The Zacks SBIC & Commercial Finance industry will continue to bear the brunt of higher prepayments as interest rates rise. This will likely keep hurting the industry players’ profitability to some extent.
Yet, higher interest rates, favorable regulatory changes and decent economic growth are expected to keep supporting the industry in the coming days. Robust asset quality continues to act as a major tailwind. Hence, a few industry players like Ares Capital Corporation ARCC, Main Street Capital Corporation MAIN and Hercules Capital, Inc. HTGC are likely to gain from these favorable developments.
About the Industry
The Zacks SBIC & Commercial Finance industry comprises companies that provide finance to small and mid-sized privately-held developing firms. These firms are typically underserved by traditional banks and other lenders. Additionally, firms suffering from financial distress are the primary target clients of these lenders. The industry players provide customized financing solutions ranging from senior-debt instruments to equity capital. This financing is provided for change of ownership transactions, strategic buyouts, recapitalizations and growth initiatives in partnership with business owners, management teams and financial sponsors, among others. Some of the other products offered by the industry participants are mezzanine loans that typically pay high-interest rates and could be converted into equity in the target firm.
3 Major Factors Shaping the Future of SBIC & Commercial Finance Industry
Rising Rates: The Federal Reserve has been aggressively raising interest rates this year, and such moves are expected to continue in the coming days to control raging inflation numbers. While this has led to a spike in prepayments and refinancing before interest rates climb further, higher rates will benefit SBIC & Commercial Finance industry players. Also, given the decent economic growth, demand for products and services offered by these companies is likely to keep growing. Thus, the industry players are expected to witness a solid improvement in revenues going forward.
Solid Asset Quality: Following the coronavirus outbreak and subsequent halt in business activities in 2020, the majority of sectors wherein SBIC & Commercial Finance companies provide loans were hit hard. This raised fears of a deterioration of asset quality for industry players. Yet, support from the administration in the form of stimulus packages, extensive vaccination drives and re-opening of businesses continue to support economic growth. These are likely to prevent a substantial rise in delinquency rates for the industry players, though inflation remains a headwind.
Regulatory Changes: In 2018, an amendment to the Investment Company Act of 1940 by the Small Business Credit Availability Act eased the leverage limits for such companies, allowing them to increase their debt-to-equity leverage to 2:1 from 1:1. This helped these companies to reduce portfolio risk by investing in higher capital structures without foregoing current returns. In other words, the act provided extra funding flexibility to these companies and will continue offering more growth opportunities.
Zacks Industry Rank Indicates Brighter Prospects
The Zacks SBIC & Commercial Finance industry is a 36-stock group within the broader Zacks Finance sector. The industry currently carries a Zacks Industry Rank #14, which places it in the top 6% of more than 250 Zacks industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates outperformance in the near term. Our research shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.
The industry’s positioning in the top 50% of the Zacks-ranked industries is a result of encouraging earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are gradually gaining confidence in this group’s bottom-line growth potential. Over the past year, the industry’s earnings estimates for the current year have been revised 13.3% upward.
Hence, we are presenting a few stocks that are well-positioned to outperform the market based on a strong earnings outlook. Before that, let’s check out the industry’s recent stock market performance and valuation picture.
Industry Outperforms Sector and S&P 500
The Zacks SBIC & Commercial Finance industry has outperformed both the S&P 500 composite and its own sector over the past year.
While the stocks in this industry have collectively lost 11.5% over this period, the Zacks S&P 500 composite and Zacks Finance sector have declined 21.5% and 17.5%, respectively.
One-Year Price Performance
Industry’s Current Valuation
One might get a good sense of the industry’s relative valuation by looking at its price-to-tangible book ratio (P/TBV), which is commonly used for valuing loan providers because of large variations in their earnings results from one quarter to the next.
The industry currently has a trailing 12-month P/TB of 0.82X. The highest level of 1.03X, lowest of 0.40X, and a median of 0.92X have been recorded by the industry over the past five years. Also, the industry is trading at a significant discount compared with the market at large, as is evident from the trailing 12-month P/TB for the S&P 500 composite of 9.79X, as the chart below shows.
Price-to-Tangible Book Ratio (TTM)
As finance stocks typically have a low P/TB ratio, comparing SBIC & commercial loan providers with the S&P 500 may not make sense to many investors. But a comparison of the group’s P/TB ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Finance sector’s trailing 12-month P/TB of 4.37X is also way above the Zacks SBIC & Commercial Finance industry’s ratio, as the chart below shows.
