OCSL Q3 2023 Updates By Scott Kennedy

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The rest of this post is from Scott Kennedy.

Summary

• This 22nd earnings assessment article reviews OCSL’s NAV and adjusted NII performance during calendar Q3 2023.

• This article also discusses how OCSL’s quarterly change in NAV and adjusted NII “matched up” to expectations. Earnings remain a key driver to stock performance.

• OCSL’s NAV matched my/our expectations while its adjusted NII was a very minor-minor underperformance.  OCSL had 1 new non-accrual portfolio company while 2 were taken-off/exited non-accrual status (including 1 restructuring).

• No change in OCSL’s percentage recommendation ranges or risk rating. OCSL is currently deemed appropriately valued (HOLD).

• Overall, an "average" quarter for OCSL.  OCSL's declared unchanged quarterly dividend of $0.55 per share and special periodic dividend of $0.07 per share were within our projected ranges.

Introduction:

Hi subscribers. For new members, my name is Scott Kennedy and currently I fully cover 20 mortgage real estate investment trust (mREIT) and 15 business development company (“BDC”) common stocks within this Investing Group regarding research/data, subscriber questions, weekly projected book values/net asset values (BV/NAV), and common stock recommendation ranges. Colorado (“CO”) Wealth Management handles the mREIT preferred stocks and he and his team handles all other applicable REIT sectors outside the mREIT sector. CO also provides some mREIT common stock and BDC articles from time-to-time which are more of an “overview/introduction” discussion; typically based either on my or our combined research/data. This also includes some macroeconomic trends and data. My name is always attached to all Investing Group articles I personally wrote so there is no confusion for subscribers.

This REIT Forum article is part of a series of articles over a span of 6-7 weeks which will analyze my previously projected BV/NAV and core earnings (or core earnings equivalent)/net investment income (“NII”) figures and compare these metrics to each mREIT’s and BDC’s actual reported results, respectively. For readers who are familiar with my public mREIT and/or BDC articles, these types of articles are beneficial to readers who desire to pursue a more active investing strategy and/or want more “real time” thoughts/analysis.

I hope my services/contributions ultimately help enhance a subscriber’s total investment returns or minimize their total investment losses within the mREIT and BDC sectors. At the very least, I hope subscribers will gain more insight into the mREIT and BDC sectors by reading my/our exclusive REIT Forum articles.

1) OCSL’s NAV and Adjusted NII Calendar Q3 2023 Performance (Projected Versus Actual Results):

On 11/14/2023, Oaktree Specialty Lending Corp. (OCSL) reported the company’s earnings results for the calendar third quarter of 2023 (fiscal fourth quarter of 2023). Table 1 below provides OCSL’s NAV and earnings summary.

Table 1 – OCSL Calendar Q3 2023 NAV and Earnings Summary

Source: Taken Directly from the REIT Forum’s © Analytical Spreadsheets/Data

Hi subscribers. I was able to review OCSL’s calendar Q3 2023 (fiscal Q4 2023) earnings results. OCSL's calendar Q3 2023 adjusted net investment income (“NII”) of $0.619 per share was a very minor - minor underperformance versus my projection of $0.635 per share (range $0.605 - $0.665 per share). OCSL’s calendar Q2 2023 adjusted NII was $0.617 per share. As such, I projected an adjusted NII increase of $0.018 per share. In actuality, OCSL reported an adjusted NII increase of $0.002 per share during the calendar third quarter of 2023. In comparison, the institutional analysts’ consensus average was adjusted NII of $0.628 per share. Due to the fact OCSL continually accrues for GAAP capital gains incentive fees (or reversals) and discount accretion in relation to the OCSI and/or OSI2 merger, I continue to believe the company’s adjusted NII is the best metric to track regarding operational performance (not NII; more indicative of net investment company taxable income [net ICTI]). Let us reconcile OCSL’s quarterly adjusted NII underperformance when compared to my expectations.

