In a sea of competitors' red ink, Ares Capital Corporation (ARCC +0.70%) is an island of black. The company reported solid fourth quarter 2014 results, earning net investment income of $0.41 per share. Realized gains of $0.17 per share offset unrealized losses of $0.09 per share.
On the back of a good earnings report, the company declared its usual $0.38 quarterly dividend plus a $0.05 special dividend.
Ares' income mix
The business development company, or BDC, industry continues to be defined by its falling investment yields. As competition for deals heats up, yields on new loans have declined. Ares Capital Corporation is no exception. Previously, I worried that a declining spread might put its dividend at risk.
So far, Ares Capital has managed to earn its dividend, helped with fee income from beefier originations. This quarter, fees made up 14.5% of total investment income (essentially revenue) and roughly 24.4% of net investment income, after adjustments for management fees.
If not for fee income, Ares would have earned roughly $0.32 per share in net investment income compared to its current distribution rate of $0.38 per quarter. Because of the close relationship between fee income and originations, investors would prefer to see fee income displaced with more stable interest income.
Portfolio moves this quarter
Ares Capital closely manages its capital structure. In January, it called high-yielding debt at 7% to reissue five-year debt at 3.875%. That benefit has yet to flow through into its results, however, as the quarter ended Dec. 31, 2014.
There is a case to be made that the company has leverage to cut its funding costs at its option. Ares has $430 million in notes maturing in 2040 and 2047, which currently yield 7.75% and 6.875%, respectively. Refinancing with shorter-term debt could shave roughly $10 million in interest expenses on an annual basis.
In addition, its October 2022 notes, which are substantially similar to the notes the company refinanced in January, are redeemable in October 2015. That could save the company another $3.6 million in interest expense. Add it all together and Ares Capital could be looking at up to roughly $14 million in annual savings ($0.04 per share) beginning in 2015, should the company shorten its maturities at market interest rates.
The company churned a significant portion of its $9.5 billion balance sheet this quarter, making commitments of $1.39 billion to new investments while exiting $1.27 billion of its assets, either through sales or prepayments.
Oil and gas investments remain a negligible portion of the total portfolio, coming in at 1.9% of investments at fair value. Three oil and gas investments -- Lonestar Prospects, Petroflow Energy Corporation, and UL Holding Co. -- were all written down in the quarter. Only UL Holding is on non-accrual, just as it was at the end of the Sept. 30, 2014, quarter. Given the write downs, it may be prudent to assume these assets will go on non-accrual in future quarters.
Is growth in the cards?
Ares ended the quarter with only $194.5 million in cash and a debt-to-equity ratio of 0.8 to 1. That's a comfortable amount of leverage, but future growth in its portfolio will have to come from issuing new equity.
Ares is one of the few BDCs for which growth is still an option; shares currently trade at a 2.2% premium to net asset value per share of $16.82. After fees, any equity raises at the current market price would be dilutive. However, should shares trade even modestly higher, the company could justify growing the portfolio at the margin. This will undoubtedly be a discussion point on the conference call later on Thursday.
All in all, it was a solid quarter for the bellwether BDC, but investors will want to see how the company plans to sustain its fee income, a key part of its income mix.
