Oaktree Strategic Income Corporation
Q4 2018 Earnings Call Transcript

Published: 29 Nov 2018

[Operator:]

Welcome and thank you for joining Oaktree Strategic Income Corporation's Fourth Fiscal Quarter and Full Year 2018 Conference Call. Today's conference call is being recorded. At this time, all participants are in a listen-only mode, but will be prompted for a question-and-answer session following the prepared remarks. Now, I would like to introduce Michael Mosticchio of Investor Relations, who will host today's conference call. Mr. Mosticchio, you may begin.

[Michael Mosticchio:]

Thank you, Operator, and welcome to all of you who have joined us for today's call to discuss Oaktree Strategic Income Corporation's fourth fiscal quarter and full year 2018 financial results. Our earnings release, which we issued this morning and the slide presentation that accompanies this call can be accessed on the investors section of our website at oaktreestrategicincome.com. With us today are Edgar Lee, Oaktree Strategic Income's Chief Executive Officer and Chief Investment Officer; Mel Carlisle, Chief Financial Officer and Treasurer; and Matt Pendo, Chief Operating Officer. Following their prepared remarks we will be happy to take your questions. Before we begin, I want to remind you that our comments today will include forward-looking statements, reflecting our current views with respect to, among other things, our future operating results and financial performance. Our actual results could differ materially from those implied or expressed in the forward-looking statements. Please refer to our SEC filings for a discussion of these factors. We undertake no duty to update or revise any forward-looking statements. I'd also like to remind you that nothing on this call constitutes an offer to sell or solicitation of an offer to purchase any interest in any Oaktree fund. Investors and others should note that Oaktree Strategic Income uses the investors section of its corporate website to announce material information. The Company encourages investors, the media and others to review the information that it shares on its corporate website. With that, I will now turn the call over to Edgar Lee.

[Edgar Lee:]

