Oaktree Specialty Lending: Plenty Of Reasons To Remain Bullish (NASDAQ:OCSL)

In March this year I wrote a follow-up article on my initial thesis on Oaktree Specialty Lending Corporation (NASDAQ:OCSL) arguing that it was the right moment for long-term investors to capitalize on the temporarily depressed share price.

After OCSL circulated its fiscal Q2 earnings report, the share price decreased quite significantly due to subpar adjusted NII results that were driven lower by a meaningful uptick in the non-accrual base.

My argumentation was that this could be considered a one-off and that on a go forward basis there should not be so huge build-up of non-accruals. The justification lied in the following aspects:

• OCSL’s portfolio is composed mostly of first lien investments with the underlying business LTV being at 40%, which is a very conservative level.
• As opposed to many business development companies, or BDCs, out there, OCSL has managed to keep the net investment volumes positive, thus steadily expanding the portfolio, which per definition creates favorable tailwinds for positive momentum in adjusted NII generation.
• The leverage profile is strong with no material near-term debt maturities that would impose a drag on the cost of financing end.

Since the publication of my latest / revisited bull thesis, OCSL has delivered positive total returns, but clearly underperformed the broader BDC market.

Let’s now review the investment case in the light of the most recent earnings report and determine whether the bull case remains still intact.

Thesis review

By looking at the recent quarterly earnings results, it might get clear why the stock market has kept OCSL’s share price flat. Yet, if we peel back the onion a bit, we will recognize that this quarter was still punctuated by several unfavorable one-offs, while the key underlying dynamics remained strong.

The key metric, which matters when assessing BDC cash generation profile – the adjusted net investment income – came in slightly lower than in the prior quarter, which in itself was a relatively bad quarter for OCSL. The adjusted NII for Q2, 2024 landed at $0.56 per share, or by $0.01 lower than in the previous quarter.

One of the key drivers here was the decrease in the adjusted total investment income (more on the top-line) by $700,000. The main reason behind this was the unfavorable timing of capital deployment and spread compression, primarily resulting from the rotation out of higher-yielding second liens.

In this regard, it is critical to underscore the fact that OCSL has managed to deliver great progress in de-risking its portfolio by reducing the exposure to second lien structures from 16% in September 2022 to 5% as of Q2, 2024. The lion’s share of the total capital rotation has been concentrated in first lien investments, which quite naturally has resulted in a slight spread compression for OCSL. For instance, in this quarter alone, OCSL suffered circa 10 basis points of spread compression due to a continued rotation into safer and less volatile first lien investments.

As mentioned in my previous article, the expectation was that going forward we will see less and less new non-accruals as OCSL’s exposure to safer investment types in combination with the robust credit profile of the underlying businesses should keep the portfolio stable.

During Q2, 2024, OCSL did not recognize new non-accruals and instead did a solid job on the restructuring front, bringing down the non-accrual level from 4.2% in the prior quarter to 2.4% now.

Moreover, if we look at the net investment funding side, we will once again notice that the momentum is positive, which enables OCSL to avoid the headwinds from shrinking asset base. During the quarter, OCSL landed $396 million in new commitments, which were sufficient to offset the repayments of $323 million. As we can see in the table below, the net new investment volumes continue to be positive, contributing nicely to the expansion of the asset base, which, in turn, makes it easier to grow the adjusted NII generation.

The new investment commitments have been signed at the weighted average yield of 11.1%, which is slightly lower than the current weighted average portfolio yield, mostly because of a continued focus on defensive investments.

For instance, the median portfolio company EBITDA as of Q2, 2024 was roughly $134 million with the leverage at 5.2 times, which is well below the overall middle market leverage levels.

In terms of the internal leverage profile, OCSL’s balance sheet still is robust and with an indebtedness that is below the sector average (107% for OCSL compared to sector average of 115%). Even though the asset base grew, the leverage profile remained unchanged from the prior quarter due to a funding of new investments through retained cash generation and additional share issuance in an amount of $46 million at an average 104% premium to the NAV (which is accretive to the existing shareholders).

Finally, while the current dividend coverage looks indeed quite thin at 102%, we have to keep in mind that this quarter was affected by the previous non-accruals and that most of the funding made at the end of the quarter. Plus, as Matt Pendo – President – commented in the most recent earnings call, there will also be an additional positive push for the adjusted NII stemming from the reduced management fee that should also enhance the dividend coverage.

Sure, Brian. Thanks for the question. So at a high level, we feel very comfortable given the change in the management fee, which was given to 1% as of July 1st and our ability in the future to cover our dividend and feel good about the dividend. One of the things this quarter that impacted the results were just some inter-quarter timing in terms of repayments than fundings. So there was a little bit — I wouldn’t necessarily take this quarter and just annualize it.

The bottom line

In my opinion, OCSL is a buy given the strengths of the underlying fundamentals – i.e., below-average leverage, de-risked portfolio through higher exposure to first lien, and strong leverage statistics of the portfolio companies. The current challenges on the adjusted NII front are temporary and create an opportunity for investors to enter Oaktree Specialty Lending.

After the Q2 2024 earnings report, I still maintain my rating at buy level.