First, when looking over OCSL’s investment portfolio, the company had quarterly loan originations funded at close and add-on investments of only $117 million during the calendar third quarter of 2023. In comparison, I projected quarterly loan originations funded at close and add-on investments of $150 - $200 million (mean of $175 million). OCSL recorded loan prepayments/repayments/restructurings of ($364) million during the calendar third quarter of 2023. In comparison, I projected quarterly prepayments/repayments/restructurings of ($250) – ($300) million (mean of ($275) million). When calculated, excluding fair market value (“FMV”) fluctuations, OCSL decreased the company’s investment portfolio size by ($247) million during the calendar third quarter of 2023 (pretty large decrease). In comparison, I projected OCSL would decrease the company’s investment portfolio size by a mean of only ($100) million. As such, a modestly smaller investment portfolio size when compared to my expectations. However, it should be noted OCSL restructured a prior non-accrual portfolio company during the quarter. In conjunction with this event, 2 new debt investments were placed back on accrual status during the quarter which slightly mitigated the lower investment portfolio size regarding accrued interest income.

Second, OCSL continued to experience a rise in the company’s weighted average annualized yield during the calendar third quarter of 2023 when compared to the prior quarter. Simply put, this was due to the continued increase in LIBOR/SOFR/PRIME. OCSL reported a weighted average annualized yield of 11.90%, 12.30%, and 12.70% for the calendar first, second, and third quarter of 2023, respectively. When calculated, this was a quarterly increase of 0.4% and 0.4%, respectively. This past quarter, this was a 0.1% outperformance when compared to my expectations. This metric should begin to plateau towards the end of 2023. In addition, it should be noted the higher LIBOR/SOFR/PRIME rises, the more underlying credit risk (non-accruals) needs to be respected (and monitored). This will have heightened importance as we head through 2023 and into 2024.

When combining these 2 offsetting factors, OCSL reported total investment income that was slightly below my expectations. OCSL reported total investment (which includes interest, payment-in-kind (“PIK”)/deferred, fee, and dividend) income of $102 million during the calendar third quarter of 2023. In comparison, I projected OCSL would report total investment income of $105 million. When calculated, including the incentive fee offset from lower pre-incentive fee income, this ($3) million variance directly resulted in an adjusted NII underperformance of ($0.033) per share when compared to my expectations.

When the variance above is combined with a remaining $0.017 per share operational expense net outperformance (mainly lower-than-anticipated base management fees and interest expense as a direct result of the company’s lower aforementioned investment portfolio size), this fully reconciles back to OCSL’s adjusted NII underperformance of ($0.016) per share when compared to my expectations for the calendar third quarter of 2023.

Moving on, OCSL reported a NAV as of 9/30/2023 of $19.63 per share (0.3% increase) versus my projection of $19.65 per share (0.4% increase). I consider this basically an exact match (at or within a 0.5% variance) and was well within my $19.15 - $20.15 per share range.

Within OCSL’s entire investment portfolio, which contained 143 portfolio companies as of 9/30/2023, the company reported a combined net realized loss and net unrealized appreciation (including foreign currency FMV fluctuations) of $1 million during the calendar third quarter of 2023. In comparison, I projected combined net realized and unrealized appreciation of $3 million (technically $2.5 million). When calculated, this ($2) million variance directly led to a NAV underperformance of ($0.02) per share when compared to my expectations. Simply put, no notable surprises within the quarterly valuation fluctuations of OCSL’s underlying portfolio companies (unlike a handful of portfolio companies during the prior quarter). If anything, the continued quick, rapid FMV depreciation within All Web Leads, Inc. (All Web) is a bit troubling (slightly more than I anticipated but immaterial overall).

