OFS is a BDC trading at 83.9% of NAV and a dividend yield of 11.9%. We previously wrote up OFS on June 30, 2014 as the company was ramping its investment portfolio to cover the dividend and david101 wrote up the company on December 30, 2015 after the company started covering its dividend. Subsequently, the company covered its dividend and was poised to finally start growing it. As a result, the stock closed the gap to NAV that had persisted since the company had been public.
We believe a combination of management missteps and concerns about credit quality have caused the stock to trade back to an attractive level, below where we initially wrote up the company, despite a number of positives.
Please see the previous write-ups for additional background on the company.
So what happened?
Going into Q1 2017 the company had $33mm of liquidity and ample room to use debt to fund asset growth as it had very little regulatory debt (SBA debentures are not counted towards its asset coverage ratio test). With the stock trading at book value for the first time since coming public, the company opted to issue equity instead of issuing debt. Management’s rationale was that a larger equity base would allow them to write larger checks, making them a more attractive financing solution for a business (no need to work with two or three other parties, each with their own diligence process). With any BDC raising equity, there is typically a one to two quarter period where dividend coverage dips as the company deploys capital. Additionally, this pushed out the timeline for the company to be able to grow the dividend.
Unfortunately for OFS, their equity raise came during a time of abnormal prepayments. In 2017 the company saw $60mm of its portfolio make unscheduled payments on their debt compared to just $25mm in 2016. Assuming an 8% spread on the $35mm of incremental unscheduled payments in 2017, that would equate to $0.05/sh of net investment income (“NII”) per quarter, equivalent to the shortfall in their dividend coverage in Q4 2017.
Concurrently with the company struggling to cover its dividend, larger BDCs struggled with credit issues. Starting in Q217 Triangle Capital Corp (“TCAP”) and Alcentra Capital Corp (“ABDC”) started reporting credit issues and the entire sector traded off. In Q217 OFS reported one investment, My Alarm Center, LLC on non-accrual, which we believe led to fears that OFS would experience credit issues similar to TCAP and ABDC, leading to weakness in OFS’s share price.
Why is OFS attractive now?
OFS is now trading at 83.9% of NAV with an attractive dividend yield of 11.9%, below where we initially wrote up the company. We believe OFS is now poised to once again cover its dividend, and to grow it over the next two years.
Above is our math on how the company will cover its dividend in Q218. We would note that coverage could be pushed out to Q3 2018 depending on prepayments in Q218 (no prepayments in Q118) and on timing of investments.
Our checks have indicated that credit quality has remained solid and they have not seen material credit issues like other BDCs. We take comfort in the fact that the manager owns 22%, aligning management incentives with shareholders. This alignment can be seen in how the company did not engage in lending to oil & gas companies, which led to BDC credit issues in 2015 and 2016. It can also be seen in the company’s historical credit performance with a cumulative net realized loss of 24bps since inception, which is well below peers. While it’s difficult to find comprehensive information, Wells Fargo’s BDC Scorecard report shows that the average BDC has cumulative net realized losses of 3.0% or more.
In addition, we view management’s recent announcement of a $10mm share repurchase program very positively. We believe this is a strong signal indicating management’s confidence in their portfolio and their ability to cover the dividend in the near future. This announcement is particularly notable as it is the first time the company has announced a share repurchase.
So what is it worth?
Based on the company covering the dividend and trading to NAV, we see a total return of 31%.
What we find especially attractive is that the company is now positioned to grow its dividend for the first time in the company’s history. With management satisfied with their equity capital base, they will look to access the debt markets to fund future asset growth. Importantly, they will use their revolving credit facility to minimize the impact of raising capital on dividend coverage raising going forward.
As of the end of Q118, the company’s asset coverage ratio is 789% (PF for the April 2018 debt issuance), well above the 150% minimum requirement. If you assume that the company grows their assets using debt by $100mm and assume it should trade at a 10% dividend yield, you could see a total return of 60% over the next two years while maintaining a conservative asset-coverage-ratio.
We would note that we’re assuming new money is deployed at a 10% yield, which is below the company’s current weighted average yield on total investments. In addition, we would note that as of Q118, 76% of the company’s portfolio consists of floating rate securities. For every 50bps increase in LIBOR, NII/sh would increase by ~$0.06/sh, which we have not baked into our analysis above.
General economic downturn – BDCs, especially SBICs, lend to small businesses that are materially affected by economic downturns.
Interest rate risk – While increasing rates would benefit NII for OFS, it would add pressure to levered small businesses.
Dividend coverage – the company currently does not cover its dividend, but we predict that the dividend will be fully covered in Q218 or Q318.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Covering the dividend in the next two quarters.
Growing the dividend over the course of the next two years.