Capital Southwest: Dual Beats, A Dividend Raise And Supplemental (NASDAQ:CSWC)

Capital Southwest (NASDAQ:CSWC) just reported double beats on its fiscal 2023 third quarter earnings with a quarterly per share cash dividend payout of $0.53 declared. This was a 1.9% increase from the prior payout for a yield of 10.7%. Against a 14% year-to-date increase of its commons, the business development company (“BDC”) has now maintained its forward annualized cash dividend yield at double digits. This yield was boosted further with a supplemental cash dividend payment of $0.05 per share for an aggregate dividend payment of $0.58 per share for the quarter.

I’ve been buying Capital Southwest since October of last year as shares pulled back due to pertinent fears about the state of the U.S. economy and the risk of falling into a recession. But the economic figures are coming in and the likelihood of a soft landing continues to grow. Indeed, the IMF recently released an economic growth outlook for the U.S. economy that pencils in GDP growth of 1.4% in 2023, down from 2% in 2022 but growth nonetheless as unemployment figures continue to be undeterred by large-scale tech layoffs. The number for December at 3.5% was the lowest level since February 2020.

Hence, I continue to remain bullish on the medium-term growth outlook for Capital Southwest, as the rising rate environment continues to feed through to an expansion of net investment income to provide a boost to dividend growth through 2023.

Whilst the dividend remains the core focus of Capital Southwest’s shareholders, the year-to-date rally of its commons has provided much-needed relief. However, I think there is a risk that this has been overdone and we could see some retrenchment in the short term if current stock market enthusiasm and tepid euphoria get tempered. Inflation still remains far ahead of the Fed’s 2% target and my worry here is it stays somewhat sticky to stage a rebound. I’m still buying shares, but my rate of purchase has slowed down since the end months of 2022.

A Raised Dividend As Investment Income Beats Consensus Estimates

Capital Southwest reported earnings for its fiscal 2023 third quarter ending December 31, 2022, after the market close on Monday. Total investment income came in at $32.8 million, an increase of 47% versus $22.3 million in the year-ago comp and a $2.54 million beat on consensus estimates. This came on the back of a credit portfolio that grew to reach $990.3 million from $745 million in the year-ago quarter.

The 32.8% year-on-year growth came as demand for first-lien senior secured debt remained healthy against flagging economic indicators in the last three months of 2022. This now accounts for 96% of Capital Southwest’s portfolio with the BDC making $160.5 million in new committed credit investments during the quarter for a weighted average yield on debt investments of 12%. This was up from 10.6% in the prior second quarter.

Originations during the quarter were made to companies in a range of industries from New Skinny Mixes, a consumer packaged goods company to FM Sylvan, a provider of industrial contracting services.

I’m Buying Into The Double-Digit Yield

The company’s total portfolio including the equity component stood at $1.2 billion as of the end of the third quarter and remained highly diversified across a broad number of industries and 81 portfolio companies. Critically, this increases the resiliency of the dividend to any unexpected economic shocks. Hence, whilst bears continue to point to a potential risk of the double-digit yield from the still lurking specter of a recession and broader economic discombobulation, the BDC’s yield on debt investments is trending upwards as its variable debt continues to ride higher Fed fund rates.

Net investment income per share came in at $0.62, $0.04 cents ahead of the total dividends paid during the quarter and a beat of $0.06 cents on consensus estimates. Further, with just $4 million of the investments on nonaccrual, around 0.3% of the portfolio at fair value, Capital Southwest remains resilient. The BDC now essentially has to walk a tightrope as while rising interest rates feed through to higher investment income it also runs the risk of disrupting the respective operations of its broader investment portfolio in a way that increases the likelihood of respective companies facing difficulty in servicing their loans. Outperformance over the next year will be built on the ability for yield on debt to be pushed higher without a corresponding increase in nonaccrual.

Capital Southwest bears would be right to highlight a NAV per share of $16.25 as of the end of the quarter, which would place the commons at a 21.9% premium to NAV. Hence, whilst there is a lot to be excited about here from the dividend raise and the supplemental, the strong premium presented a reason for me to slow down my rate of purchases. I remain long and will look for a pullback to add more heavily to my Capital Southwest position.