When the variance noted above is combined with a NAV outperformance of $0.02 per share directly due to no excise tax being accrued for (OCSL declared a special periodic dividend in lieu of taxing this tax) and the adjusted NII underperformance of ($0.016) per share discussed earlier, this directly calculates to OCSL’s quarterly NAV underperformance of ($0.02) per share when compared to my expectations.

Regarding credit risk, OCSL put 1 new portfolio company, Continental Intermodal Group LP (Continental) on non-accrual status during the calendar third quarter of 2023. Continental is an oil and gas portfolio company. This consisted of a 1^st lien debt investment with a principal balance of $22.1 million as of 9/30/2023. As such, a medium-sized loan. This was correctly anticipated on my end (as noted in our weekly mREIT and BDC newsletter; “flagged” through use of my company’s internal data sources/research). OCSL also took 2 portfolio companies off non-accrual status during the quarter. One was a positive outcome while the other outcome was “mediocre” in my professional opinion.

First, Athenex, Inc. (Athenex) was taken off non-accrual status as the portfolio company repaid all outstanding debt and was exited. OCSL recorded a minor net realized gain regarding the company’s sold equity investments in Athenex. As such, a very good outcome regarding this once non-accrual portfolio company. Second, SIO2 Medical Products, Inc. (SIO2) had a partial debt-to-equity restructuring during the calendar third quarter of 2023. As such, OCSL took a new equity stake in this portfolio company. Simply put, a large portion of OCSL’s existing debt investments in SIO2 were restructured to equity. 2 new, notably smaller debt investments were created as a result of this process and were placed on accrual status. In conjunction with this event, OCSL recorded a ($14) million realized loss within SIO2 during the calendar third quarter of 2023. This will be a portfolio company that continues to receive heightened monitoring in future quarters.

As a reminder, OCSL had 0 portfolio companies on non-accrual status as of 12/31/2022. OCSL now still had 4 portfolio companies on non-accrual status as of 9/30/2023. This should be considered a fairly large/quick increase for this BDC and a bit of an “eye sore”. OCSL’s non-accrual rate as of 9/30/2023, based on amortized cost basis and FMV, was 2.2% and 1.7%, respectively. Both percentages will remain near sector averages. As correctly stated 3 quarters ago, I anticipated a handful of new non-accruals within OCSL’s investment portfolio as we headed through calendar year 2023.

So, all-in-all, a very minor - minor underperformance on OCSL’s adjusted NII (variance of $0.016 per share) and basically an exact match on the company’s NAV (variance of only 0.1%). As such, I believe an “average” quarter for OCSL. Regarding dividends, OCSL declared an unchanged dividend of $0.55 per share for the calendar fourth quarter of 2023 while also declaring a special periodic dividend of $0.07 per share. Both dividend declarations were within my projected range of $0.55 - $0.57 and $0.00 - $0.10 per share, respectively (as shown in last quarter’s BDC sector comparison article [PART 2]).

When taking OCSL’s recent and projected performance into consideration, along with macroeconomic trends/events (mainly Fed monetary policy, the general projected movement of rates/yields, and projected economic performance over the foreseeable future), no change to my/our OCSL percentage recommendation ranges (relative to CURRENT NAV) or risk rating (will remain at a 3.5).

At a closing price as of 11/14/2023 of $19.86 per share, OCSL is deemed to be APPROPRIATELY VALUED/a HOLD recommendation (price target of $20.15 per share). Currently, OCSL is not one of the most overvalued BDC stocks that I/we cover but, in my opinion, is not one of the most undervalued either.

Conclusions Drawn + BUY, SELL, or HOLD Recommendation:

Readers have continued to request that I provide these types of “earnings assessment” articles showing how my previously disclosed quarterly projections “stacked-up” to each covered mREIT’s/BDC’s results. I believe the analysis above accomplishes this request for the REIT Forum subscribers.

In summary, here is how OCSL performed when compared to my expectations regarding the third quarter of 2023 (includes any risk rating and BUY, SELL, or HOLD recommendation range changes; as well as current recommendation):