Ares Capital (NASDAQ:ARCC) is one of the leading business development companies or BDCs in the market. It last traded at a market cap of $11.4 billion. With a forward earnings multiple of 8.5x, it is also ahead of its peers’ median of 7.8x, suggesting a relative ratio prime. I urged investors to avoid recession fears in my previous updatewhile the ARCC reached its lowest level at the end of October.
Despite its market-leading size, ARCC’s total return has disappointed over the past year, underperforming that of its peers represented in the VanEck BDC Income ETF (WE). Despite this, this is still a respectable performance, as ARCC generated a total return of almost 19%.
With the Fed expected to have reached the climax of its rate-hike regime, concerns are growing about the company’s situation. wallet performances are progressing. Investors should note that Ares Capital’s portfolio is mainly based on variable rates. Based on the third quarter or Third Quarter Results Update at the end of October, 97% of its new investments were allocated at floating rates. As a result, it is possible that Ares Capital’s core earnings growth will come under pressure in 2024 as it exceeds the challenging limits of FY23’s remarkable earnings growth.
Analyst estimates suggest that Ares Capital could generate core earnings growth of 15.6% in 2023. However, Wall Street does not expect this momentum to continue in 2024. As a result, growth in Ares Capital’s profits could have peaked in 2023, as analysts predict a 0.1% decline in 2024.
Despite the normalization of growth, the decline should not be dramatic, which suggests a resilient 2024, even if the Fed could make three rate cuts this year. Therefore, the Fed is still expected to keep rates high for a longer period of time, which makes sense as the economy has remained resilient. Additionally, management argued that it had adjusted its hedges to respond to a possible decline in interest rates in the future.
As a result, Ares Capital reportedly exchanged its maturing fixed-rate debt into a “variable rate debt instrument” during its third-quarter earnings call. The company noted that the move was intended to more closely align with its “floating rate asset portfolio, indicating a strategic match of assets and liabilities.” Additionally, management emphasized its expectation that “interest rates could remain rising but eventually trend downward. » In other words, Ares Capital remains willing to take a higher stance for longer, but is willing to pivot to a lower rate environment.
I believe credit should be given to management’s foresight and execution in this aspect. It is now clear that the market has positioned itself for a lower rate environment, supported by the Fed’s communication of three rate cuts. However, based on Ares Capital’s earnings call at the end of October 2023, the 10Y (10 American years) jumped above the 5% mark. As a result, it wasn’t so clear at the time. Therefore, management’s ability to anticipate correctly should lend more credibility to its execution as it attempts to maintain the resilience of its core earnings in anticipation of a higher environment for longer.
Based on ARCC’s performance since its low point in October 2022, I believe the market has already priced in hard landing risks significantly. Given the exposure to mid-market companies that could be more affected by the impact of a recession, the market appears confident that such risks should not be the baseline scenario.
Additionally, Ares Capital is not expected to face imminent risks from its strong forward dividend yield of 9.7% at current levels. In other words, unless investors expect the Fed to cut rates significantly, which would hurt its core earnings projections, income investors should continue to buy significant declines from the leader of the BDC.
Based on current projections, Ares Capital is expected to see a more substantial decline in its core EPS in 2025, of over 6%. With ARCC still valued at a premium to its BDC peers, I view the risk/reward at current levels as reasonably balanced, given the expected peak in its earnings growth rates in 2023.
Additionally, from a total return perspective, ARCC may continue to underperform. I assessed that it was facing resistance at current levels. It is important to consider that ARCC has regained its upward trend in the medium term. With ARCC still trading at a noticeable discount to its 10-year average of 10x, I don’t see substantial downside risk at current levels.
Additionally, the lows and higher price structures suggest that this could help ARCC continue to advance as it looks to decisively break out from the $20 level. However, I would prefer to observe the reaction to the ARCC resistance level before evaluating another more attractive buying opportunity.
Given ARCC’s relative premium and less constructive price action, I believe ARCC’s ability to outperform at current levels may face greater challenges. However, a sharper pullback could provide a more attractive entry point for income investors looking to invest in its attractive dividend yields.
Note: Downgraded to Hold.
Important Note: Investors are reminded to exercise due diligence and not rely on the information provided as financial advice. Please always apply independent thought and note that grading is not intended to time any specific entry/exit at the time of writing unless otherwise noted.
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