Gladstone Capital Stock: 9% Yield, Improving Coverage, 1.12x NAV (NASDAQ:GLAD)

Gladstone Capital Corporation (NASDAQ:GLAD) is a well-managed business development company and compelling investment choice for passive income investors, albeit one that requires them to pay a premium to net asset value.

The BDC is primarily focused on collateralized First and Second Lien debt and reported improving dividend pay-out metrics, based on net investment income, in the third quarter.

The BDC’s stock pays passive income investors a covered 9% yield and the dividend is being paid on a monthly basis. Gladstone Capital’s stock is selling for 12% stock premium which I think makes GLAD probably fully valued.

With that said, though, passive income investors are getting a solid yield that appears to be sustainable.

My Rating History

My last stock classification on Gladstone Capital was Hold, which I am neither raising nor lowering. Gladstone Capital successfully completed a one-for-two reverse stock split in the third quarter and managed to cover its dividend with net investment income well.

The BDC thus profited from a substantial improvement in the dividend pay-out ratio, but also suffered a higher non-accrual ratio.

Portfolio Review, Non-Accruals And Dividend Pay-Out Metrics

Gladstone Capital’s investment portfolio consisted primarily of highly collateralized First and Second Liens in the third quarter, which accounted for 90.4% of the business development company’s total investments.

The portfolio, including Debt and Equity investments, had a fair value of $757.8 million, reflecting a QoQ decline of 4%. Gladstone Capital’s portfolio value declined primarily due to settlements and loan repayments: The BDC received $86.4 million in repayments and net proceeds, compared to only $15.2 million in repayments in the prior quarter.

Gladstone Capital had a total non-accrual ratio of 2.1% as of June 30, 2024 as loan investments in B+T Group Acquisition, Inc., Edge Adhesives Holdings, Inc., and WB Xcel Holdings, LLC are on non-accrual. In the prior quarter, the non-accrual ratio was 1.8% based on fair value, so the business development company has seen a 0.3 percentage point deterioration in its credit profile QoQ.

Gladstone Capital earned $12.4 million in net investment income in 2Q24, up 6% YoY, predominantly because of a boost to the BDC’s interest and dividend income. The business development company earned $21.7 million in interest income (not including payment-in-kind contributions), up 4% YoY. Gladstone Capital primarily benefited here from its investments in floating-rate debt, which produced higher interest income in the last year.

Gladstone Capital earned $0.57 per share in net investment income in the third quarter, reflecting an increase of $0.07 per share QoQ. This increase in net investment income substantially improved the business development company’s pay-out metrics in the prior quarter.

Passive income investors should recognize that because of the business development company’s one-for-two reverse stock split in 2Q24, Gladstone Capital’s NII and dividends have been restated to match the changed share count.

In the third quarter, Gladstone Capital paid $0.50 per share in dividends, which equates to a dividend pay-out ratio of 88% compared to a twelve month dividend pay-out ratio of 92%.

As mentioned previously, the pay-out ratio improved by 11 percentage points QoQ, thanks to higher interest and dividend income, thereby also improving the margin of safety for passive income investors.

12% Premium To Net Asset Value, GLAD Is Probably Fairly Valued

Gladstone Capital’s net asset value as of June 30, 2024 amounted to $20.18, reflecting a QoQ rise of 2%. The BDC’s stock is thus selling for a 12% NAV premium which is higher than the NAV multiples of peer business development companies including Goldman Sachs BDC Inc. (GSBD), Fidus Investment Corp. (FDUS) and Blue Owl Rock Corp. (OBDC).

Gladstone Capital is, as far as I am concerned, probably fair valued when taking into account that the central bank is poised to lower interest rates in the very near-term, which poses a headwind for business development companies with floating-rate investments.

Gladstone Capital has an aggressive floating-rate posture, meaning 93.4% of its debt investments, as of June 30, 2024, were floating-rate.

I often view a BDC’s net asset value as a benchmark for intrinsic value, but I am sometimes willing to pay a premium of up to 10% in case the value proposition is particularly compelling.

My intrinsic value estimate for Gladstone Capital therefore comes out to $22.20 which compares to a present stock price of $22.56. I don’t plan to realize a lot of upside here, but do think that the dividend is well enough covered to suggest that the $0.165 per share per month dividend is sustainable.

Why The Investment Thesis Might Get Challenged

The last two years were good years for business development companies as higher interest rates propelled their floating-rate portfolios higher, resulting in larger net investment income. This game is poised to come to an end at this month’s Fed meeting, which is almost certainly going to yield the first rate cut in years.

My Conclusion

Gladstone Capital profited from higher net investment income in the last quarter, which was catalyzed by growth in interest and dividend income. This triggered an 11 percentage point drop in the dividend pay-out ratio and, as a consequence, the business development company has a higher margin of dividend safety.

What counteracts this growth in net investment income was the increase in the non-accrual ratio: With non-accruals amounting to more than 2.0% now, the credit profile is not as great as is the case with other business development companies that are available for passive income investors.

I think that Gladstone Capital has a good chance of maintaining its monthly dividend moving forward, which is why I keep my stock classification for Gladstone Capital at ‘Hold.’