2023-08-15 14:07:29 ET
Summary
- Oaktree Specialty Lending Corporation reported a solid quarter with a 2.5% total NAV return and a flat adjusted net income.
- Oaktree's leverage remained within the target range, but its interest expense was above the sector average due to elevated floating-rate debt.
- The company's portfolio quality showed mixed indicators, with non-accruals and realized losses being negative, but PIK income and lack of amendments being positive.
In this article we catch up on the latest quarterly results of Oaktree Specialty Lending Corporation (OCSL). The company notched another solid quarter with a 2.5% total NAV return in fiscal Q3 . OCSL trades at a 10.9% yield and a 3% premium to book.
OCSL is primarily focused on secured loans with a low allocation to equity securities. Its sector overweights are software and healthcare - a fairly common combination in the business development company, or BDC, space.
Oaktree
Quarter Update
OCSL had a decent quarter with a 2.5% total NAV return.
Adjusted net income (adjusted for merger accounting) stayed flat at $0.62. Over the last two quarters, net income increased only by a penny or just 1.6% which is pretty tepid for the BDC sector.
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The dividend was kept unchanged at $0.55. This leaves dividend coverage at a fairly healthy 113%.
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The NAV fell 0.4% over the quarter as net realized / unrealized losses were partly offset by retained income. Without the benefit of retained income the NAV would have fallen 0.9%. The NAV rose the previous quarter due to merger accounting adjustments. Without those adjustments, the NAV would have now fallen for the sixth straight quarter.
Recall that in January OCSL completed the merger with the Oaktree Strategic Income II, Inc., adding $572m of investments into the broader portfolio. Oaktree will waive $9m of the base management fee across two years which comes out to around a tenth of the total base fee over this period.
Income Dynamics
Leverage remained the same at 1.14x - within the target range of 0.9x to 1.25x. The drop in leverage off its recent high also partly explains why net income has stalled somewhat.
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OCSL has an elevated level of floating-rate debt (through credit facilities and fixed-rate debt swapped to floating) which has pushed its interest expense 0.8% above the sector average despite a higher-quality rating profile.
This also means that its yield gap (between assets and liabilities) of 5.7% is below the sector average of 6.6%. By contrast, ARCC has a weighted-average cost of debt of 4.6% and a yield gap of 7.6%, allowing it to generate a higher level of net income, all else equal.
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The weighted average yield on new originations was 12.6% - above the overall portfolio yield - which provides an additional tailwind to net income. Said in other words, new lending is done at wider credit spreads than the historic loans that make up the broader portfolio.
Net new investments were pretty flat after falling off somewhat. The flat number however hides the fact that total repayments and new fundings were actually elevated, indicating a relatively high level of turnover in the portfolio. A high level of turnover in a lending-friendly environment is very beneficial to the BDC as it allows the company to rotate its capital into more attractive loans without having to raise leverage.
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The company also modestly benefited from cost synergies of the OSI2 merger. It is on track to bank $1.4m of operating expense savings on an annualized basis. This works out to about a 13% of operating expense saving.
Last quarter, we highlighted that investors shouldn't expect significant gains in net income for the company due to its relatively low net income beta to short-term rates, the stabilization in the Fed's hiking trajectory and the drop in leverage. This is what we see playing out in Q3, and it's a trend that is expected to continue.
Portfolio Quality
Three investments were moved to non-accrual with two of them representing fairly small positions in the broader portfolio. Management expect a successful resolution to these new non-accruals. There were also optimistic comments on the set of non-accruals incurred in the previous quarter.
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It was another quarter of realized losses for the company. That said, the total losses are below the gains that the company has accumulated since 2021 (net realized gains of about 1%). The trend is obviously concerning so this is an area to watch. OCSL has prided itself on having a high-quality underwriting process so the worsening trends in non-accruals and realized losses could run counter to that narrative if they continue.
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PIK income fell slightly. Management indicated that they are not seeing much on the amendment request front which is a good sign.
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Portfolio company leverage was 5.0x which is quite low by middle-market standards.
Overall, there are portfolio quality pointing in different directions - with non-accruals and realized losses being negative indicators while PIK and lack of amendments being positive indicators. This is an area worth watching for investors.
Return And Valuation Profile
OCSL has seen a lot of variability in its valuation over the last year or so, in line with the rest of the BDC sector. At the moment it's trading at an elevated level.
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For most of the past year, OCSL has traded at a premium to the sector average valuation, however this premium has now deflated
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We can see this more clearly by looking at its valuation differential chart which shows that it's trading at about the same valuation as the broader sector. This makes for an attractive entry point for investors waiting to make an allocation to the company.
Systematic Income
This is particularly as the company has outperformed the sector over various time periods in total NAV terms, though not by much in some periods.
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The company had a tough run starting in mid-2021 until Q3-2022 where it underperformed the sector over six straight quarters. In the last three quarters however it has managed somewhat of a turnaround. If the broader credit market continues to recover, it will likely claw back some of its previous underperformance given its tendency to mark down its portfolio more heavily than the average BDC. In a market recovery the portfolio is likely to be marked back up.
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Stance And Takeaways
Overall, Oaktree Specialty Lending Corporation has put up a good fiscal third quarter. Portfolio quality metrics were somewhat mixed, and this is an area of performance worth watching.
Over the past year, we downsized our allocation to OCSL (red lines) when its valuation blew out to a double-digit premium relative to the sector. Since then we added it back (green lines) closer to a low single-digit premium. Oaktree Specialty Lending Corporation stock is currently attractively valued and we would look to add to our position on further valuation drops relative to the sector.
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For further details see:
Oaktree Specialty Lending: Solid Quarter, But Portfolio Quality Bears Watching