2023-09-15 11:40:34 ET
Summary
- Oaktree Specialty Lending is a well-performing BDC that continues to generate healthy dividends despite economic volatility.
- OCSL has a strong track record of generating shareholder returns and has a low non-accrual rate.
- The stock currently yields an attractive 11% and trades at a slight premium to NAV, making it a good option for income investors.
It's been a while since I last visited Oaktree Specialty Lending (OCSL) in December of last year, when I had a Strong Buy rating. Perhaps I was being overzealous at the time, as the stock has seen its share of lows over this timeframe, and currently trades just 1.6% shy of the price at which I recommended it last. In this article, I revisit the stock, provide and updated rating, and discuss why income investors may want to pay heed to OCSL at present, so let's dig in!
Why OCSL?
Oaktree Specialty Lending is an externally-managed BDC that's gone through a series of transformations. It was formerly Fifth Street Finance, at which time it saw declines in its book value, and was renamed after Oaktree Capital Management took over as the external advisor. Since then, Oaktree merged OCSL and OCSI (Oaktree Strategic Income) into its current form. This has benefitted shareholders due both companies having a single and dedicated management team, resulting in cost synergies at a $1.4 million annualized run-rate.
OCSL has benefitted from Oaktree's stewardship with improved NAV/share performance. This is reflected by NAV/share growing from $17.44 at the end of 2017 to $19.58 at present. This, combined with a growing dividend payout has resulted in rewarding shareholder returns, with a 10.5% annualized return on equity over this timeframe, as shown below.
OCSL currently holds $3.1 billion in total investments that's spread across 156 portfolio companies. The majority of its investments (88%) are in the form of senior secured debt, with 76% being first lien and 12% being second lien. OCSL's focus is tilted toward technology and healthcare, with application software, biotech, data processing, and pharma/healthcare being its top 5 sectors, as shown below.
The tech sector has seen its fair share of challenges over the past 18 months, as higher interest rates have put a damper on IPOs and M&A activity due to high cost of capital. However, the upcoming IPO of Instacart could be a good barometer of market sentiment, and the recent IPO of Arm Holdings (ARM) on September 15th has demonstrated strong optimism around tech IPOs, as ARM's shares soared by 25% on the day of its market debut.
While this is a positive for any BDC's portfolio companies, OCSL is positioned to benefit either way, as 86% of its debt investments are floating rate, meaning that higher interest rates spell higher returns for OCSL. OCSL's yield on debt investments was at an appealing 12.3% as of fiscal Q3, sitting 300 basis points higher than where it was in the prior year period.
It's also maintained a steady NAV/share which declined by $0.08 primarily as a result of a modest decline in value of certain debt investments. At the same time, OCSL is out-earning its regular $0.55 per share dividend with $0.62 in NII/share during the last reported quarter. Management is also taking a prudent approach towards lending, as 90% of its originations in the last reported quarter were first lien loans and 90% were private direct loans.
Direct loans give the lender a closer relationship with the borrower as opposed to broadly syndicated loans, and helps the portfolio company to benefit from BDC management expertise in resolving issues before they become bigger problems. Speaking of which, non-accruals at OCSL remain low, representing just 0.8% of portfolio fair value.
Concerns around OCSL stem from BDC portfolio companies generally being more economically vulnerable due to their relatively smaller size and less avenues for funding compared to their larger publicly-traded peers. Also, lower interest rates down the line and increased competition for deals could lead to yield compression. However, the recent pullback in regional banks could lead to an elevated pipeline of deals for OCSL at least for the near-term.
OCSL also carries a reasonably strong balance sheet with a debt-to-equity ratio of 1.14x, sitting within management's target range of 0.9x to 1.25x and well below the 2.0x statutory requirement for BDCs. It also has ample capacity to meet its funding needs, with $542 million in total liquidity.
Lastly, OCSL currently yields an attractive 11.1% and the dividend is well-covered by an 89% NII-to-dividend payout ratio. At the current price of $19.86, OCSL trades at a slight premium to NAV with a price-to-book ratio of 1.01x. I view OCSL as deserving of this valuation considering its strong track record of generating shareholder returns since taking over from Fifth Street Asset Management.
However, I'm downgrading the stock from a 'Strong Buy' to a 'Buy' considering that plenty of uncertainty remains for the economy. This is driven by a hotter than expected August inflation report, which may push interest rates higher. While higher interest rates are a plus for OCSL on the surface, that also introduces more risk to the overall economy should it lead to a recession.
Investor Takeaway
Oaktree Specialty Lending is a well-performing BDC that continues to churn out healthy dividends despite broader economic volatility. The stock currently yields an attractive 11%, that's well-covered by an 89% NII-to-dividend payout ratio, trades at just a slight premium to NAV. It also carries a reasonably strong balance sheet with plenty of capacity to fulfill funding needs, and has been focused on direct lending, which comes with closer relationships to borrowers. Considering all the above, I view OCSL as being a 'Buy' at present for a well-diversified income portfolio.
For further details see:
Oaktree Specialty Lending: Great 11% Yield For Income Investors