Price-to-Tangible Book Ratio (TTM)
3 SBIC & Commercial Finance Stocks to Invest
Ares Capital: This Zacks Rank #2 (Buy) stock is a specialty finance firm that primarily invests in U.S. middle-market companies (firms having annual earnings in the range of $10-$250 million). Based in Maryland, ARCC offers customized financing solutions, ranging from senior-debt instruments to equity capital, with a focus on senior secured debt. Its investments in corporate borrowers generally range from $30 million to $500 million while investment in power generation projects is between $10 million and $200 million.
As of Sep 30, 2022, Ares Capital had total investments (fair value) of $21.34 billion, total assets of $22.04 billion and a net asset value (NAV) of $18.56 per share.
Ares Capital has been witnessing growth in total investment income over the last few years. The company is expected to continue witnessing a rise in investment income in the quarters ahead, given the regulatory changes and rising demand for customized financing. Also, its investment commitments to new and existing portfolio companies have been steadily rising.
As of Sep 30, 2022, ARCC had a debt of $11.82 billion and cash and cash equivalents (including restricted cash) of $257 million. The company has a revolving credit facility, allowing it to borrow up to $4.3 billion at any time, with a maturity date of Mar 31, 2027.
In order to maintain its RIC status, Ares Capital distributes approximately 90% of its taxable income. In October 2022, it announced a dividend hike of 12%, marking the third such increase this year. Also, it has a share repurchase program worth $500 million in place, which will expire on Feb 15, 2023.
ARCC has a market cap of $9.7 billion. Over the past 12 months, the company’s shares have lost 7.2%. The Zacks Consensus Estimate for earnings has been revised 5.2% upward to $2.04 for 2022 over the past 30 days.
Price and Consensus: ARCC
Main Street Capital: This Zacks Rank #1 (Strong Buy) private equity firm specializes in providing equity capital to lower middle-market (LMM) companies. Main Street Capital also offers debt capital to middle-market companies. Based in Houston, TX, MAIN invests in LMM companies that generate annual revenues between $10 million and $150 million.
As of Sep 30, 2022, Main Street Capital had total investments (fair value) of $3.74 billion in 195 portfolio companies, which consisted of investments in the LMM portfolio, middle-market portfolio and private loan portfolio. As of the same date, MAIN’s NAV was $25.94 per share.
At the end of the September quarter, Main Street Capital had total liquidity of $420.2 million, which included $61.2 million in cash and cash equivalents and $359 million of unused capacity under its revolving credit facility. As of Sep 30, 2022, MAIN had total debt worth $1.48 billion, consisting of debentures and senior notes.
Since its October 2007 initial public offering (IPO), Main Street Capital has regularly raised its monthly dividends. Cumulatively dividends paid or declared since IPO through the third quarter of 2022 stand at $35.80 per share.
Main Street Capital has a market cap of $2.9 billion. Over the past 12 months, MAIN’s stock has declined 16.9%. The Zacks Consensus Estimate for earnings has been revised 4.7% upward to $3.15 for 2022 over the past 30 days.
Price and Consensus: MAIN
Hercules Capital: Headquartered in Palo Alto, CA, HTGC is a specialty finance company that provides venture capital to technology and life science-related companies. Its investments are generally between $15.0 million and $40.0 million, and it expects these to generate revenues within at least two to four years.
Despite the tough macroeconomic scenario, Hercules Capital is expected to continue witnessing growing demand for customized financing from private equity firms and venture capitalists. The company maintains a robust balance sheet position.
As of Jun 30, 2022, it had $700.1 million in liquidity, including $57.1 million in unrestricted cash and cash equivalents and $643.4 million in credit facilities. Also, HTGC has long-term issuer ratings of BBB- and Baa3 from Fitch Ratings and Moody’s Investors Service, respectively, along with a stable outlook, which renders it favorable access to the debt market. At the end of the third quarter of 2022, the weighted average cost of debt, comprising interest and fees, was 4.4%.
The fair value of Hercules Capital’s total investment portfolio was $2.83 billion as of Sep 30, 2022. NAV was $10.47 per share on the same date.
HTGC’s concentrated focus on its credit performance is encouraging. Driven by the rise in demand for customized financing and a robust deal pipeline, total new commitments are expected to keep increasing.
Hercules Capital’s capital deployment plan seems impressive. It announced a 2.9% hike in the quarterly distribution in October 2022, following hikes of 6.1% in July, 3.1% in October 2021 and 3.2% in May 2019. Management revisits its dividend policy at the end of every quarter and determines if any changes are required.
Hercules Capital has a market cap of $1.8 million. Shares of this Zacks Rank #1 company have declined 18.2% over the past year. The Zacks Consensus Estimate for 2022 earnings has been revised 5.9% north to $1.43 over the past month.
Price and Consensus: HTGC
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