Description

I believe that TPG Specialty Lending (TSLX) has total return potential of ~24% over the next 12 months.  The trailing dividend yield is 8.8% and the Company’s is significantly overearning it’s dividend.  I believe the company will raises its dividend later this year (they have intimated they plan to) and over time the deployment of additional leverage will encourage them to raise the dividend even further.  As the Company continues to increase earnings and the dividend the stock price should increase increase in a corresponding fashion.

By way of background in the fall of 2017 lawmakers passed the Small Business Credit Availability Act, which allowed BDCs to increase leverage.   In the fall of 2018, TSLX shareholders approves the Company’s proposal to increase leverage to 1.5x with a targeted leverage ratio of .90x to 1.25x debt to equity vs. the prior targeted leverage of .75x to .85x debt to equity.  A more modest increase in leverage from .85x to 1.1x leverage would increase annual ROEs of 100 bps or ~17 cents per share of additional earnings.  Additional leverage is accretive to ROEs up to approximately 4.00% of annual credit losses in any given year.

TSLX’s external advisor is part of TPG Sixth Street Partners, with over $25 billion of credit related assets under management as of June 30, 2018

TSLX’s investment strategy had a number of differentiated features that help distinguish it from other BDCs and translate to a high-quality portfolio and very strong risk-adjusted returns.

·        99% of originations are from non-intermediated channels

·        They focus on investing at the top of the capital structure and protecting that position

o   94% of the portfolio by fair value first-lien debt investments and 97% of the portfolio by fair value is secured. 

o   Weighted average of 2.3 key financial covenants per credit agreement

·        Diversified portfolio of investments in 48 portfolio companies where the largest investment only represents 4.2% of the portfolio at fair value.  Cyclical exposure in the portfolio is relatively low at 9.7%.

·        Average gross unlevered IRR, weighted by capital invested, of 18.8% on fully exited investments based on total capital invested of $2.9 billion

·        Annualized ROE on Net Income of 11.4% since IPO, compared to BDC Peer Track Record of average of approximately 5.0%

·        The Company’s shares have massively outperformed its BDC peers, the high yield index, leveraged loan index and even the S&P while the Company’s beta is arguably substantially lower than all of those comparables. 

o   Total returns since IPO (03/20/14 through the 2Q2018 earnings announcement date – as noted on their 3Q earnings call slides) were +85% vs their BDC peers at +16%, the HY index at +22% and the S&P +68%.  (I have not updated the inception to current date returns through 02/14/19 but the favorable comparisons would be substantially similar – TSLX has substantially outperformed on an absolute and risk-adjusted basis.

Valuation

TSLX trailing dividend yield is 1.56 per share and they paid 22 cents in special dividends ($1.78 on a combined basis which is a 50% payout of realized gains they have generated over the past twelve months.  At today’s price of $20.31 that equates to a dividend yield of 8.8%. 

In the 3Q of 2018, TSLX reported net investment income per share of $0.50 and net income (net income is after realized gains and losses whereas net investment income is before realized gains and losses) per share of $0.57, both of which exceeded TSLX’s third quarter base dividend per share of $0.39.   Book value per share was $16.42 as of the end of the third quarter.  So the 3Q results imply an annualized return on equity on net investment income and net income of 12.2% and 14.1%, respectively.

Street estimates are for 2018 earnings of 2.10 and 2019 earnings of 2.02.  Given the Company’s ability and stated intent to deploy additional leverage, a track record of generating realized gains and the fact that the fair value of their portfolio as a percentage of call protection at quarter end was 95.8 which would result in additional economics should portfolio holdings get refinanced in the near term, I expect earnings to increase rather than decrease in 2019.

Based on 2019 Street consensus of EPS of $2.02 the stock is trading at an earnings yield (EPS/current stock price) of 9.94%.  I have mentioned that the Company should be able to increase is ROE by 100 bps by increasing leverage from .85x debt to equity to 1.1x.  That translates to ~16 per share of additional earnings.  For a moment let’s model no realized gains or losses in 2018 and both net investment income and net income of $2.00 per share (consistent with the 3Q2018 NII of .50 per share annualized).  They let’s assume modest realized gains and the deployment of leverage over time allows them to generate EPS of $2.10 to $2.20 per share.  At today’s price the earnings yield would increase to 10.3% to 10.8%. 

Currently, the peer group trades at an earnings yield of 10.3%.  Given the Company’s ability and track record of generating the highest ROEs in the space, a 94% senior secured portfolio, and a portfolio with strong covenant and call protection I believe that TSLX deserves to trade a significantly lower earnings yield (higher P/E) than the peer group median.  My price target is an earnings yield of 9.0% on 2019 earnings per share of $2.10 or an target price of $23.33.  (By way of comparison Solar Capital trades at an earnings yield of 8.8% and Oaktree Specialty Lending trade at an earnings yield of 9.3% based on 2019 consensus estimates).  That translates to a price increase of ~14.9% coupled with a trailing dividend yield of 8.8% or a total return opportunity of ~24%.  

I believe that increased 2019 earnings per share, an increase in the Company’s dividend, and the likelihood that the Company will continue to generate realized gains and NAV should serve as catalysts to both increase earnings and the multiple that investors are willing to pay for the stock. 

Catalyst

Increase in 2019 earnings and the Company's dividend