Fully Assessing Oaktree Specialty Lending's Results For Fiscal Q4 2018 (Includes Updated Price Target)

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About: Oaktree Specialty Lending Corporation (OCSL), Includes: AINV, ARCC, BDCL, BDCS, BIZD, BLK, FSAM, FSIC, GAIN, GBDC, MAIN, MCC, NEWT, OAK, OCSI, PFLT, PSEC, SLRC, TCPC, TSLX, YETI
by: Scott Kennedy
Summary

This article assesses OCSL’s performance for the fiscal fourth quarter of 2018 (calendar third quarter of 2018) and compares results over the trailing twelve months.

First, this article analyzes OCSL’s income statement for the three-months ended 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018.

This includes comparing how OCSL’s reported results compared to my projections regarding the company’s quarterly NII and NAV per share fluctuation.

Second, this article performs a FMV investing rating analysis on OCSL’s portfolio companies over the prior several quarters.

My summarized thoughts on OCSL’s performance for FQ4 2018, updated price target, and buy, sell, or hold recommendation are stated in the “Conclusions Drawn” section of the article.

Focus of Article:

The focus of this article is to analyze Oaktree Specialty Lending’s (OCSL) results for the fiscal fourth quarter of 2018 and compare the company’s performance over the trailing twelve months (“TTM”). First, this article analyzes OCSL’s income statement (technically speaking the company’s “consolidated statement of operations”) for the three months ended 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018. This includes an analysis of OCSL’s net investment income (“NII”) and earnings per share (“EPS”) (also known as “net increase (decrease) in net assets resulting from operations”). This also includes a comparison of OCSL’s NII and EPS per share amount when compared to my previous projections. Second, this article provides a fair market value (“FMV”) investment rating analysis on OCSL’s portfolio companies over the prior several quarters (basically since new management has taken over).

This assessment article will show past and current data with supporting documentation within two tables. I am providing this analysis due to multiple requests to periodically cover OCSL’s performance. This assessment article alone is not the only data/information that should be examined to initiate a position within OCSL. However, I believe this analysis would be a good “starting point” to begin a discussion on the topic. My BUY, SELL, or HOLD recommendation, updated positive and negative catalysts/trends to consider, and updated price target for OCSL are stated in the “Conclusions Drawn” section at the end of the article.

1) Assessing OCSL’s Quarterly Consolidated Statement of Operations:

To begin this analysis, Table 1 is provided below. Table 1 shows OCSL’s consolidated statement of operations for the three months ended 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018. Due to the fact OCSL’s performance is generally not “skewed” due to seasonal trends, I believe comparing the company’s performance over the TTM is the most appropriate type of quantitative analysis for this assessment article. In other words, it is deemed unnecessary to compare the quarter of one year to the same quarter of a prior year.

Table 1 – OCSL Consolidated Statement of Operations (three months Ended 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018)

OCSL Consolidated Statement of Operations (Three-Months Ended 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018) (Source: Table created by me, partially using OCSL data obtained from the SEC’s EDGAR Database)

Income and Expense Accounts:

Using Table 1 above as a reference, OCSL reported total interest income of $29.9, $26.6, $26.6, and $35.3 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly interest income by ($3.3), less than $0.1, and $8.7 million, respectively. I believe readers would agree OCSL modestly decreased the company’s interest income during the fiscal second quarter of 2018 while having a notable “uptick” during the fiscal fourth quarter of 2018. This increase was due to several reasons.

First, this increase was partially due to the recent restructuring/amendment of one of OCSL’s debt investments within its joint venture (“JV”), Senior Loan Fund JV I LLC (Senior Loan Fund JV). As discussed last quarter, OCSL receives interest income from two debt investments within Senior Loan Fund JV. One debt investment is floating-rate notes that are directly tied to the London Interbank Offered Rate (LIBOR). The other debt investment is fixed-rate notes that previously solely consisted of “payment-in-kind” (“PIK”) interest income that had a stated rate of 15%. While the stated interest rate on the company’s fixed-rate notes was reduced at the end of the fiscal third quarter of 2018 to 10%, along with this reduction was a conversion from 100% PIK (deferred) interest income to 100% “cash” interest income. While I believe the (5%) interest rate reduction should be seen as negative in nature, I was encouraged by the 100% conversion from PIK (deferred) interest income to cash interest income.