Thank you, Mike, and welcome everyone to our fourth quarter and fiscal year-end earnings conference call. We appreciate your continued interest in OCSI and your participation in today's call. We're proud of the progress we have made since we took over Management of OCSI, just over one year ago. Our team has successfully executed against our strategic initiatives by positioning OCSI's portfolio for improved performance and enhancing the return-on-equity for our shareholders. Our portfolio repositioning efforts reflect our late cycle approach to investing in private credit as we have reduced the overall risk of the OCSI portfolio by shifting into investments that are better aligned with Oaktree's investment philosophy. We have exited most of our non-core positions and are actively investing in larger, more diversified companies. As of September 30, 2018, non-core investments represented only 12% of OCSI's portfolio, a decrease from 58% as of September 30, 2017. During the last fiscal year, we also made great strides in enhancing OCSI's borrowing capacity and lowering our cost of capital. In the third quarter, we amended our credit facility with East West Bank, and in the fourth quarter we amended, expanded and extended our secured revolving credit facility with Citibank. We also redeemed our 2015 debt securitization and replaced it with a new and more flexible credit facility with Deutsche Bank. All of these actions resulted in lower interest rate margins. Also in the fourth quarter we received overwhelming support from our shareholders to allow for increasing leverage, which we plan to prudently deploy over the next several quarters as we selectively add investments that are well suited to support higher leverage. And finally, we successfully integrated OCSI into Oaktree's operational platform, realizing cost savings and efficiencies. Through this integration, we upgraded OCSI's accounting valuation compliant systems and processes, as well as our information technology functions. The momentum we built throughout the year continued in the fourth quarter and this was evident in our improved financial performance. In the fourth quarter, we delivered net investment income of $0.19 per share, a 27% increase from the first quarter. Our NAV per share at fiscal year-end was $10.04, up 1% from the prior year. Importantly, NAV was stable throughout the year. Turning to the fourth fiscal quarter, we successfully continued our portfolio repositioning efforts with core holdings now representing 88% of the portfolio at September 30, compared to 42% at the beginning of the fiscal year. The remaining 12% of the portfolio was non-core but performing, and there was virtually no investments on non-accrual status. During the fourth quarter we exited $20 million of non-core investments, which in total were realized above their previous fair value marks. With respect to our remaining non-core assets, we expect to continue exiting these investments at a steady pace while also maximizing value for our shareholders. Approximately $18 million of the investments that are non-core are publicly quoted liquid loans. With respect to the remaining $39 million of private loans, we intend to opportunistically exit these positions when we believe their values have been optimized. I'll turn now to the current market environment. Direct lending remains highly competitive. We continue to see an oversupply of funds in the marketplace competing for transactions, even as signs emerge that borrower demand is moderating from the strong pace over the last couple of years. The current economic cycle is long by historical standards, but there are still no widespread signs of credit deterioration. That said, there has been some recent volatility in the equity high yield bond and broadly syndicated loan markets, largely driven by concerns about higher interest rates, global geopolitical issues, and weakness in energy related commodities. We haven't seen this volatility spread into the direct lending market but we are monitoring the situation closely. Against this backdrop, we continue to position our portfolio defensively, taking a highly selective and disciplined approach when evaluating new opportunities. At September 30, the portfolio was well diversified with a fair value of $557 million invested across 75 companies, resulting in an average investment size of $7 million or 1.3% of the portfolio at fair value. 95% of the overall portfolio excluding our investments in the Glick JV were in senior secured first lien floating rate loans. We remain focused on investing in larger and more diverse companies that operate in noncyclical defensive or structurally growing industries with lower overall amounts of leverage. The median debt portfolio company EBITDA has increased by over 50% since we began managing the portfolio and now over half of our borrowers have EBITDA as greater than $100 million. The underlying leverage in our portfolio of companies has declined to 4.2 times from 5.4 times one year ago, a stark contrast to the increasing leverage levels we have observed in the middle market over the past year. We believe investing in larger and more diversified companies with lower amounts of leverage will help reduce the risk of credit impairment in the portfolio. During the fourth quarter, we originated $92 million of new commitments across 15 companies and 12 industries. Virtually all were first lien floating rate loans and the median portfolio company EBITDA was approximately $110 million reflecting our approach to investing in private credit. In addition, $70 million of these investments were made in conjunction with other Oaktree funds. While the market for direct lending remains competitive, our investment team has been able to uncover unique opportunities away from the private equity own segment of the market. The less competitive non-private equity backed segment allows us to structure transactions with more credit or friendly terms while also generating strong risk-adjusted returns for our shareholders. A great example of this was the Allen Media loan we originated in March. As you may recall, Oaktree originated a $310 million first lien loan to Allen Media to fund the acquisition of a well-known media asset of which OCSI provided $24 million. During the fourth quarter, our loan was refinanced by debt issued in the public markets generating a gross unlevered IRR of over 50% in the short time we held in. This transaction demonstrates our ability to leverage the Oaktree platform to source unique investment opportunities and our ability to provide desirable capital solutions to private companies. Looking ahead, we will continue to evaluate opportunities across all segments of the market that we believe will generate the best risk-adjusted returns over the long-term. However, we remain cognizant of the frothy market environment and our focus on deploying capital in a disciplined and cautious manner. In summary, we are pleased with our fourth quarter and year-end results and the significant progress we have made in optimizing the portfolio over the past year. We believe we have constructed a high-quality portfolio at OCSI and look forward to caring this momentum into 2019. I’ll now turn the call over to Mel Carlisle to review our financial results in more detail.

[Mel Carlisle:]

Thank you, Edgar. We generated solid fourth quarter results and maintained our portfolio’s excellent credit quality. Net investment income in the fourth quarter was $5.6 million or $0.19 per basic and diluted share. This was up from $5.1 million or $0.17 per share in the third quarter. The increase was mainly driven by higher investment income and partially offset by higher operating costs. Total investment income of $14.7 million increased $3.1 million from the June quarter. This was mostly due to higher prepayment fees and OID acceleration on loan payoffs. Net expenses were $9.2 million up from $6.6 million last quarter. The increase was mainly due to higher Part I incentive fees, net of fees waived an increase in interest expense due to a $2 million non-cash write-off of unamortized financing costs. These costs were related to the 2015 debt securitization which was redeemed during the quarter. Credit quality remains solid, we have only one very small investment on nonaccrual which represented just 0.01% of the debt portfolio at fair value at September 30. NAV increased 1.3% from the June quarter to $10.04 per share mainly due to the higher net investment income and write-ups on portfolio investments. On Page 14 of the earnings presentation, we have provided bridge that explains the key factors that led to the increase in NAV. Cash and cash equivalents were $16.4 million at quarter end and we had $180 million of undrawn capacity on our credit facilities. Total debt outstanding was $275 million with a weighted average interest rate of 4.3%. Our leverage ratio increased slightly to 0.93x from 0.89x at June 30 reflecting higher borrowings on our credit facility. We plan to gradually extend our leverage over the next few quarters as we add senior secured investments to the portfolio. Unfunded commitments outstanding at quarter end were $22.8 million. These commitments are mostly related to portfolio companies with revolving credit facilities or delayed draw term loans. Turning to the Glick joint venture. At September 30, the JV had $166 million of total assets invested in senior secured loans to 31 companies. This compares to $182 million of total assets invested in senior secured loans to 32 companies last quarter. These decreases reflect four early loan payoffs in the fourth quarter. At quarter end, our leverage ratio at the JV was 1.4x, unchanged from the prior quarter and our credit facility had $30.7 million of undrawn capacity. With that, I will turn the call over to Matt Pendo.

