Carlyle Secured Lending: Improving Fundamentals Warrant A Buy (NASDAQ:CGBD)

January this year, I wrote an article about Carlyle Secured Lending (NASDAQ:CGBD), which is a relatively small sized BDC with a focus on traditional and already established businesses.

At that time, I indicated several aspects of CGBD, which made it an interesting BDC to consider in investor portfolios.

For example, the major exposure to first lien investments coupled with a diversified portfolio across relatively defensive sectors clearly helped de-risk the portfolio. The underlying dividend coverage was also strong with a coverage ratio of 118% that was supported by historically low non-accrual levels. In addition, the entry point seemed rather enticing, as CGBD had lagged behind the BDC index during all of 2023.

Yet, the recent dynamics on the investment risk rating front, where roughly 20% of the total AUM was spread across categories, which imply that borrowers are operating below expectations and level of risk to the cost basis has increased since the time of origination, rendered this CGBD just slightly too speculative for me. So, I decided to issue a conservative hold rating, especially against the backdrop of the first signs of increasing non-accruals across the BDC space and the fact that there were more defensive alternatives at similar P/NAV metrics out there such as Fidus Investment (FDUS), Gladstone Capital (GLAD) or PennantPark Floating Rate Capital (PFLT).

Looking at the YTD total return performance, we can, however, see how CGBD has really taken off, registering strong returns of ~12.8% and outperforming the overall BDC index.

The key driver behind this remarkable performance has clearly been the strong 4Q23 earning package, which managed to beat the consensus expectations and shrug off some of the fears around worsening portfolio quality.

Let’s now dissect the key items of the most recent earnings and contextualize this with the CGBD investment case to determine whether there is now a more enticing basis for going long here.

Thesis update

The core performance of CGBD was truly solid and robust across the board. One of the most important metrics for BDCs – the net investment income per share – landed at $0.56 per share, which is an increase of 8% compared to the prior quarter and on an annualized basis represents a yield of 13% based on year-end NAV.

The top-line component of net investment income was driven higher by the positive impact of base rates and an uptick in other income, which was mostly boosted by slightly more elevated pre-payment activity.

The expense component remained flat relative to the prior quarter primarily due to stable funding rate dynamics.

So all in all, performance-wise, 4Q23 marked an all-time high for CGBD’s net investment income generation. As a result of this performance, the following items were also impacted in a positive fashion:

• Net asset value continued to increase (up by ~1% compared to 3Q23) as the net investment income result surpassed the base and supplemental dividend paid.
• The base dividend coverage surged higher to 140%, which is considerably above the BDC peer average.
• The improvements in the coverage metric warranted a decision by management to increase the underlying base dividend by $0.03 from $0.37 to $0.40 per share.

Here it is also important to underscore, that CGBD issued stable guidance for 2024 in terms of the expected net investment income generation ($0.50 per share), where if we compare this amount to the communicated base dividend, the dividend coverage ratio lands at a solid 125%. According to Tom Hennigan, Chief Financial Officer, (on the recent earnings call) the $0.50 per share result could be deemed as a baseline, which will be subject to interest rate dynamics:

In terms of the forward outlook for earnings for the rest of 2024, we see stability at this $0.50 plus level based on the latest interest rate curves and our current conservative positioning on leverage. Despite rising rates, we’ve maintained a conservative, disciplined approach that we believe will enable us to continue consistent dividend payout in a variety of rate environments, included when rates normalize.

On top of this, CGBD has also achieved positive new investment volumes, which have not only increased in volume, but also remained attractive from the yield perspective despite the overall downward pressure on BDC yield margins.

Finally, another critical driver of CGBD’s performance (and especially at the share price level) was the portfolio status. The BDC experienced improvements both at the underlying company cash generation level and at the non-accrual front as well. The 4Q23 revenues and EBITDA went up by 1% and 3%, respectively, if compared to the results in prior quarter. On a fully year basis, both of these metrics expanded by around 13% compared to 2022. Similarly, there were no incremental non-accruals or new additions to the watch list (i.e., risk rating category 4 and 5). In terms of the non-accruals, CGBD made progress with Dermatology Associates, which was previously classified as a non-performing investment. In February this year, CGBD together with other lenders, entered into equity positions which will reflect positively on the non-accrual front in 1Q24.

The bottom line

The most recent earnings package circulated by CGBD surprised the market to the upside. The core results go hand in hand with the underlying fundamentals, where the focus on cash generating and lower end of the middle market businesses have borne fruit. Importantly, the portfolio level dynamics have also improved, showing strengthening financials of CGBD investments and no new non-accruals. Furthermore, the dividend remains well-covered, having an ample buffer for being complemented by additional supplemental dividends.

Given the aforementioned dynamics and the fact that Carlyle Secured Lending still trades at a slight discount to NAV (P/NAV of 0.98x), this BDC has become a more attractive buy for me now. The attractiveness is further supported by the strengthening of higher for longer scenario, which will allow CGBD to keep the enticing yield spreads in place as 99% of its investments are based on a floating rate component.