Second, Oaktree Capital Group LLC’s (OAK) management team has continued to focus their attention on originating/purchasing senior secured debt investments while “shying away” from unsecured debt and equity investments. As such, while legacy/“non-core” debt and equity investments are prepaid/sold/written-off, OCSL’s portfolio additions have basically been entirely senior secured debt investments. Ultimately, this has increased OCSL’s accrued interest income over the prior two fiscal quarters which should be seen as a more positive catalyst/trend.

Expanding on this point, OCSL reported loan originations and add-on investments of approximately $600 million during the company’s combined prior two fiscal quarters while reporting portfolio sales/repayments/restructurings of approximately ($550) million. When calculated, OCSL’s investment portfolio increased by approximately $50 million over the prior two fiscal quarters (prior to all quarterly “fair market value” [FMV] fluctuations and scheduled principal payments). While this was not a notable net increase to OCSL’s investment portfolio over the span of two fiscal quarters, I would point out this was the largest increase since late 2015. Simply put, a larger debt investment portfolio typically equates to an increased amount of interest income being accrued.

Third, nearly all of OCSL’s floating-rate debt investments continued to benefit from the recent rise in the London Interbank Offered Rate (“LIBOR”). As of 6/30/2018 and 9/30/2018, 83% of OCSL’s debt investments had floating-rates. In addition, basically all of OCSL’s floating-rate debt investments had surpassed their respective cash LIBOR floor. However, partially offsetting this positive catalyst/trend is the continued net decrease within OCSL’s weighted average annualized yield. As of 6/30/2018, OCSL’s debt investment portfolio had a weighted average annualized yield of 8.8%. As of 9/30/2018, this percentage decreased to 8.4%. This decrease was a combination of the following: 1) decreased interest rate on recently restructured fixed-rate notes within Senior Loan Fund JV (discussed earlier); 2) recent non-accruals within Garretson Firm Resolution Group, Inc. (Garretson), Thing5, LLC (Things5), and Refac Optical Group (Refac); and 3) lower initial weighted average yield/spread on newly originated loans.

Fourth, OCSL recorded a notable amount (proportionately speaking) of original issue discount (“OID”) accretion income on the recently prepaid/refinanced debt investment in Allen Media, LLC (Allen Media).

When quantifying the four factors above, this ultimately led to OCSL reporting a notable increase in total accrued interest income for the fiscal fourth quarter of 2018 when compared to the prior quarter.

Moving down Table 1, OCSL reported PIK (deferred) interest income of $1.9, $1.9, $1.5, and $0.5 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly PIK (deferred) interest income by $0.1, ($0.5), and ($1.0) million (rounded), respectively. As stated earlier, OCSL’s fixed-rate notes within Senior Loan Fund JV were recently amended to fully convert its PIK (deferred) interest income to 100% cash interest income. As such, OCSL recorded $0 of PIK (deferred) interest income within the company’s control investments during the fiscal fourth quarter of 2018 versus an accrual of $1.0 million during the prior quarter.

Moving down Table 1, OCSL reported fee income of $1.0, $3.9, $2.4, and $2.0 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly fee income by $2.9, ($1.5), and ($0.4) million, respectively. The elevated amount of fee income during OCSL’s fiscal second, third, and fourth quarters of 2018 was directly attributable to a net increase in the amount of loan originations and add-on investments discussed earlier.

OCSL reported dividend income of $1.0, $2.3, $1.3, and $0.4 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly dividend income by $1.2, ($0.9), and ($1.0) million (rounded), respectively. Out of all of OCSL’s control investments, only Senior Loan Fund JV has provided dividend income over the TTM. In addition, I believe the ($1.0) million reduction in dividend income for the fiscal fourth quarter of 2018 was directly attributed to the above-mentioned restructuring of OCSL’s fixed-rate debt investment within Senior Loan Fund JV. As stated above, this loan was previously 100% PIK (deferred) interest income which was recently amended to 100% cash interest income. Since PIK interest income is deferred income whereas cash interest income is accrued for (and paid) in the period of occurrence (excluding the notion of receivable interest at quarter end for simplicity), Senior Loan Fund JV technically now has a lower amount of cash to provide dividend income to OCSL. Typically, the higher the number of control investments providing recurring (or even periodic) dividend income, the more attractive the portfolio. Since only one control investment has provided dividend income over the TTM (which has, in itself, recently decreased), I believe this should be seen as a negative factor/trend.

