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Oaktree Strategic Income: Dividend Outlook

BDCs:
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NEWS

Last Friday February 9, 2018, OCSI followed sister BDC OCSL and reduced its dividend while reporting IVQ 2017 results. Unsurprisingly, the credit quality of the portfolio inherited from Fifth Street Asset Management’s investment advisory clutches is not as dire, and the mood more upbeat going forward from the new Oaktree team.


ANALYSIS

However, like OCSL – and we discussed in an earlier post – we note that the new distribution level has been set dangerously close to the current recurring earnings level. That could be a problem with OCSI leveraged to the hilt at 0.88 to 1.00, and with “spread compression” still very much at play in all segments of the market but especially in the lower yield-lower risk loans which OCSI currently plays. We can see from the comments in the press release that Oaktree hopes to goose the overall portfolio yield – just 7.1% WITH the JV earnings included- by adding higher risk-higher return loans from the Oaktree origination platform.

“Since we began managing the portfolio in mid-October, we have been focused on redeploying capital from loan payoffs and exits into larger, first lien loans to a diversified group of stable, middle-market companies.  Looking to the future, we are excited about the opportunity to deploy capital into higher yielding, proprietary originations generated by Oaktree’s platform.”

That will take some time and begs the question as to whether the two BDCs will become more alike and just useful pockets for the Oaktree organization to place its middle market and upper middle market loans. The BDC Reporter- which has been crawling around under the chassis of OCSI’s portfolio for some time – will be taking a new look with a review of the latest 10-Q.


VIEWS

Stayed Away

It was just that kind of look into the portfolio that caused us over a year ago to worry about what was then FSFR’s credit quality and spared us any exposure – Oaktree’s arrival notwithstanding. When most everyone was cheering the arrival of the new Investment Advisor, we were more circumspect because bad loans trump any reputation.

Back in July 2017 we wrote an article with the forthcoming title: “Why FSFR Is Over-Valued”. Here are some highlights from our thoughts six months ago

“As a multiple of Taxable Income, FSFR stock price is already high by most standards. At the close on July 17, the stock price was at $8.97. Taxable Income Per Share was $0.17, or $0.68 annualized. That’s already a Price-to-Current Earnings multiple of 13.2x. If we assume – with our readers’ indulgence – that a combination of the factors listed above reduces Net Investment Income Per Share to $0.60, the multiple will be 15x. That’s almost the same multiple as Golub Capital (NASDAQ:GBDC) with a much better track record and corporate history is trading for. Of course, the market can pay whatever multiple it sees fit, but we’d surmise a multiple of 10x would be more plausible after the good feelings accompanying the Oaktree deal wear off and as investors face the realities of the FSFR business model, whoever is at the helm. At that multiple, FSFR would trade at $6.0-6.8. Coincidentally or otherwise, that was the valuation given to FSFR back in February 2016, when BDC investors everywhere were sharpening their pencils and having a hard look at values.

That’s a potential (25%) downdraft. Is that worth the risk for a BDC – Oaktree’s new found role notwithstanding – paying a dividend currently of $0.76, or an 8.4% yield, some of which is probably return of capital?

Conclusion

We don’t think so and expect the market will eventually agree once the BDC falls out of the headlines for awhile. Of course, we can’t say when this shift might occur, but we believe the stock is overvalued and due for a fall. However, in this overheated market where even BDCs with very real challenges, falling earnings and leveraged to the max can attract buyers. The day of reckoning may be some way off and could be determined by a much broader investor sentiment regarding leveraged debt and credit investments.”

On The Money

As we predicted in our July 2017 article, FSFR/OCSI’s Net Investment Income Per Share has now dropped to $0.60 a share on an annualized basis.  Investors seem to remain more optimistic than we counted on, but OCSI’s stock price has dropped from a high of $9.04 to $7.70. Yet even the current – lower price – seems unwarranted and may yet slide back towards the 52 Week Low or below of $7.03, closer to our July 2017 projection of $6.0-$6.8. Here’s one reason why:

More To Go ?

With OCSI’s distribution cut the BDC Reporter’s Dividend Outlook for 2018 scores another correct call. Unlike the market which thought OCSI ‘s distribution to be only AT RISK, we had a DECREASE Projection, which was proved right with this sharp change in the pay-out. For the moment – and until we’ve done our in-depth homework – we rate OCSI’s distribution’s sustainability through the IQ 2019 to be AT RISK. Of course, another dividend cut would  be likely to drag the stock price even lower.

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