Active Portfolio Management Will Drive Future Success In Lower Middle Market

Key Takeaways

• Strategic focus on lower middle market investments is likely to yield superior risk-adjusted returns, enhancing future earnings and NAV growth.
  
• Healthy originations and increased M&A activity suggest potential for revenue growth and portfolio expansion, improving overall earnings potential.
  
• Limited deal opportunities, reliance on follow-ons, and potential portfolio markdowns pose challenges to Saratoga's revenue growth and earnings stability.

Catalysts

A business development company specializing in leveraged and management buyouts, acquisition financings, growth financings, recapitalization, debt refinancing, and transitional financing transactions at the lower end of middle market companies.

• Healthy originations in both new and existing portfolio companies, along with an increase in M&A activity in the lower middle market, suggest potential for revenue growth.
  
• Management is evaluating the use of debt calls to reduce leverage, which can lead to better net margins by decreasing interest expenses.
  
• Significant levels of available cash and investment capacity indicate room for portfolio expansion, which can enhance overall earnings by increasing the asset base.
  
• Continued realization of equity gains from successful investments provides opportunities for net asset value growth, bolstering longer-term earnings potential.
  
• The strategic focus on lower middle market investments, characterized by strong due diligence, conservative capital structures, and active portfolio management, is likely to yield superior risk-adjusted returns, positively influencing future earnings and NAV growth.

Saratoga Investment Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Saratoga Investment's revenue will decrease by -12.8% annually over the next 3 years.
• Analysts assume that profit margins will increase from 22.0% today to 51.6% in 3 years time.
• Analysts expect earnings to reach $52.9 million (and earnings per share of $3.63) by about January 2028, up from $34.1 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 9.3x on those 2028 earnings, down from 10.5x today. This future PE is lower than the current PE for the US Capital Markets industry at 23.0x.
• Analysts expect the number of shares outstanding to grow by 0.5% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 10.86%, as per the Simply Wall St company report.

Saratoga Investment Future Earnings Per Share Growth

Risks

• The slowdown in the lower middle market deal activity, compounded by factors like elevated interest rates and resistance from PE firms to sell assets, could impact Saratoga's future revenue growth as deal opportunities might remain scarce.
  
• The trend of declining interest rates and outsized repayments reduced investment income, and future decreases could further compress net interest margins, affecting earnings.
  
• Heavy reliance on follow-on investments rather than new platform investments, due to low new M&A activity, may limit portfolio diversification and growth, potentially impacting future revenues if existing portfolio companies underperform.
  
• The risk of future refinancing is mitigated by decreasing interest rates but higher-yield loans paying off creates uncertainty around revenue stability if interest rates rise.
  
• Although Saratoga has managed its two problematic investments (Zollege and Pepper Palace) well, further markdowns in portfolio value due to underperforming consumer-facing companies could challenge net asset value growth and earnings predictability.

Valuation

• The analysts have a consensus price target of $25.85 for Saratoga Investment based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $29.0, and the most bearish reporting a price target of just $25.0.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be $102.5 million, earnings will come to $52.9 million, and it would be trading on a PE ratio of 9.3x, assuming you use a discount rate of 10.9%.
  
• Given the current share price of $24.94, the analyst's price target of $25.85 is 3.5% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.