Continuing to move down Table 1, OCSL reported net expenses of $20.6, $19.5, $17.4, and $21.2 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly net expenses by ($1.0), ($2.1), and $3.8 million (rounded), respectively. OCSL’s modest increase in expenses during the fiscal fourth quarter of 2018, when compared to the prior quarter, mainly consisted of the following: 1) modest increase in incentive fee income due to a larger amount of total investment income; 2) modest increase in interest expense due to a minor increase in LIBOR and a larger weighted average outstanding borrowings balance; and 3) a modest reversal of management fees waived due to a notable prior period adjustment regarding the classification of certain prior dividend distributions.

When all the amounts above are combined, OCSL reported NII of $13.3, $15.3, $14.4, and $17.0 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. When calculated, OCSL increased (decreased) the company’s quarterly NII by $1.9, ($0.8), and $2.6 million (rounded), respectively. The following was my OCSL NII per share projection for the fiscal fourth quarter of 2018 versus the company’s actual reported amount:

My Previous OCSL FQ4 2018 NII Projection: $0.112 per share

OCSL’s Actual FQ4 2018 NII: $0.121 per share

As readers can see, my OCSL NII per share projection for the fiscal fourth quarter of 2018 was slightly lower when compared to the company’s actual results (but still within my projected range). As such, I believe OCSL’s NII was a minor outperformance when compared to my expectations. A majority of this outperformance was due to the amount of OID accretion income recorded on the recently prepaid/refinanced debt investment in Allen Media. Let us now discuss OCSL’s valuation accounts.

Valuation Accounts:

Still moving down Table 1, OCSL reported net unrealized appreciation (depreciation) on investments (excluding secured borrowings) and foreign currency forward contracts of ($45.1), ($0.8), $98.9, and $47.3 million for the fiscal first, second, third, and fourth quarters of 2018, respectively. Simply put, OCSL’s unrealized depreciation during the fiscal first quarter of 2018 was notable. This included notable unrealized FMV depreciation within the following portfolio companies: 1) Maverick Healthcare Group, LLC (Maverick) ($16) million; 2) Dominion Diagnostics, LLC (Dominion) ($15) million; 3) AdVenture Interactive, Corp. (AdVenture) ($7) million; and 4) Onvoy, LLC (Onvoy) ($6) million. After new management properly wrote-down many underperforming investments, OCSL’s minimal depreciation during the company’s fiscal second quarter of 2018 was more promising.

OCSL’s notable $98.9 million net unrealized appreciation during the company’s fiscal third quarter of 2018 was mainly the result of unrealized to realized reclassifications (will be discussed in the realized account). Aside from that, the following portfolio companies experienced notable unrealized valuation fluctuations during the quarter: 1) Senior Loan Fund JV ($2) million; 2) Dominion $3 million; 3) Thing5 ($4) million; and 4) Veritas US Inc. (Veritas) ($3) million. As a whole, the remainder of OCSL’s investment portfolio reported modest net unrealized appreciation (especially newer investments).

Similar to the fiscal third quarter of 2018, OCSL’s notable $47.3 million net unrealized appreciation during the company’s fiscal fourth quarter of 2018 was mainly the result of an unrealized to realized reclassification (will be discussed in the realized account). Aside from that, the following portfolio companies experienced notable unrealized valuation fluctuations during the quarter: 1) First Star Speir Aviation 1 Limited ($4) million; 2) Senior Loan Fund JV ($2) million; 3) Cenegenics, LLC (Cenegenics) ($8) million; 4) Yeti Acquisition, LLC (YETI) $8 million; 5) Dominion $4 million; 6) BeyondTrust Software, Inc. (BeyondTrust) $10 million; and 7) Veritas $2 million. As a whole, the remainder of OCSL’s investment portfolio reported minor net unrealized appreciation.

Continuing to move down Table 1, OCSL reported a net realized gain (loss) on investments and foreign currency forward contracts of ($0.3), $4.9, ($89.4), and ($30.3) million for the fiscal first, second, third, and fourth quarters of 2018, respectively. As such, after a minor net realized loss during OCSL’s fiscal first quarter of 2018, the company reported a modest net realized gain for the fiscal second quarter of 2018.

However, mainly due to writing-off several legacy/non-core investments, OCSL reported a notable net realized loss for the fiscal third quarter of 2018. The following portfolio companies experienced notable realized valuation fluctuations during the quarter: 1) Traffic Solutions Holdings, Inc. (Traffic Solutions) ($17) million; 2) Metamorph US 3, LLC (Metamorph) ($7) million; 3) Ameritox Ltd. ($75) million; and 4) Lytx, Inc. (Lytx) $4 million. As a whole, the remainder of OCSL’s investment portfolio reported a minor net realized gain. Regarding Ameritox, this portfolio company was already completely written-down to a FMV of $0 as of 3/31/2018.

