SLR Investment: Continued NII Growth Expected From Q1 Earnings (NASDAQ:SLRC)

Overview

When investing into business development companies, I tend to focus on how sustainable the high yield is. After all, the high yield is the main appeal as I use BDCs to prioritize and add income to my portfolio. I came across SLR Investment Corp (NASDAQ:SLRC) this past weekend and wanted to see if it met my standards. For me to consider a BDC, they have to meet the following criteria:

• Diverse portfolio of investments across different sectors.
• Strong portfolio credit quality.
• Net Investment Income must out earn the distribution by a sufficient margin on a consistent basis.
• Growing Net Asset Value.
• Transparent reporting on the good and bad.

With these things in mind, let’s also take a look at SLRC’s total return performance when compared against some peers. We can see that SLRC has the worst total return profile compared against these batch of peer BDCs, including PennantPark Floating Rate Capital (PFLT), Main Street Capital (MAIN), Fidus Investment Corp (FDUS), and Prospect Capital (PSEC). I find it very odd that Prospect Capital has had the worst price performance out of these batch of peers but still manages to outperform SLRC. This was the first thing to raise a red flag in my mind but lets look a bit deeper and give SLRC a fair chance before coming to any presumptions.

For context, SLRC operates as a business development company that focuses on investing in companies that have an EBITDA between the range of $15M to $100M, making this a middle market focused BDC. What makes SLRC a bit different is that it’s technically classified as a closed end fund that is externally managed but they elected to be classified as a BDC.

Portfolio & Strategy

SLRC’s strategy is to invest in senior secured loans of these middle market companies. Their main objective is to generate income from these investments, to be disbursed out to shareholders. They do this by investing in 4 different senior secured investment types: Cash flow loans, Asset-based loans, Equipment financing, and Life Science loans. Taking a look at their latest portfolio composition, we can see that equipment financing makes up the largest bulk of their portfolio. Asset based loans make up the second largest bulk at 31.6% of the portfolio and has the highest weighted average yield of 14.5%.

In addition, the portfolio has exposure to over 110 different industries and holds about 790 unique issuers. This gives the total portfolio an average exposure of only 0.1% per issuer, or $3.9M. So SLRC gets a check for portfolio diversity! In addition, the portfolio is made up of mostly floating rate loans, sitting at approximately 65.3% as of last quarter. This has helped SLRC benefit from the rapidly rising interest rate environment starting in 2022. We can see how the price of SLRC rose when rates were cut to near zero levels.

Conversely, the price of SLRC decreased and then stabilized once rates rose starting in 2022. While this may have slowed price growth, the NII (net investment income) rose because of their portfolio of floating rates that were able to effectively pull in higher levels of interest income from their investments.

Lastly, over 97% of their portfolio sits in first lien senior secured loans which is great from a risk management perspective. Senior secured loans sits on the top of the corporate capital structure which means that they are the most prioritized in terms of repayment. In cases where portfolio companies are going through default or liquidation, this means that SLRC’s debts come in at the top of the list for repayment, offering some additional security.

Financials – Earnings Estimate

SLRC is set to reported their Q1 earnings on May 8th after market close. Looking at their last Q4 earnings reported in February, I wanted to provide some earnings estimates as I believe it will be another strong quarter for SLRC. NII was reported in at $0.44 per share while total investment income rose 0.3% year over year. NII increased 7.3% from the prior year as well due to elevated rates.

As I previously mentioned, a higher interest rate environment has led to increase in SLRC’s net investment income. Rates started rising around Q2 of 2022 and we can see that take effect on SLRC’s earnings in their history below. Over the last Fed meeting, it was confirmed that rates will remain at the two decades high for a longer period of time due to high inflation and a strong job market. This would be an ideal time to be in a BDC that is mostly comprised of floating rate loans to best capitalize on this environment.

With the prolonged period of higher rates in mind, I fully expect SLRC to continue pulling in a higher NII above $0.42 at minimum. I estimate that their Q1 earnings to be reported soon, will show NII between a range of $0.43 – $0.45 per share because of the highest level of loan originations ever recorded by SLRC.

Originations for 2023 reached their highest level ever, helping contribute to a slightly growing NAV up to $18.09 per share. During Q4, the company made about $450M in investment during the quarter to continue growing their portfolio in this favorable environment. Due to the heightened level of investments during the last year, I fully expect their 2024 guidance to be higher.

This is reassuring to see management capitalize on the higher rate environment and continue to grow their portfolio. Additionally, the company’s current net debt to equity ratio sits at 1.19x, falling within the company’s targeted range of 0.9x – 1.25x. SLRC’s liquidity profile is solid with $613M drawn on a total of $860M of commitments.

