Oaktree Special Loans: A 13% Yield Buying Opportunity (OCSL)

Oaktree Special Loans (NASDAQ:OCSL) came under increasing selling pressure in 2024 as the BDC revealed credit performance issues that resulted in a fairly significant increase in the delinquency rate. The BDC's balance sheet quality continued to The June quarter suffered a setback, but Oaktree Specialty Lending is looking to strengthen its portfolio by focusing more on implementing a first-lien strategy going forward. Despite the increase in the non-accrual percentage, Oaktree Specialty Lending supported its dividend with net investment income, and I believe the BDC will not necessarily need to cut its dividend. With the stock trading at a price-to-net asset value ratio of less than 1.0X, I believe equity investors also benefit from a greater margin of safety in valuation.

Previous rating

I rated Oaktree Specialty Lending stock a Strong Buy in May, despite… BDC suffers from weaker balance sheet quality, due to a strong origination image: A solid 11% return to boost your revenueSince then, Oaktree Specialty Lending shares are down about 14% in price, and the BDC also reported a sizable increase in its non-accrual percentage in the most recent quarter. However, Oaktree Specialty Lending adjusted its base management fee structure in an attempt to safeguard its dividend, which provides a cushion for OCSL's dividend. I continue to believe that the current dividend is sustainable and that Oaktree Specialty Lending could avoid a dividend cut.

Loan problems weigh on OCSL

Oaktree Specialty Lending is primarily focused on investments in first- and second-lien debt, which together accounted for 85% of investments in the June quarter. The BDC made investment commitments of $302 million in new first- and second-lien debt and $3 million in new second-lien debt in the fiscal third quarter, while $35 million was invested in new unsubordinated debt and equity.

Oaktree Specialty Lending’s portfolio suffered continued performance issues in the most recent quarter as more debt investments went sour and the BDC added three new investments to its non-accruals. A total of eight debt investments did not perform in the June quarter, causing the non-accrual percentage to reach 3.7% on a fair value basis. This means that Oaktree Specialty Lending suffered a 1.3 PP increase in its non-accrual ratio quarter over quarter. Declining credit, coverage and yield metrics for BDCs typically result in higher dividend risks, so investors have become considerably more cautious with OCSL over the past two quarters.

Due to Oaktree Specialty Lending's performance issues in the debt portfolio, the BDC has also experienced a decline in its distribution coverage profile. In the third quarter of 2024, Oaktree Specialty Lending generated $0.55 per share in adjusted net investment income, which was almost enough to support the dividend of $0.55 per share. In other words, Oaktree Specialty Lending's distribution coverage ratio in the third quarter of 2024 was 100%. In the previous quarter, the distribution coverage ratio was calculated at 102%, meaning that the ratio was down 2 percentage points quarter-over-quarter.

To avoid a dividend cut, management announced a change to its base management fee structure that will provide a cushion for Oaktree Specialty Lending's dividend coverage.

The change in fee structure is expected to add between $0.03 and $0.04 per share each quarter (approximately $0.15 per share annually) to the BDC’s net investment income. BDC management reduced the base management fee from 1.50% to 1.00% and OCSL waived additional base management fees in the most recent quarter, saving Oaktree Specialty Lending $1.5 million in the third quarter of 2024.

Oaktree Specialty Lending Valuation

Oaktree Specialty Lending is currently trading at a P/E ratio of 0.92X and hence trading well below the BDC’s long-term average P/E ratio of 1.02X. The reason for the change in valuation is that Oaktree Specialty Lending’s debt portfolio has started to underperform in fiscal 2024, which has created selling pressure as well as concerns about the BDC’s dividend. The industry group average P/E ratio, which I calculate including Ares Capital (ARCC) and Blue Owl Capital (OBDC), was 0.98X, so there is a potential chance for equity investors to buy OCSL on the dip.

In my view, Oaktree Specialty Lending could appreciate to its net asset value over the next twelve months, but only if the BDC avoids further deterioration of its balance sheet and loan quality. More defaults would almost certainly translate into incremental declines in its net asset value as well as weaker distribution coverage. With an XP/NAV ratio of 1.0, Oaktree Specialty Lending could be fairly valued at around $18.19 per share, implying 8% upside potential.

Risks with OCSL

The obvious risk for Oaktree Specialty Lending is that the BDC’s impaired loans will increase, resulting in additional write-downs that are not yet reflected in the company’s net asset value. Due to weakening balance sheet quality, the margin of safety for dividends has also been eroded here… which is why OCSL shares are now trading at an 8% discount to net asset value. Going forward, fixed-income investors should closely monitor Oaktree Specialty Lending’s distribution coverage profile as well as the amount of impaired loans included in the BDC’s portfolio. A dividend cut would clearly be the worst-case scenario for Oaktree Specialty Lending and could cause long-term reputational damage to OCSL’s well-regarded management team.

Final thoughts

Given the change in the company's base management fee structure, which is expected to add $0.03 to $0.04 per share each quarter to net investment income, I do not believe that Oaktree Specialty Lending will need to reduce its dividend. However, if the BDC's credit quality continues to suffer and management needs to move more debt investments into non-accrual status, Oaktree Specialty Lending may be forced to write down more investments, which would negatively impact net asset value. At this point, I do not expect Oaktree Specialty Lending to cut its dividend, but it is worth noting that the BDC's margin of safety when it comes to the dividend clearly deteriorated in the June quarter. In my view, OCSL remains a promising buy for equity investors given the company's 13% yield and discount to net asset value.