Similar to the fiscal third quarter of 2018, OCSL reported a notable net realized loss for the fiscal fourth quarter of 2018. The following portfolio company experienced a notable realized valuation fluctuation during the quarter: 1) TransTrade Operators, Inc. (TransTrade) ($33) million. As a whole, the remainder of OCSL’s investment portfolio reported a minor net realized gain. Regarding TransTrade, similar to Ameritox, this portfolio company was already completely written-down to a FMV of $0 as of 6/30/2018.

As a whole, I believe OCSL’s investment portfolio (from a valuation perspective) slightly outperformed my expectations which ultimately led to the company reporting EPS of $0.236 for the fiscal fourth quarter of 2018. In comparison, I projected OCSL would report EPS of $0.193. Most of this outperformance stems from OCSL’s FMV appreciation within BeyondTrust. As stated earlier, OCSL recorded net unrealized appreciation of $10 million on the company’s equity investment in BeyondTrust. In comparison, I projected net unrealized appreciation of only $2 million. While it was disclosed in September 2018 Veritas Capital was selling BeyondTrust to sector peer Bomgar, I assumed most of the FMV “write-up” of BeyondTrust would not occur during the calendar third quarter of 2018 since the merger was expected to close during the calendar fourth quarter of 2018.

Along with projecting/determining certain stockholders’ equity transactions, the following was my OCSL NAV per share projection as of 9/30/2018 versus the company’s actual reported amount:

My Previous OCSL NAV as of 9/30/2018 Projection: $6.05 per share (range $5.95-$6.15 per share)

OCSL’s Actual NAV as of 9/30/2018: $6.09 per share

So, OCSL slightly outperformed when compared to my EPS/NAV per share expectations. Now let us shift topics a bit and check the overall “health” of OCSL’s investment portfolio.

2) FMV Investment Rating Analysis on OCSL’s Debt and Equity Investments:

Since FMV depreciation (whether unrealized or realized) directly impacts OCSL’s EPS in the quarter of occurrence, this analysis has a direct impact on the company’s future NAV sustainability. I believe this analysis will bring some added clarity to readers to better understand how OCSL’s investment portfolio was rated, regarding valuations and credit risk, over the prior several quarters. To begin this analysis, Table 2 is provided below.

Table 2 – OCSL Investment Rating Analysis as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018 (Based on FMV; Includes Cost Basis as of 9/30/2018)

OCSL Investment Rating Analysis (Source: Table created by me, partially using OCSL data obtained from the SEC’s EDGAR Database [link provided below Table 1])

Using Table 2 above as a reference, I classify OCSL’s debt and equity investments within one of the following three portfolios: 1) control (dark blue coloring); 2) affiliate (olive green coloring); or 3) non-control/non-affiliate (purple coloring). A control investment is where OCSL owns (through an equity investment) at or greater than 25% of a portfolio company’s outstanding voting securities. An affiliate investment is where OCSL owns (through an equity investment) at or greater than 5% but less than 25% of a portfolio company’s outstanding voting securities. Within these three classifications, five different investment ratings are shown based on each portfolio’s recent FMV. I am including five separate points in time to better highlight movements within each classification.

In my professional opinion, this specific analysis is a good forward-looking metric to spot potential portfolio companies that would have a higher probability for an eventual loss of principal and/or non-accrual. In addition, spotting certain past/recent trends within a business development company’s (“BDC”) investment portfolio provides additional insight regarding accurate, reliable projections in the future (which I believe I have continued to provide to readers through articles/analysis).

When it comes to this analysis, I personally assign these investment ratings to each company’s portfolio holdings and are typically “harsher” per se in my ratings when compared to most management teams that perform a similar analysis. In most instances, my personal ratings ultimately provide a more accurate/clearer picture of a BDC’s “health” at any given point in time when it comes to credit risk/underperformance/eventual non-accruals.

An investment rating of “1” describes the portion of OCSL’s debt and equity investments that were performing at or above expectations. An investment rating of “2” describes the portion of investments that were performing near expectations. An investment rating of “3”, “4”, and “5” describes the portion of investments that were performing slightly, modestly, and materially below expectations, respectively.