[Matt Pendo:]

Thank you, Mel. We made great progress executing on our strategic plan to enhance returns to our shareholders over the past year. While we are encouraged by the advances to-date, there continues to be a meaningful opportunity for us to further increase OCSI's long-term return on equity. In July, we received strong shareholder approval to increase our leverage limit. Since then, we've completed all of the necessary amendments from our credit facility providers to allow for higher leverage. We plan to prudently deploy leverage up to our target range of 1.2x to 1.6x over the next several quarters as we selectively add investment that are consistent with our investment philosophy. We believe that additional leverage will allow us to grow and further diversify our portfolio while enhancing our return on equity. In addition during the fiscal year we successfully rotated out of $6 million of non-income generating investments including two loans and nonaccrual. At September30, we held one equity position valued at $1.8 million which was sold in October. As we rotated out of various non-core positions over the past year, we accessed the broadly syndicated loan market to help us redeploy assets due to the elevated pace of loan repayments. Our exposure to broadly syndicated loans price lower than LIBOR plus 400, total of $51 million at September 30. Depending on market conditions, we expect to continue temporarily investing in these liquid loans to earn spread income during quarters of elevated repayments. OCSI continues to benefit from rising interest rates given that our debt portfolio is entirely comprised of floating rate loans. We expect to benefit if rates continue to increase in 2019. Finally, we expect to modestly increase the amount of second lien investments in the portfolio over time. At quarter end, second lien loans made up only 5% of our portfolio excluding our investments in the Glick JV, providing ample capacity to increase their allocation to refine - should we find compelling investment opportunities. Taking an aggregate, we expect these actions to be further accretive to our ROE. Now turning to the dividend. As noted in our press release, we declared a $0.155 dividend today. We remain focused on maintaining the distribution level that is sustainable and based on the earnings capability of our portfolio. I'll conclude by saying that we're very proud of the progress we've made in our first year managing OCSI. We start a new fiscal year with our portfolio performing well. Looking ahead, we will continue to leverage Oaktree substantial resources and expertise to further enhance our return on equity and deliver value to our shareholders. Thank you all for joining us today. We look forward to updating you again soon. And with that Operator, please open the lines for questions.

[Operator:]

[Operator Instructions] And our first question will come from Mickey Schleien of Ladenburg.

[Mickey Schleien:]

I wanted to ask you, despite the market's moves yesterday, at least to me it still looks like the federal raise rates several more times through next year. So, I'd like to ask you how the average interest coverage ratio is trending in the portfolio and how are you managing that risk?

[Edgar Lee:]

So I'd say just as a general statement, so far companies have continued to experience improving cash flow profiles, and therefore that coverage ratio despite interest rate is going up that coverage ratio stayed relatively constant thus far across the portfolio. There will be individual names that are doing slightly better and worse but on average it's been pretty constant.

[Mickey Schleien:]

Are there any particular areas of risk in the portfolio that maybe increasing with the change in control of the house next January? For example, Aerospace, I see is an important sector for you and there was a case to be made that growth in defense spending may decrease, so any particular areas that you're concerned of from a sector perspective?

[Edgar Lee:]

Specifically with respect to OCSI, there aren't any general trends or high level concerns that we have as it relates to the change in the house or control of the house. The portfolio does have exposure to aerospace and defense but most of that exposure is in the aerospace sector and most of those borrowers are under long-term contracts that will go on for a number of years. More broadly in the marketplace overall, I think government spending is an area to focus on and one that we're closely monitoring. And in particular in places like aerospace and defense or particularly defense, but the other place would be in healthcare and pharmaceuticals. The portfolio today doesn't have a material amount of exposure in that area but it is an area that we're watching closely as well.

