Saratoga Investment Stock: Well Positioned for Rate Increases


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Posted on the Value Lab 6/17/22

Saratoga Investment (New York Stock Exchange: SAR) is a midsize US business lender. Although they are diversified, the risks are now systemic, without really hiding in the asset markets. Middle market loans are riskier and if solvency is not a concern, credit quality should be if employment were to fall due to the double pressure of rates and some immutable inflation factors. On the other hand, they are well positioned from the perspective of the NII for rate increases. While yields are high and multiples low, we are emphatically on Saratoga due to the risks of capital depreciation.

Q4 Note

The Q4 demonstrates the profile of the company well. The origination rate is high and these loans offer good returns. The companies are medium-sized, between 2 and 50 million dollars in EBITDA, therefore very small companies, and with a fairly large proportion of borrowers in IT. Origination is driving the growth of the NII, although typical of the previously low rate environment, spreads have tightened throughout the year.

Saratoga Investment - Diversified in Industry

Industries (Q4 2022 Pres)

Saratoga Investment - BDC returns remain healthy

Yields (Q4 2022 Pres)

The company is also well-diversified geographically, but the problem is that the rising interest rate environment poses a systemic problem for debt as an asset class. Although the company does not have spread risk, as virtually all of its assets are variable rate, debt being primarily fixed rate and long-term, it does have credit risk.

Saratoga Investment Outperformance

Report of (Q4 2022 Pres)

Leverage ratios are quite low due to the company’s profile, with Saratoga having lower rates than its peers, but a depreciation of assets would mean a lot of pain for potential shareholders.

Inventory

Consider the following table. Due to the accounting closing dates, the 2021 financial year contains the impact of COVID-19.

Saratoga Investment Asset Growth and Credit Quality

Loans could underperform (Q4 2022 Pres)

Fiscal 2022 is not an accurate representation of fundamental performance, as the rate environment and the spending boom would have saved most companies. With high origination rates, leading to a 50% increase in assets under management, loans are taking place in a buoyant environment and occupy a third of the portfolio. The need to extend dry powder to sure deals will mean concessions in terms of credit.

Additionally, Saratoga also invests in client equity, sometimes in conjunction with debt, so a bit of a PE style. While mark-to-market is difficult with equities, equity market declines of more than 10% in recent days mean that the value of these relatively risky assets is also falling.

Conclusion

The PE is low at 5.6x and the yield is close to 10% with a good track record of dividend growth. Ultimately, Saratoga is fairly immune to solvency issues, but for shareholders there are risks of capital depreciation. There is no more Fed outlay on US small businesses, and the market needs to recognize this new problem. The stock could go much lower as these equity risks become more of a concern with inflation and demand destruction fueled by rates and employment level risks, and with other stocks trading at similar multiples but with much safer end markets and assets, we pass stocks like these.

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