Investment Rating 1 and 2 (Performing Near, At, or Above Expectations):

Still using Table 2 as a reference, I have classified 74%, 73%, 69%, 74%, and 71% of OCSL’s investment portfolio performing at or above expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively (based on FMV). As such, OCSL’s investment portfolio experienced a fairly consistent/steady performance over the company’s prior several quarters. The percentage increase during the fiscal third quarter of 2018 was mainly attributable to a larger amount of debt investments being originated versus reclassifications. Typically, all debt originations within new portfolio companies are initially classified as an investment rating 1 or 2. The percentage decrease during the fiscal fourth quarter of 2018 was mainly attributable to several investments being reclassified from an investment rating of 1-4 to a rating of 5 and mainly consisted of legacy/non-core portfolio companies. As of 9/30/2018, this investment rating had a FMV of $1.05 billion.

Next, I have classified 15%, 15%, 21%, 17%, and 17% of OCSL’s investment portfolio performing near expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. As such, OCSL’s investment portfolio had a minor percentage net increase regarding debt and equity investments performing near expectations over the prior several quarters. This percentage net increase was mainly attributable to legacy/non-core investments being sold/written off and newer debt investments being classified as an investment rating of 1 or 2 (as stated above). As of 9/30/2018, this investment rating had a FMV of $249 million.

When combined, I have classified 89%, 88%, 90%, 91%, and 88% of OCSL’s investment portfolio performing near, at, or above expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. As such, I believe a majority of OCSL’s investment portfolio was performing near, at, or above expectations when based on FMV. However, when based on OCSL’s cost basis, it should be noted only 78% of the company’s investment portfolio was performing near, at, or above expectations as of 9/30/2018. Simply put, the 10% percentage difference between OCSL’s FMV and cost basis as of 9/30/2018 continued to be “above average” versus most BDC peers I currently cover. The reason for this larger than average differential is the portion of OCSL’s investment portfolio that remains on non-accrual status which continues to have a very low/diminishing FMV. Most of these particular investments still have their entire cost basis since the time when first placed on non-accrual status. I wanted to provide OCSL’s investment rating as of 9/30/2018 based both on the company’s cost basis and FMV for added reader insight.

When calculated, I have determined 11%, 12%, 10%, 9%, and 12% of OCSL’s investment portfolio was experiencing varying levels of underperformance/non-performance as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. When compared to the fourteen other BDC peers I currently cover, OCSL had a slightly higher percentage of debt and equity investments performing either slightly, modestly, or materially below expectations as of 9/30/2018 (a “cautionary”/negative factor/trend). When based on cost basis, 22% of OCSL’s investment portfolio was experiencing varying levels of underperformance/non-performance as of 9/30/2018 (most materially below expectations; 20%). This was a modestly-notably higher percentage when compared to most of the fourteen other BDC peers I current cover.

To put things in better perspective, the following “FMV versus cost ratios” were for OCSL and fourteen other BDC peers as of 9/30/2018 (in order of highest to lowest ratio): 1) NEWTEK Business Services Corp. (NEWT) 1.2218x; 2) Gladstone Investment Corp. (GAIN) 1.1192x; 3) Main Street Capital Corp. (MAIN) 1.0973x; 4) Solar Capital Ltd. (SLRC) 1.0127x; 5) TPG Specialty Lending (TSLX) 1.0123x; 6) Golub Capital BDC Inc. (GBDC) 1.0012x; 7) PennantPark Floating Rate Capital Ltd. (PFLT) 0.9993x; 8) Apollo Investment Corp. (AINV) 0.9892x; 9) Prospect Capital Corp. (PSEC) 0.9829x; 10) Ares Capital Corp. (ARCC) 0.9779x;11) Oaktree Strategic Income Corp. (OCSI) 0.9719x; 12) FS Investment Corp. (FSIC) 0.9659x; 13) Blackrock (BLK) TCP Capital Corp. (TCPC) 0.9642x; 14) OCSL 0.9280x; and 15) Medley Capital Corp. (MCC) 0.8571x.

Investment Rating 3 (Performing Slightly Below Expectations):

I have classified 1%, 1%, 1%, 2%, and 1% of OCSL’s investment portfolio performing slightly below expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. All debt and equity investments within this classification should be carefully monitored each quarter to watch for future FMV write-downs and possible eventual non-accruals. As of 9/30/2018, this investment rating had a FMV of $13 million. When calculated, this analysis shows OCSL’s investment portfolio had a decreased FMV balance of ($6) million regarding the company’s debt and equity investments performing slightly below expectations over the prior several fiscal quarters. This decrease was mainly attributable to a couple debt and equity investments being reclassified from an investment rating of 3 to an investment rating of 4 or 5 (a negative catalyst/trend).