[Mickey Schleien:]

I was actually going to ask you about healthcare because you could make a case that perhaps healthcare spending will go up if you stay away from reimbursement risk, is that a sector that actually may become more interesting to you?

[Edgar Lee:]

I think healthcare has always been an interesting area for us. Healthcare, if we think about it you break it down into three segments; healthcare services, healthcare equipment, and then life sciences, life sciences being pharmaceuticals and other drugs. And health science is we've been focusing on areas where or on companies where they can help actually reduce costs of providing healthcare services. And then we think there's been a fair amount of shift and risk associated with depending on Medicare or Medicaid reimbursement and CMS codes, changes in CMS codes. And therefore we've been very cautious about getting overly exposed to the actual service providers and instead are focused more on providers who cut those costs. On the life sciences area, we've been trying to stay away from the generic drug companies, those are ones that have come under particular scrutiny from the Trump Administration as well as Congress, and rather focusing more on companies that are focused on developing novel drugs that cure life threatening diseases, where pricing or high prices can be more relatively justified.

[Mickey Schleien:]

My last couple of questions relate to oil and gas investments which are fairly significant at about 7% of the portfolio. So first thing, I just wanted to understand, are these - any of these legacy investments?

[Edgar Lee:]

None of the…

[Mickey Schleien:]

[indiscernible].

[Edgar Lee:]

Sure. None of those are legacy investments. Our energy exposure has actually declined over time even since the end of the 9/30 quarter. So it has come down meaningfully from there, one. Two, it's important to consider as a number of these companies are not energy related E&P companies or exploration production companies which tend to be the most sensitive to movements in oil prices. Many of these companies are actually the pipeline midstream companies that enter into long-term contracts that those contracts are take-or-pay contracts so the much more stable in their cash flows and look more like infrastructure assets. And therefore are less sensitive to the recent moves in oil prices. And then the third point on that is, some of these assets are natural gas related not oil related and if you watch natural gas prices over the last couple of months, they've gone up quite tremendously because of the anticipated cold winter here and limited amount of gas and storage.

[Mickey Schleien:]

That's very helpful. Did you say that the energy exposure went down since September?

[Edgar Lee:]

It did.

[Mickey Schleien:]

Okay. And talking about valuation of these four companies price of oil is declined about 30% since September 30. So I just - I’m not that familiar with your valuation process but does it look at the valuation as of September 30 or given that it takes a few weeks to put the valuation together. Is there a haircut given how steeply oil declined in October and in November?

[Mel Carlisle:]

So these securities would be valued as of 9/30. Some of these securities do publicly trade and would reflect but the marks on these would be at the 9/30 quarter.

[Mickey Schleien:]

Those were all my questions for today. I appreciate your time in taking my questions. Thank you.

[Operator:]

The next question will come from Chris York of JMP Securities.

[Chris York:]

So the first question is housekeeping since that I can triangulate to see from OCS itself but how much prepayment and maybe [OID] did you receive from Allen Media?

[Matt Pendo:]

So that would be 1.9 million. That includes the OID acceleration, as well as the prepayment fee.

[Chris York:]

And then in your model what is a reasonable expectation for the time necessary to grow the investment portfolio in new senior secured investments to the low target leverage range of 1.2?

[Edgar Lee:]

So it’s going to take several quarters. I mean I think we got everything in place obviously from the board and the share of the vote and on the leverage facilities. We took leverage up a little bit in the quarter versus previous quarter, but it can take several quarters and we’re going to be - it’s really driven by the asset side in terms of where we see investment opportunities. This could have the ability to take leverage up if we don't find the right assets then we’re just going be a little patient, so it will take several quarters.

[Chris York:]

And then maybe staying on that asset side, should investors use the consolidation of the Glick off balance sheet JV is it likely candidate to be consolidated?

[Matt Pendo:]

I wouldn't consider it likely I mean I think likely is too strong a word.

[Edgar Lee:]

Yes, I would add Chris and we always maintain the option there, but it's not one that is currently at the top of our list. No, I just add on to Matt's prior comments about leverage that we've been methodical about increasing leverage and that is actually been very beneficial to us especially given the recent volatility in the marketplace. And I think because we didn't ramp leverage too quickly, we've been able to avoid some of the challenges and number of other managers maybe experiencing today.

