Restructuring And Tactical Leadership Propel Earnings And Boost Liquidity For Future Growth

Key Takeaways

• Successful resolutions and proactive restructuring enhance potential NAV growth, and credit quality, and stabilize future earnings.
  
• Strong liquidity, floating rate assets, and sponsor relationships fuel portfolio and revenue growth prospects.
  
• Competitive pressures and market dynamics constrain Saratoga's growth, with low deal volumes and rising expenses impacting potential earnings and revenue growth.

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.

• The successful resolutions of four nonaccrual investments, along with the repayment of others, have reduced uncertainty in Saratoga's portfolio, thereby potentially increasing future Net Asset Value (NAV) and improving credit quality metrics.
  
• Despite currently high short-term interest rates, Saratoga benefits from the elevated levels in rates and spreads due to its largely floating rate assets, aiding in stability and potentially enhancing future net interest income.
  
• The investment in sponsor relationships and ongoing business development initiatives suggests potential for robust pipeline growth, leading to improved revenue and investment income through new originations.
  
• Management’s proactive restructuring actions in portfolio companies, such as Pepper Palace and Zollege, and bringing in new leadership could enhance future recovery values and earnings.
  
• The company’s significant liquidity position, with available cash and leverage ready for deployment, indicates potential for substantial portfolio growth, thereby increasing future earnings and NAV.

Assumptions

• Analysts are assuming Saratoga Investment's revenue will decrease by -10.3% annually over the next 3 years.
• Analysts assume that profit margins will increase from 13.6% today to 62.6% in 3 years time.
• Analysts expect earnings to reach $70.0 million (and earnings per share of $5.23) by about October 2027, up from $21.2 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 6.6x on those 2027 earnings, down from 15.7x today. This future PE is lower than the current PE for the US Capital Markets industry at 22.0x.
• Analysts expect the number of shares outstanding to decline by 0.98% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 10.74%, as per the Simply Wall St company report.

Risks

• The lower middle market deal volumes, where Saratoga operates, have not yet picked up, with ongoing historically low M&A volumes creating challenges in finding new investments, potentially affecting future revenue growth.
  
• Tightening spreads and full leverage due to competitive pressure amongst lenders, despite low deal volumes, could lead to further payoffs and impact Saratoga’s potential earnings growth.
  
• Increased interest expenses from new notes and SBA debentures issued during the past year, as well as increased management fees from higher AUM, could limit Saratoga’s net interest margins.
  
• The potential for a 200 basis point decrease in interest rates could significantly impact adjusted NII per share, potentially falling below the current dividend, affecting earnings.
  
• Market dynamics, such as an abundance of capital and sellers’ reluctance to transact at current debt levels, coupled with delayed deal recovery in the lower middle market, could continue suppressing revenue growth opportunities.

Valuation

• The analysts have a consensus price target of $26.05 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 2027, revenues will be $111.9 million, earnings will come to $70.0 million, and it would be trading on a PE ratio of 6.6x, assuming you use a discount rate of 10.7%.
• Given the current share price of $24.11, the analyst's price target of $26.05 is 7.4% 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.