Investment Rating 4 (Performing Modestly Below Expectations):

I have classified 3%, 4%, 4%, 1%, and 1% of OCSL’s investment portfolio performing modestly below expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. All debt investments within this classification should be CONSIDERED for non-accruals. In other words, heightened monitoring should occur. Also, debt and equity investments within this classification have a modest probability of a partial non-recovery of one’s remaining principal/cost basis. As of 9/30/2018, this investment rating had a FMV of $21 million. When calculated, this analysis shows OCSL’s investment portfolio had a decreased FMV balance of ($28) million regarding the company’s debt and equity investments performing modestly below expectations over the prior several quarters. This decrease was mainly attributable to several debt and equity investments being reclassified from an investment rating of 4 to an investment rating of 5 (a negative factor/trend).

Investment Rating 5 (Performing Materially Below Expectations):

Finally, I have classified 7%, 7%, 5%, 6%, and 10% of OCSL’s investment portfolio performing materially below expectations as of 9/30/2017, 12/31/2017, 3/31/2018, 6/30/2018, and 9/30/2018, respectively. All debt investments within this classification should be on non-accrual status unless there is a specific reason otherwise (exceptions can [and do] occur). Also, certain debt and equity investments within this classification have a modest-high probability of a partial non-recovery of one’s remaining principal/cost basis (including a possible total write-off). As of 9/30/2018, this investment rating had a FMV of $155 million. When calculated, this analysis shows OCSL’s investment portfolio had an increased FMV balance of $48 million regarding the company’s debt and equity investments performing materially below expectations over the prior several quarters.

It is never a positive trend when a company has any part of its investment portfolio within this rating classification. When based on cost basis, $322 million (or 20%) of OCSL’s investment portfolio had debt and equity investments performing materially below expectations as of 9/30/2018. While the vast majority of these materially underperforming investments are attributed to the prior management team, Fifth Street Asset Management (OTCPK:FSAM), they are still around for new management to “pick up the pieces” when it comes to some legacy/non-core portfolio companies. The following portfolio companies had at least one debt investment on non-accrual status as of 9/30/2018: 1) Cenegenics; 2) Maverick; 3) PLATO Learning Inc. (PLATO; formerly Edmentum, Inc.); 4) Garretson (fairly new non-accrual); 5) Dominion; 6) Advanced Pain Management Holdings, Inc. (Advanced Pain); 7) Thing5 (fairly new non-accrual);and 8) Refac (new non-accrual).

Regarding Refac, OCSL’s four debt investments within this portfolio company were due 9/30/2018. However, Refac failed to repay its debt obligations to OCSL (and still have not repaid as of early December 2018). As such, these debt investments were placed on “past due” status at the end of the quarter; even though Refac has continued to make previously contractual principal and interest payments. OCSL has also put these debt investments on non-accrual status with interest payments also lowering the asset base; as opposed to running interest payments through the income statement (common practice for this type of situation). Refac is currently in the process of divesting certain assets/services and is currently in the process of refinancing its existing debt with third party lenders (OCSL has declined to engage in refinancing; back to the non-core thesis). If Refac’s refinancing is successful, there is a likely probability OCSL will be able to “re-coop” most (if not all) of its existing four debt investments with this portfolio company.

Readers should understand any future/further non-accruals would bring the risk of a decrease in interest income per GAAP and the risk of decreases in NAV from future FMV write-offs. I believe the debt and equity investments within these lower classifications should continue to be monitored to a greater degree as they are the most susceptible to FMV write-downs, non-performance (which would lead to non-accruals), and ultimately a probable partial (in some cases total) loss of principal/cost basis. This would negatively impact OCSL’s future NAV sustainability. This analysis also identifies certain portfolio companies that are performing above expectations. This provides direct evidence for possible net investment appreciation. This would positively impact OCSL’s future NAV sustainability.

From the analysis above, I believe OCSL’s investment portfolio as of 9/30/2018 had a majority of investments “in good health” (especially newer investments) while many legacy/non-core investments remain at heightened risk of FMV depreciation.

Conclusions Drawn:

Readers have requested that I provide these types of assessment articles showing how my previous quarterly projections “stacked-up” to actual results. I believe the analysis above accomplishes this request. Since a company’s operating performance (quarterly earnings) is one of the key drivers to stock price valuations, I believe these types of assessment articles are appreciated by most readers (owners and non-owners of OCSL alike). In addition, this article provides my overall thoughts on the quarter which I believe most readers see as beneficial when assessing certain investing strategies.

