FS KKR Capital’s (FSK) latest quarter was a tough one to justify fundamentally, as the announced 21% dividend cut came right on the heels of a 20% NAV decline. That said, there were also some positives for longer-term investors, with a credit facility amendment and the issuance of a private unsecured note cushioning the downside, while the creation of an investment fund designed to support FSK stock could offset some of the fallout from the dividend cut. The even better news is that the stock is very cheap. Shares currently trade at c. 0.6-0.7x NAV, while offering a c.15% yield, which spells opportunity for long-term investors willing to look through the near-term negatives.

Recapping a Quarter Filled With Headline Negatives

FSK’s adjusted NOI per share reached $0.19, with the 1Q distribution largely in-line. Total revenue of $179 million was underwhelming as yield compression, and some inflows to non-accruals weighed on the top line. The average yield of debt investments also declined c. 70 bps to 9% for the quarter, alongside a c. 30 bps decline in the weighted average borrowing cost, reflecting the lower rate environment and a more conservative investment strategy.

Source: FS KKR Earnings Presentation

FSK accelerated capital deployment at c. $1.3 billion for the quarter, with repayments of c. $914 million resulting in net originations of $382 million. The portfolio did, however, decline c. 5.6% Q/Q as a result of unrealized depreciation.

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Source: FS KKR Financial Results

While management did exercise some cost control, leading to expenses of $81 million (-19% Y/Y), it was insufficient to offset the portfolio losses for the quarter. The quarter’s net asset value (NAV) of $6.09 fell 20% Q/Q, on the back of c. $1.59 of net realized/unrealized losses in the quarter.

Source: FS KKR Earnings Presentation

Net leverage also rose to 1.28x at quarter-end (up from 0.89x sequentially). Somewhat surprisingly, FSK announced a $0.15 distribution for Q2, down from the $0.19 distribution previously, as management seeks to move toward a more variable payout policy.

Source: FS KKR Earnings Presentation

A Closer Look at the Big Portfolio Mark-Down

The most striking metric from this quarter was the c. 11% Q/Q decline in FSK’s spread-related valuation marks as well as credit impairment marks (most of which was due to COVID-19). FSK management was rather frank in highlighting that more impairments are likely going forward, but as long as COVID-19 is contained to a near-term impact, we are likely to see the worst of the impairments fade in the upcoming quarters.

One of the biggest uncertainties today is the duration of the COVID-19 crisis on company-specific business plans. And while these uncertainties have been reflected in our first quarter valuations, we expect that a meaningful percentage of the unrealized depreciation we experienced during the first quarter ultimately will reverse itself in the future, as healthy companies begin to emerge from the COVID-19 downdraft.

From a portfolio perspective, c. 70-75% of the losses were COVID-19-related spread-related markdowns of c. 5-6% of par value, with the balance coming from credit-related markdowns. Nonetheless, credit risk remains higher than average, with 54% in senior secured first-lien debt, 13% second lien secured debt, 2% in other secured debt, 5% in subordinated debt, 11% in collateralized securities, 8% in a joint venture, and 6% in equity. Loans placed on non-accrual have reached 3.9% of the total portfolio.

Source: FS KKR Earnings Presentation

Meanwhile, realized losses of $130 million consisted of c. $54 million in losses from the Art Van Furniture investment (non-accrual), Safariland, the Micronics Filtration restructuring (non-accrual), and asset sales to the JV. Of the $671 million unrealized depreciation, the more salient contributors were c. $118 million in mark-to-market losses related to the JV, a $59 million write-down in Belk, a $45 million write-down in JW Aluminum, and a $41 million write-down in Amtek.

Source: FS KKR Earnings Presentation

It goes without saying that KKR is a top-tier credit manager, but clearly, some overhang from the legacy assets (pre-dating KKR’s management) is warranted until these have been cleared out, and until then, I think some overhang could remain (the NAV discount stood at c. 34% based on Friday’s close).

A Closer Look at the Big Dividend Cut

Going forward, management will switch to a variable dividend policy (95-100% payout of quarterly NII) in line with NOI guidance for the coming quarter. On that basis, the Q2 20 quarterly dividend was cut to $0.15/share (from $0.19/share before), which at a run-rate of $0.60 per year would entail a c. 15% yield.

From a balance sheet perspective, FSK is strategically focused on reducing its equity exposure from 6% to 3-5%, increasing its asset-backed investments from 11% to 10-15%, growing its joint venture, and reducing leverage back down to its target 0.95x to 1.25x range (Q1′ 20 net debt/equity rose to 1.28x). The leverage reduction target is particularly encouraging but could take time, considering the marks on the portfolio.

Source: FS KKR Earnings Presentation

While the headline dividend cut seems negative, I think it is a step in the right direction to introduce flexibility into the payout. Not only is managing a BDC to a fixed dividend particularly challenging in credit, but it also allows management to more freely allocate capital according to business needs.

The Share Repurchase is Not Quite Finished

Having repurchased 8.9 million shares in Q1 ’20 (average price of $4.45), this effectively completes the program and brings the BDC as a buyer out of the market. Instead, the new FSK – Franchise Vehicle looks set to take up the slack. According to disclosures from the earnings report, FS/KKR Advisor, LLC affiliates have committed c. $100 million to a $350 million investment vehicle that may invest in shares of FSK and FS KKR Capital Corp. II.

There is no management fee, nor are there any restrictions regarding institutions exercising their voting right, and there is no preferred return offered to institutional investors in the vehicle. The vehicle expects to enter the market through a 10b5-1 program so that it can operate through blackout periods. At this time, however, it is uncertain when the vehicle will begin to invest in FSK, how quickly, and to what extent. Even if the vehicle does not conduct planned repurchases anytime soon, I see the move as a positive as it does highlight the advisor’s commitment to the BDC’s success.

Source: FS KKR Financial Results

Lots to Like About a 15% Yield and a Wide NAV Discount

With the stock currently trading at c. 0.6-0.7x NAV, I see the stock as heavily discounted. Using a 0.8x multiple on year-end NAV of $7.50, which assumes a recovery into the second half of the year (note end-2019 NAV was $7.64), my price target for FSK shares is c. $6. I’d note this is a somewhat conservative estimate considering FSK also has the backing of a well-capitalized parent organization that can effectively provide a backstop in times of distress. In the meantime, investors get paid a c. 15% yield to hold the stock, making this a worthy consideration for any income investor’s portfolio. Repurchases by the FSK-Franchise co-investment vehicle would serve as a positive re-rating catalyst for FSK shares.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.