Dividend & Valuation

Based on the latest declared quarterly dividend of $0.41 per share, the current dividend yield is 10.6%. As previously mentioned, NII for the quarter was reported in at $0.44 per share. This would represent a dividend coverage of approximately 107%, which in my opinion is not wide enough of a margin to instill confidence of long term coverage. As a result, we’ve seen a huge lack of dividend raises or supplementals, which is odd considering the favorable environment here.

While there’s nothing inherently wrong with not increasing the distribution or rewarding shareholders with supplementals, this admittedly does make SLRC a bit less appealing as an income focused investment when you compare it against other peer BDCs that have provided these things. Using Portfolio Visualizer, we can see how the income growth of SLRC would compared against peer BDCs, Hercules Capital (HTGC) and PennantPark Floating Rate Capital (PFLT).

This comparison assumes a $10,000 initial investment in 2012 with no additional capital ever being deployed. However, dividends were reinvested during this time. We can see that in 2012, SLRC’s dividend income was higher than these peers, amounting to an annual amount of $1,131, compared to HTGC’s $1,040 and PFLT’s $956. Fast forward to 2023 and we can see that SLRC’s dividend income gets smoked by these peers.

2023’s Total Dividend Income

• SLRC: $2,111
• PFLT: $3,340
• HTC: $6,169

Final Position Balance – 2024

• SLRC: $21,540
• PFLT: $34,497
• HTGC: $68,723

While all of these BDCs offering similar dividend yield profiles, we can see that HTGC and PFLT has better capitalized and rewarded shareholders with a higher level of dividend income and better total return. These totals account for all raises and supplementals that were distributed. You can argue “why would I care about dividend growth if the yield is already high?” but at the same token, why would you settle for less dividend income in an environment that’s supposed to be extremely favorable for SLRC? As a result of this data, SLRC would not meet my personal criteria for consideration as part of my portfolio.

In terms of valuation, SLRC has consistently traded at a discount to NAV (net asset value) over the last decade. At the moment, the price trades at a discount to NAV that is greater than it was before the pandemic in 2020. The current discount sits at -14.7%. For reference, the price traded at an average discount to NAV of -15.09% over the last 3 year period.

Even though the current discount to NAV sits higher than the 3 year average, I believe this would be a good entry point if you wanted to hold SLRC. As previously mentioned, it does not seem like rate cuts are in the near future based on the latest Fed meeting. This means that conditions will likely continue to be more favorable for SLRC and they should continue to pull in higher net investment income.

As a result of this, I can see the discount eventually shrinking as NAV grows and the price appreciates. As a reference, before the initial drop caused by the pandemic, the price range f SLRC sat between $18 – $20 per share. Since market conditions have remained favorable, SLRC’s new investments may contribute to future growth to get the price back to those levels.

Risk Profile

In terms of transparency of report, SLRC also gets a check here in my opinion as they provided a clear rating system of their investments. The company has a numbered rating system for the credit quality of their portfolio companies, from 1 – 4. A rating of 1 is the best quality, assuming that the portfolio company is exceeding expectations and paying off their debt with zero issues. A rating of 4 is the worst, likely meaning that the portfolio company is significantly underperforming and full repayment is no longer expected.

We can see that the majority of their portfolio sits at a rating of 1 and 2, for an approximate total of 97%. This is reassuring from a quality standpoint as well as the company’s low non-accrual rate. Non-accruals are portfolio companies that are not able to pay their debts and are no longer contributing to SLRC’s net investment income. As of their last earnings call, we received the following confirmation.

We continue to be pleased with the credit quality of our portfolio with no new non-accruals during the quarter. Our December 31 non-accrual rate base stop [ph] was 0.6% and 0.4% on fair value, which remained significantly below the BDC industry average. – Michael Gross, Chairman and Co-CEO

For reference, here are some of the non-accrual rates for the peers previously mentioned:

• PFLT: 0.1% of investment cost.
• HTGC: 1.2% of investment cost.
• PSEC: 0.2%

Takeaway

While SLR Investment Corp (SLRC) has a growing NII by taking advantage of the attractive rate environment, the lack of supplementals and dividend raises stand out to me. They likely aren’t able to provide many increases because the NII covers the distribution by a slight margin of only 107%. I also anticipate the portfolio to continue growing considering the focus on new investments within which will likely contribute to higher NII levels as rates remain elevated. While the portfolio quality is also diverse and non-accruals remain low, I ultimately will not be starting a position in SLRC as there are more attractive peers that I am already exposed to in my portfolio. With that being said, if you are already a long time holder, I don’t see any red flags that would make me suggest a sell. Therefore, I would rate SLRC as a Hold for now.