From the analysis provided above, I believe it was determined OCSL’s NII, EPS, and NAV per share figures for the fiscal fourth quarter of 2018 were a slight outperformance when compared to my expectations. This mainly stemmed from the following two events during the quarter: 1) notable OID accretion income and prepayment fees from the recent prepayment/refinancing of Allen Media; and 2) notable unrealized appreciation within BeyondTrust (I was expecting most appreciation to occur during the December quarter; when the acquisition was finalized). However, all three metrics were still within my projected range.

When it comes to the overall health of OCSL’s investment portfolio, I believe management’s turnaround strategy is still a “work in progress” and will likely take another year or so before putting the legacy/non-core investment portfolio behind them. In the meantime, many legacy/non-core investments continue to suppress overall returns and sector metrics. However, I am encouraged by OCSL’s commentary and the recent growth of the company’s debt investment portfolio in larger, less leveraged portfolio companies. Ultimately, this will likely improve sector metrics “down-the-road”.

My BUY, SELL, or HOLD Recommendation:

In my opinion, the following positive factors/catalysts should be highlighted for existing and potential OCSL shareholders: 1) continued relative price stability within the high yield debt market (positively impacts valuations where credit risk remains low; even with broader market volatility in January-February 2018 and at the start of the fourth quarter of 2018); 2) fairly attractive-attractive quarterly economic returns (combined change in NAV and dividends received) generated over the past three fiscal quarters; 3) modest exposure to the oil and gas sector (positive since crude oil prices have rebounded from depressed prices over the past several years [even with the recent sharp decrease in price]); 4) low exposure to the retail sector (some parts negatively impacted by continued change in consumer behavior/trends); 5) recent change in management (greater financial platform/expertise/underwriting skills versus predecessor); 6) company continues to not ask for shareholder approval to issue new shares at a material discount to CURRENT NAV; 7) continued discount to most sector peers when comparing stock price to the company’s NAV (some market participants [including myself] would argue this discount remains at least partially justified); 8) management’s current strategy of allocating most available capital to senior secured debt investments within portfolio companies who are more diversified, less levered, and have greater earnings before interest, tax, depreciation, and amortization (“EBITDA”) versus previous management’s investments; 9) recent increased probability of, at the least, a stable dividend per share rate over the foreseeable future; and 10) recent restructuring of Senior Loan Fund JV’s fixed-rate notes regarding its 100% conversion from PIK (deferred) interest income to cash interest income.

However, the following cautionary/negative factors should cause heightened awareness for existing and potential OCSL shareholders: 1) recent elevated amount of loan repayments due to refinancing with other market participants or impacts with current corporate interest deductibility (including negotiated lower stated interest rates with existing portfolio companies [negatively impacts NII]); 2) continued unrealized depreciation within various legacy/non-core investments and continued high non-accrual rate (including recent Garretson, Thing5, and Refac non-accruals); 3) continued below average percentage of floating-rate debt investments when compared to sector peers (however the company continues to have an attractive weighted average cash LIBOR floor); 4) poor cumulative performance regarding many prior and current control investments;5) several notable net decreases to the company’s dividend per share rate over the prior several years (similar to several underperforming peers); 6) continued generation of net realized losses within the company’s legacy/non-core investments; 7) external management structure which continues to lead to higher operating expenses when compared to internalized sector peers; 8) lack of dividend income generated within the company’s control investments with the exception of Senior Loan Fund JV (who has also recently decreased their dividend income generation);and 9) (1.9%) decrease in the company’s weighted average annualized yield regarding its debt investments over the prior five fiscal quarters (contrary to most sector peers with the recent increase in LIBOR).

OCSL recently closed at $4.73 per share as of 12/5/2018. This was a ($1.36) per share discount to OCSL’s NAV as of 9/30/2018 of $6.09 per share. This calculates to a price to NAV ratio of 0.7771 or a discount of (22.29%). When calculated, OCSL currently has a price to annualized NII per share ratio of 9.79x.

With the analysis above as support,I currently rate OCSL as a SELL when the company’s stock price is trading at or less than a (20%) discount to its NAV as of 9/30/2018, a HOLD when trading at greater than a (20%) but less than a (30%) discount to its NAV as of 9/30/2018, and a BUY when trading at or greater than a (30%) discount to its NAV as of 9/30/2018. These recommendation ranges a slight increase when compared to my last OCSL article (approximately 3.5 months ago).

