSK have bought $2.8m of FSK shares. Further, I believe many management team members that don’t have reporting requirements have also been buying stock. FSK announced a $200m share repurchase program shortly after the merger close, and they have executed $56m of the $200m as of early May. I believe that FSK may fully utilize the remaining $144m share repurchase authorization by year-end, which would add about 3c/share to NAV.

FSK pays a quarterly dividend of 19c which equates to a yield of 12.7%. Although Q1 earnings were 18c, 1c shy of the dividend, I believe the 19c/quarter dividend is sustainable. Although FSK may generate earnings slightly less than 19c/quarter for the next quarter or two, it has a large cushion on its balance sheet in the form of the 36c/share of undistributed net income which will allow FSK to maintain its dividend. I expect earnings will grow to cover the dividend over the next few quarters as investment income grows. Higher investment income will be driven by FSK’s plan to take debt/equity from its current level 80% to a targeted 95% level as well as reducing the 8% of portfolio that is non-income generating to a 5% target.

As FSK shows stable (or growing) NAV/share and improving dividend coverage, I believe FSK’s market valuation can re-rate to 90-100% of NAV. From the current 76% Price/NAV, this would represent 19-32% capital appreciation over the next 12-24 months. While one waits for the re-rating to occur, one can collect an annual dividend yield of 12.7%.

Catalyst

Stability (or growth) in NAV/share

Growth in earnings to improve coverage of 19c/quarter dividend