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Today's analysis dials in on Oaktree Specialty Corporation (NASDAQ:OCSL), a U.S.-based lender that specializes in corporate lending to companies with innovative solutions.
The fund emphasizes both income and value appreciation. However, there are frequent tradeoffs due to Oaktree's emphasis on variable-rate loans. Therefore, we decided to assess the fund's prospects given the changing yield curve environment that has recently emerged.
Without further ado, here are some of our latest findings on Oaktree Specialty lending.
Business Overview & Recent Performance
Although primarily a direct credit provider, Oaktree delves into joint ventures that subsequently provide lending, listed equity, and real assets. Phasing in indirect credit and non-credit investments does make sense as organic asset base growth and diversification provide Oaktree with valuable collateral to maximize its leverage; however, the fact remains that its direct credit segment remains its dominant force for now as it spans 73% of Oaktree's AUM.
Author's Work, Data from Oaktree
Let's start off by discussing Oaktree's direct credit endeavors and recent performance before traversing into its ancillary activities later on.
As shown in the diagram below, Oaktree relies on floating-rate debt investments. For those unaware, floaters can provide inflation hedges as their coupons are correlated to the interest rate cycle. However, floaters often suffer from price depletion in elevated interest rate environments due to higher discount rates and exorbitant funding rates for leveraged lenders such as Oaktree.
Author's Work, Data from Oaktree
Furthermore, Oaktree's sweet spot is first and second-lien loans. Although these loans are typically secured by collateral, they fall quite low on the priority of claims, meaning the securitization of the collateral used to secure the loans may be overstated at times.
Author's Work, Data from Oaktree
A consideration that is part and parcel of the collateral consideration is Oaktree's sector proclivity. As mentioned in the introduction, Oaktree often lends to innovative companies, which is quite evident by observing its overweight exposure to software, specialty retail, real estate, and biotechnology, to name a few. Moreover, consider that such loans onboard higher industry risk premiums than your average, which can enhance returns but also introduce substantial tail risk.
Industry Exposure (Oaktree)
Furthermore, Oaktree earned a cyclical high-weighted average interest of 12.3% in its third quarter. This was primarily due to the higher interest rate environment paired with high credit risk in the United States. However, although it earned a great deal of interest, Oaktree's weighted average interest rate on funding stood at 6.6%, rising significantly from 6.2% in Q2 and 5.6% in Q1. Therefore, the fund's high returns coexisted with higher funding rates.
Oaktree
Lastly, an overview of Oaktree's indirect credit and non-credit investments are worthy of consideration. The firm's joint venture AUM spans 6% of its portfolio, whereby the company owns an average of 87.5% of its JVs. These JVs subsequently provide senior secured loans to middle market companies, and as mentioned before, we think it onboards valuable diversification strategies to Oaktree.
Furthermore, Oaktree is partnered with Brookfield Asset Management (BAM) in real asset ownership and invests in public and private equity; although these investments can have some impact (on capital appreciation in particular), they remain an infinitesimal part of Oaktree's portfolio. Therefore, tempting us to conclude that many investors will overlook intra-segment activity for now.
JV Portfolio Summary (Oaktree Capital)
Why We See An Opportunity
Systematic Analysis
Our positive outlook on Oaktree stems from both its capital allocation and its funding rate prospects. Moreover, we think the company holds solid baseline performance that can be enhanced even further with a structural shift occurring in the credit markets.
Firstly, if we look at funding, it is clear that Oaktree relies on overnight funding rates via SOFR, credit risk embedded in LIBOR, and a risk-premium-adjusted spread added to its benchmark funding rates. During the past month, the level of the yield curve has dropped, which we anticipated would occur given the softening of the economic cycle. We believe additional drops in the level of the curve will eventually push down SOFR substantially, leading to a better funding environment for Oaktree. Of course, an inverse relationship with the credit curve may counteract such benefits. Still, we think the net effect will result in lower funding rates, providing benefits to Oaktree's net asset value.