Therefore, I currently rate OCSL as a HOLD. As such, I currently believe OCSL is appropriately valued. My current price target for OCSL is approximately $4.90 per share. This is currently the price where my recommendation would change to a SELL. This is a $0.30 per share increase when compared to my last OCSL article. The current price where my recommendation would change to a BUY is approximately $4.30 per share. This is also a $0.30 per share increase when compared to my last OCSL article.

While I do believe OCSL’s new management team can eventually turn around this BDC, I also believe this will take, at the least, several additional quarters. In the meantime, below average NII will persist along with heightened risk that a couple more legacy/non-core holdings will eventually be put on non-accrual status. Simply put, I currently believe market participants can wait until a more attractive valuation presents itself. In addition, I currently believe other sector peers are more attractively valued. A recent list of the BDC stocks that I currently believe are attractively valued was provided within the following article:

Main Street Capital's Dividend, NAV, And Valuation Vs. 10 BDC Peers (Post Q3 2018 Earnings) - Part 1

Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader’s current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions.

Current BDC Sector Stock Disclosures:

On 9/6/2017, I re-entered a position in PSEC at a weighted average purchase price of $6.765 per share. On 10/16/2017 and 11/6/2017, I increased my position in PSEC at a weighted average purchase price of $6.285 and $5.66 per share, respectively. When combined, my PSEC position has a weighted average purchase price of $6.077 per share. This weighted average per share price excludes all dividends received/reinvested. Each PSEC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a BUY recommendation on PSEC.

On 2/2/2018, I re-entered a position in MAIN at a weighted average purchase price of $37.425 per share. On 2/5/2018, I increased my position in MAIN at a weighted average purchase price of $35.345 per share. My second purchase was approximately triple the monetary amount of my initial purchase. On 3/1/2018, 10/4/2018, and 10/23/2018, I increased my position in MAIN at a weighted average purchase price of $35.365, $37.645, and $36.674 per share, respectively. When combined, my MAIN position has a weighted average purchase price of $36.128 per share. This weighted average per share price excludes all dividends received/reinvested. Each MAIN trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a BUY recommendation on MAIN.

On 6/5/2018, I initiated a position in TSLX at a weighted average purchase price of $18.502 per share. On 6/14/2018, I increased my position in TSLX at a weighted average purchase price of $17.855 per share. My second purchase was approximately double the monetary amount of my initial purchase. When combined, my TSLX position has a weighted average purchase price of $18.071 per share. This weighted average per share price excludes all dividends received/reinvested. Each TSLX trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a HOLD recommendation on TSLX.

On 10/12/2018, I initiated a position in ARCC at a weighted average purchase price of $16.40 per share. This weighted average per share price excludes all dividends received/reinvested. This ARCC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a BUY recommendation on ARCC.

On 10/12/2018, I re-entered a position in NEWT at a weighted average purchase price of $18.355 per share. This weighted average per share price excludes all dividends received/reinvested. This NEWT trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a HOLD recommendation on NEWT.

On 10/12/2018, I initiated a position in SLRC at a weighted average purchase price of $20.655 per share. This weighted average per share price excludes all dividends received/reinvested. This SLRC trade was disclosed to readers in real time (that day) via the StockTalks feature of Seeking Alpha. I currently have a BUY recommendation on SLRC.

All trades/investments I have performed over the past few years have been disclosed to readers in real time (that day at the latest) via the StockTalks feature of Seeking Alpha (which cannot be changed/altered). Through this resource, readers can look up all my prior disclosures (buys/sells) regarding all companies I cover here at Seeking Alpha (see my profile page for a list of all stocks covered). Through StockTalk disclosures, at the end of November 2018 I had an unrealized/realized gain “success rate” of 84.6% and a total return (includes dividends received) success rate of 100% out of 39 positions (see my profile for more detailed investing statistics). The slight decrease in the first percentage, when compared to September 2018, was due to the fact my position in three mREIT preferred stocks recently turned slightly negative (when excluding dividends received; still had a total return). I encourage other Seeking Alpha contributors to provide real time buy and sell updates for their readers which would ultimately lead to greater transparency/credibility.

Disclosure: I am/we are long ARCC, BLK, MAIN, NEWT, PSEC, SLRC, TSLX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I currently have no position in OSCL, AINV, BDCL, BDCS, BIZD, FSAM, FSIC, GAIN, GBDC, MCC, OAK, OCSI, PFLT, TCPC, or YETI.