Saratoga Investment: 11% Yield And Dividend Hiked But Leverage Elevated (NYSE:SAR)
Saratoga Investment (NYSE:SAR) last declared a quarterly cash dividend of $0.71 per share, a 1.4% increase from prior and for an 11% annualized dividend yield. This formed the eleventh dividend raise since a pandemic-era cut as the BDC rides up a Fed funds rate currently sitting at 5.25% to 5.50%. The September Federal Open Market Committee’s decision to maintain rates at their present level came with the caveat that there could be another 25 basis point hike in 2023 and that the base rate will stay higher for longer. This mantra has now moved to the forefront of financial markets against the ever-growing specter of a hard landing. However, even against the pullback seen across income tickers after this FOMC decision, the market is currently pricing in an 81.6% chance that rates remain unchanged at the next FOMC meeting on the 1st of November.
BDC investors face a relative conundrum here as higher base rates get translated to strong total investment income gains only to the extent that economic weakness does not generate more volatility with non-performing loans. To be clear, whilst the current macroeconomic environment with a Fed funds rate at a 22-year high has provided Saratoga with the opportunity to realize record investment income, the BDC’s net debt to NAV at 234% as of the end of its fiscal 2023 second quarter has materially ramped up the risk that a possible hard landing of the US economy has a materially more outsized impact on the BDC. Leverage juices investment income when times are good but amplifies losses during periods of downside volatility.
High Leverage And Record Investment Income
This leverage ratio now sits at its highest level in over a decade, a positioning that has come hand in hand with a total investment income of $34.63 million as of the end of Saratoga’s last reported fiscal 2024 first quarter ending May 31, 2023. This was a material growth of 85.4% over its year-ago comp and a beat by $3.22 million on consensus estimates. Adjusted net investment income came in at $12.8 million, around $1.08 per share, a huge 100.8% increase from its year-ago comp and a 10.9% sequential increase from its prior fourth quarter.
This meant the BDC was able to cover its dividend by 152%, around a 65.74% payout ratio. The low payout ratio infers that Saratoga is fully cognizant of the implications of its high leverage and wants to minimize the specter of disruption it poses. A rise in non-accruals on the back of its high leverage is less likely to spark a disruption to the dividend if the payout ratio is more constrained than it otherwise could have been.
Net asset value came in at $337.45 million as of the end of the first quarter, around $28.48 per share, and a dip by around 70 cents from $29.18 per share in the prior fourth quarter. The direction of NAV over the last few years has not been entirely positive with NAV per share down from $28.69 in the year-ago period after peaking in the fourth quarter of Saratoga’s fiscal 2023 fourth quarter at $29.33 per share. NAV drives the direction of price returns and Saratoga is still sporting market-beating returns, up 48% over the last 3 years.
The Discount To NAV
The BDC is currently swapping hands at a roughly 10% discount to NAV, a unique difference against a wider REIT universe where premiums have jumped up with investors seeking to build exposure to one of the core sectors set to benefit from the Fed’s higher for longer environment. Does this discount make Saratoga a buy? It depends on the BDC’s ability to grow NAV and gradually reduce its gearing over the next year. Saratoga currently has a share buyback scheme running and bought back 94,071 shares during the quarter. This was completed at an average price of $23.17 for $2.1 million. The program runs until January of calendar 2024 but can be extended with 801,967 common shares left to be purchased.
I like that Saratoga is currently 84.7% invested in first lien loans which take priority over other debt obligations. Critically, around 99% of its loans have floating interest rates and the BDC only had one investment on nonaccrual as of the end of the first quarter. This was around 0.9% of its $1.084 billion portfolio at fair value. I think we’re now at the stage of the BDC investment cycle where positioning for an economic drawdown would be prudent, hence, an investment in Saratoga would be dependent on the BDC forcing back its leverage ratio down and pushing NAV per share on an upward path. The BDC is a hold.