Ares Capital Corp. (NASDAQ:ARCC ) is the largest and one of the highest quality publicly traded business development companies ("BDC") in the market today. It boasts an investment grade credit rating, has proven to pay out very attractive, consistent, and steadily rising dividends to shareholders, and most importantly has delivered market-crushing returns across a broad range of business cycles:

ARCC Total Return Price data by YCharts

ARCC just reported Q2 results. In this article, we will share 3 important takeaways from the Q2 report and also provide an updated outlook on the stock.

ARCC continues to generate strong growth. While NAV per share declined sequentially, this was partially due to the fact that they paid out a special dividend during the quarter. On top of that, ARCC still posted 3.6% year-over-year NAV per share growth, and Core earnings per share grew sequentially by 9.5%. Net investment income per share grew by a whopping 26.8% sequentially and an extremely impressive 33.3% year-over-year. BDCs are not known as growth investments, so these numbers are very impressive.

Moving forward, ARCC's growth profile remains quite strong even without the company having to make more aggressive investments into new loans. That is largely due to the fact that the vast majority of ARCC's investments are in floating rate instruments. With the Federal Reserve continuing to increase interest rates, ARCC's investments are poised to deliver rising yields to the company's bottom line. As management stated on the earnings call:

As of June 30, 2022, 74% of our total portfolio at fair value was in floating rate investments...we expect continued increases in short-term rates to have a positive impact on the net interest earnings performance of the company...we have yet to see the full quarter benefit from higher market rates that have already occurred in the second quarter. Given about 60% of the base rates for our floating rate loans currently reset every 3 months and the increase in base rates through these resets generally occurred in the latter part of the quarter...By holding all else equal for the second quarter and assuming that the June 30 base rates were in effect for the full quarter, we estimate our second quarter core earnings would have been about $0.05 per share higher resulting in core earnings of approximately $0.51 per share or about an 11% increase over our actual Q2 2022 core EPS results...

To look at this with a longer-term lens, as of quarter end, holding all else equal and after considering the impact of income-based fees, we calculated that a further 100 basis point increase in market rates from June 30 could increase our annual earnings by approximately $0.31 per share, a 17% increase above this quarter’s annualized core EPS.

As is evident from these remarks, ARCC is exceptionally well-positioned to deliver rising earnings per share in the coming quarters. On top of that, ARCC recently issued 8 million shares of common stock that will likely be sold at a slight premium to NAV. As a result, management will have a fresh keg of dry powder from which to invest in attractive opportunities on an accretive basis to further grow earnings per share over the long term.

Another big positive from the Q2 report and earnings call was that the recently hiked dividend is in good shape moving forward. With core earnings already covering the current dividend and set to continue rising in the future with rising interest rates and continued accretive investments by management, ARCC should have little trouble covering its dividend assuming a relative status quo is maintained in the macro conditions. When you consider their significant amount of spillover income on top of that, the dividend appears unlikely to be cut for at least the foreseeable future.

When asked on the earnings call about the future outlook for the dividend in light of these developments, the CEO said:

we never talk about dividends beyond this quarter, but we felt highly confident in our ability to increase the dividend this quarter. And I’ll couple that by saying we’ve also built a pretty substantial amount of spillover income, as you’re aware of the company. And I don’t feel the need, frankly, to add any more to that number. I could argue that number might even be a little bit high, which is why we’ve been using it to pay a special dividend throughout this year. So we feel good about the earnings trajectory, and we feel good about the dividend where it is today and potentially growing from here.

While everything looks great at the moment, one major item for concern is that ARCC's leverage ratio has gotten a bit high. While it had some exciting and very attractive opportunities to deploy capital during the quarter, it had to do so at the expense of the leverage ratio, which is now at the upper end of ARCC's target range at ~1.23 times. While this is not egregiously high, given the current market uncertainty and two straight quarters of declining GDP along with numerous other indicators that a severe recession could be in store, it is not ideal to be a bit overleveraged. Management even admitted to this on the earnings call, stating:

Frankly, in a more volatile market like the one we’re experiencing, I’d like to have that number come down. I think we all would – that being said, the ability to upsize Ivy Hill and the ability to make that portfolio acquisition at that we did was just too attractive. So we pushed the leverage to the upper end, but I think the goal longer term would be to be managing that down here in the third and fourth quarters.

Overall, it was another strong quarter for ARCC, and the near-term growth profile for the company looks quite strong. That said, leverage has crept up and with management acknowledging on the earnings call that they expect defaults to increase in general with the declining economic environment, ARCC will need to balance deleveraging with continued growth investments and dividend growth.

As a result, we expect them to use some of their recent equity raise to deleverage the balance sheet, which in turn will mean that per share growth metrics may not be quite as impressive as they would be otherwise. We view ARCC as a Hold right now. That said, it is not a bad place to allocate some capital for those who are looking for a good balance between lucrative current income and favorable exposure to rising interest rates while also not going too far out on the risk spectrum.

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This article was written by

Disclosure: I/we have a beneficial long position in the shares of ARCC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.