[Chris York:]

Yes, I would agree with that. Staying on that topic of leverage, so on the writing inside of your balance sheet think about debt liabilities. What is the desire and then maybe preference in pursuing term debt facility in your capital structure. How do you way maybe flexibility versus term and cost?

[Edgar Lee:]

We way everything, so depending on what we think we can get done we’ll look at that. We've got experience at Oaktree. We can do lots of different things and experience it all up and all of them have good bank relations with the bank. So we look and consider everything, and really what we've done is we took over the Management, you know we did with the various facilities and affiliates and JV's, where you can see kind of - hopefully a pretty thoughtful pattern of achieving a book - a lower cost more optimal capital structure.

[Chris York:]

And I think investors can certainly agree on that. Matt, can you remind us of the ROE expansion, potential possibly obtained under your target leverage?

[Matt Pendo:]

I still think we hope to be and expect to be - our target is a high single-digit ROE, so I don't think that's - I don't think that's changed. I think the leverage - the higher leverage allows us to obviously the positive to that. The one we get there and et cetera it's - I don't want to make any predictions on that.

[Chris York:]

Okay. And then this is a little outside of the box question. You recorded a weighted average leverage ratio of 4.2x, now the market is 5.7x, now is that EBITDA a GAAP EBITDA or is it the EBITDA with add back?

[Matt Pendo:]

That is an EBITDA using our adjusted EBITDA. So I would not call that a GAAP EBITDA, nor would I use that as the borrowers adjusted EBITDA.

[Chris York:]

Okay. The more conservative number, okay. So presumably you spread the numbers yourself under conservative Oaktree assumption, so what is that may be difference in your underwriting of the core repeatable EBITDA versus the sponsor number? Because I'm just trying to get a flavor for Oaktree's risk aversion relative to the more generous capital markets.

[Edgar Lee:]

So to the extent there are add back's where we deem them to have a lower likelihood of - where there is more uncertainty let me put it that way, associated with some of those add backs we would not necessarily give them full credit for those add backs.

[Chris York:]

Fair enough, okay.

[Edgar Lee:]

For example, cost savings are more easily achieved in an area that we would focus on and potentially be more constructive on. Revenue synergies are ones where for example we would give them less credits. And also to the extent that those add backs are a significant portion of the EBITDA, for example, we've seen cases where add backs have been twice as large as the core EBITDA. We'll take a much - we'll give it much more scrutiny and unlikely we would give them all the credit for that.

[Chris York:]

My thought process was that you went through all of your portfolio companies and sums maybe the reported an add back EBITDA versus the Oaktree EBITDA what that spread was, what that difference was, is it obviously yours would be lower, so that was just the outside the box thought. And then lastly, I know Oaktree has been interested in sourcing direct to originators since acquiring the contracts from Street Asset Management. How is the progress been ongoing at your investment professionals?

[Edgar Lee:]

So, we've continued to add investment professionals to the team both on the origination side as well as on the industry expertise side. As you know Chris, we, Oaktree itself is a very large organization with over 250 investment professionals here. So it is a very sizeable organization, and I'm just focused on - my comments are more focused on just those that are specifically day-to-day focused on the BDC, but that doesn't mean that the other 250 investment professionals aren't helping us originating, find intelligent investment opportunities. And that has - those efforts of adding individuals and getting the larger Oaktree organization focused on the BDC's has really helped us build a much more robust pipeline which we think you'll see the benefits - our investors will see the benefits of in the coming quarters.

[Chris York:]

That was the thought process of the question. That's it from me, thanks Edgar, thanks guys.

[Mel Carlisle:]

Chris, it's Mel. I want to correct the Allen Media number, it should be $2.7 million. I think I got the wrong line.

[Chris York:]

Okay. Yes, that seems more consistent with the triangulation from OCSI. Okay.

[Operator:]

[Operator Instructions] And we have no further questions Mr. Mosticchio.

[Michael Mosticchio:]

Thank you again for joining us for our earnings conference call. A replay of this conference call will be available for 30 days on Oaktree Strategic Income's website in the Investor Section or by dialing 877-344-7529 for U.S. callers or 1412-317-0088 for non-U.S. callers with the replay access code 10125431 beginning approximately one hour after this broadcast.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.