OFS Capital Stock: maintaining our buy rating after the Q3 update
Maintaining our rating
We initiated our hedge on OFS Capital (NASDAQ: SFO) with a “BUY” rating on August 29, 2022. We cited OFS Capital’s track record of success and the company’s generous stock ownership programs that can enhance shareholder value. Since our publication, the company the stock price has edged higher, rising 3.03% since the time of this writing, far exceeding the -1.84% decline in the S&P 500 during this short period. After OFS Capital’s third quarter results, we re-evaluated the stock and reiterated our “BUY” rating as the fundamentals remained the same, and we liked seeing the company increase its distributions this quarter. We believe continued financial performance and shareholder-friendly policies will benefit investors.
Third-quarter results were in line with expectations as the company reported interest rate-sensitive changes in financial performance. As interest rates rose, the company’s investment value declined from $547.7 million to $516.6 million quarter over quarter. Despite the decline in investment value due to interest rate sensitivity, the company’s annualized return increased from 9.1% to 11.6%. The higher revenue performance contributed to higher adjusted net earnings per share of $0.33, about 33% higher than last quarter, when management reported $0.24 for the same measure. The beating in net income is notable, as the market was only expecting $0.23 per share, which would be in line with the prior quarter. This earnings overshoot demonstrates that the market has generally undervalued this stock.
In addition, the company’s balance sheet remains strong. Management declared $13.1 million in cash, which is about 10% of its market capitalization. On the liability side, the company said 65% of outstanding debt is at a fixed rate, which limits the extent of cost pressures resulting from interest rate hikes. The fact that 65% of its debt is fixed rate, while 94% of its investments are variable rate should be good capital structure and good financing decisions for investors. Overall, we believe the Company’s liquidity position remains strong given its cash balance as well as its access to other revolving credit facilities.
Similar to our previous analysis, we are watching the company’s distribution trends, and this quarter the company increased its distributions from $0.30 per share to $0.29 per share, representing an increase of 3.4% compared to the previous quarter. Thus, the positive distribution trend continues and we remain firm in our thesis that the company can be a good source of income for income-oriented investors. Since its IPO, the company has paid $12.36 per share in distributions and as interest rates rise the company will see higher distributions as 94% of its portfolio is floating rate. The company’s gross distributions along with its net asset/share value protection have become a good combination to become a proxy for income-generating investments.
Same macroeconomic risks
As noted in the cover story, OFS Capital is susceptible to macroeconomic risks similar to other financial companies. The risk of a recession next year is high and well anticipated by the market. While the recent inflation release has eased some concerns, it remains clear that rates will remain elevated for the foreseeable future and current data is a long way off the Federal Reserve’s 2% target. Nonetheless, we believe the payout increases as well as the quarter-over-quarter rise in the company’s net investment income demonstrate the resilience of the portfolio, and the company’s liquidity mitigates major concerns of a slowdown due to economic deterioration.
The third quarter results did not change our thesis on OFS Capital. The company has shown that even in a more unfavorable interest rate environment it can increase its distributions and we have seen the impact of investment income due to higher rates. Although macro risks remain, the company continues to perform well and we believe the third quarter earnings report is favorable to support our view. All in all, we are maintaining our “BUY” rating on the stock.