Oaktree Capital
Furthermore, a lower yield curve can enhance the present value of Oaktree's loan book, as declining yields may lead to lower discount rates on bonds, concurrently raising the fund's asset base. Sure, lower variable income coupons could phase out such benefits. However, as with funding rates, we argue that the net effect will likely be accretive to Oaktree.
worldgovernmentbonds.com
A more secular view of Oaktree's portfolio is a worthwhile consideration. As mentioned before, Oaktree invests in innovative, middle-market companies. This means that high industry growth multiples and elevated industry risk premiums characterize Oaktree's portfolio. Therefore, the gains on Oaktree's portfolio via spreads charged and capital appreciation can be superior, assuming the economy does not default in the longer term.
Note: I plotted the aforementioned variables in the diagram below. Note that higher growth rates and industry risk premiums generally lead to higher long-term growth but are sensitive to economic tail risk.
Author's Work with data from Aswath Damodaran, Verified Research, and Acumen Research & Consulting
The final matter I want to point out for this section is the juxtaposition of new positions versus old ones for Oaktree, which illustrates the incoming divergence between funding and investment opportunities.
Oaktree funded $243 million (after committing $251 million) in new investments during Q3 with going-in weighted average yields of 12.6%. Around $60 million of these funds were allocated to existing companies, with 90% of the committed funds being to first-lien debt. In addition, Oaktree's new inclusions marked up its cash-based yield to 11.4% in Q3 from 10.9% in Q2.
As mentioned before, we think funding rates will drop significantly due to a lower level in the yield curve. However, credit risk premiums might expand given economic softening, providing valuable spread differentials between Oaktree's long-term investments and intermediate-term funding.
Credit Spreads (St.Louis Fed)
Valuation & Distributions
Valuation and dividends could be key value drivers for Oaktree's stock leading forward.
As visible in the following diagram, Oaktree is more or less fairly valued on a net asset value per share basis. However, as repeatedly stated within the article, we think a divergence between funding rates and investment yields will occur, potentially leading to a better valuation multiple.
Author's Calculations with Data from Seeking Alpha and Oaktree
Source: Author's calculations, Data from Seeking Alpha
Furthermore, a forward P/E multiple formula paints a good picture. Our analysis shows that Oaktree could reach $25.45 per share, providing an upside potential of more than 25%. Although forward P/E multiples aren't fully reliable, they provide valuable context.
Author's Calculations with Data from Seeking Alpha, Oaktree
Source: Author's Calculations, Data from Seeking Alpha
Lastly, we think Oaktree's dividends provide substance to a bullish scenario. In fact, as illustrated in the introduction, dividends provide the bulk of Oaktree's returns. Therefore, it is logical to look at dividends as a salient part of Oaktree's returns.
Oaktree's quarterly dividend has a 5-year average yield on cost of 18.55%, which is scintillating, to say the least. Its gross dividend payouts will likely cool down as nominal yields retreat; however, it is evident that the asset's income-based prospects are alluring throughout the economic cycle.
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Noteworthy Risks
The first risk to point out is that Oaktree Specialty Lending's performance is very much contingent on interest rate activity. Although we believe lenders will benefit from intermediate-term interest rates, we concede that rates are exceptionally difficult to forecast, especially when volatility is at peak levels. Therefore, consider that our systematic analysis of Oaktree may be flawed.
Furthermore, Oaktree doesn't present much relative value. For example, its book value, in particular, sits at the higher end of the spectrum, with many of its counterparts showcasing better value. Even though our systematic analysis indicates that Oaktree is a strong buy, bottom-up investors might turn their backs on the security, leading to diminishing price support.
Seeking Alpha
Lastly, Oaktree has experienced a torrid time with regard to earnings releases. The fund has missed out on half of its last eight earnings-per-share targets. Some investors get put off by continuous earnings misses, meaning Oaktree may face technical price pressure if it delivers additional earnings misses.
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Final Word
Our analysis indicates that Oaktree Specialty Lending Corporation's key variables are aligned and ready to act as catalysts.
Potentially lower funding rates combined with secular growth and high credit exposure could enhance Oaktree's net asset value. Furthermore, although dividends might taper in a lower yield curve environment, we think the influence of enhanced term and credit premiums will result in lucrative arbitrage opportunities.
We hereby assign a strong buy rating to Oaktree Specialty Lending Corporation.
