Distributive policy

Owl Rock Capital’s Third Quarter Earnings: Shareholder-Friendly Dividend Policy (NYSE: ORCC)

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Investment thesis

Owl Rock Capital Corporation (NYSE: ORCC) is BDC’s third largest among 48 publicly traded business development companies. Management introduced a new shareholder-friendly dividend policy based on the initial policy established in 2019. there will be a regular dividend and an additional dividend every quarter starting in the fourth quarter of 2022. This may attract more income investors as management’s previous dividend promises have been delivered and with the new policy, the yield term is greater than 11%. The company also announced strong third quarter results and I expect it to continue on this path until interest rates continue to rise. The stock’s slight undervaluation could also attract investors who want exposure to a larger-cap BDC at a fair price.

Dividend policy

Since the company’s IPO in 2019, management has been paying consecutive dividends. From the beginning, the management tries to implement a stable dividend policy and also enhances its credibility as a dividend-friendly company for income investors. When they started paying dividends in the third quarter of 2019 as a public company, they laid out a plan for the next year and a half for dividends. They swapped the only floating rate dividends for regular, floating rate dividends. The regular dividend was set at $0.31 per share and the floating rate dividend was announced and accepted by the board.

ORCC estimated dividend 2019

Presentation of Q2 2019 quarterly results

Why is this important? Because investors could have seen that management was able to deliver on its promises and stick to the previously promoted dividend plan. It takes years to build credibility and in a quarter of a time, all credibility can be destroyed. Income investors may now feel that management is capable of executing its dividend plans. Management even kept its dividend during turbulent times in 2020, when earnings fell and the payout ratio spiked for a short time. On the one hand, this is good news because investors can be sure that management is delivering on its dividend promises. On the other hand, it also means that the management focuses too much on dividends and even in a problematic situation, they prefer to dilute the shares or increase the leverage, which could be worse for long-term investors, only a few quarters with a lower dividend.

New dividend

A few days ago, ORCC income investors received some good news. Management has decided to increase the regular dividend from $0.02 per share to $0.33 per share quarterly. This is a 6.5% dividend increase which is close to current inflation levels (with the special dividend included it is higher) so that ORCC investors can hedge inflation by retaining their participation in society. Furthermore, the additional dividend was reinstated after a year and a half. The special variable dividend will be management’s leeway if things go wrong. They will only have to “reduce” the additional dividend but keep the regular dividend to continue to build their credibility in times of business difficulties.

ORCC new dividend policy 2022

Presentation of Q3 2022 quarterly results

In addition, management’s goal is for ORCC shareholders to be able to receive a dividend 8 times per year (4 regular dividends and 4 additional dividends). The calculation of the special dividend is as follows: “The additional dividend will be variable each quarter, calculated at 50% of the NII above our regular dividend, rounded to the nearest penny and subject to certain measurement tests.” In practice, it looks like this: the NII for the fourth quarter should be $0.40 per share and the regular dividend is $0.33 per share. The difference between them is $0.07 per share, this number should be halved and rounded to the nearest penny. So, if that’s the case, investors can expect an additional dividend of $0.04 for the first quarter of 2023.

Craig Packer – CEO said, “…we are delighted to take this step today to increase our dividend, which we believe we can comfortably cover in the future. And in light of ORCC’s earnings trajectory, we believe the addition of the supplemental dividend improves our payout profile while allowing us the flexibility to assess further increases to a regular dividend if performance warrants.”

Owl Rock Capital third quarter results

In the third quarter, they reported a net asset value of $14.85 per share, up 2.5% quarter-on-quarter and down 0.7% year-on-year. When the company went public, the net asset value per share was $15.28, so investors have seen a decline in net asset value of about 3% so far. The NII ($0.37 per share) increased 15.6% from the prior quarter. Management has been very active in lending, in 3 years it has doubled the number of portfolio companies from 90 in the second quarter of 2019 to 180 at the end of the third quarter of 2022. The management has used the effect of leverage, since the Small Business Credit Availability Act in 2018. They have increased their debt since the IPO relatively aggressively.

Owl Rock Capital debt to equity
Data by YCharts

Let’s see what investors can expect from ORCC in the future. The focus will be on interest rate movements over the next 6-9 months. This will be beneficial for the company and the investors. As we could have seen, the average yield of the portfolio has increased by 2.3% since the start of the rise in the base rate. In the second quarter, there was an increase in interest rates of 125 basis points and in the third quarter, an increase of 150 basis points. Looking at the changes, we can see that the 125 basis point rise increased the portfolio’s return by 0.9% and the 150 basis point rise in the third quarter increased the portfolio’s return by 1.3%. In the fourth quarter, the Fed has already raised interest rates by 75 basis points and, for December, analysts expect an increase of 50 basis points. This will most likely result in a further 0.9% portfolio yield increase for ORCC in the fourth quarter and smaller increases of 0.2-0.4% in the first half of 2023 as long as the Fed continues to raise the basic rate. This is due to the company’s 98% floating rate loan portfolio. So I expect the portfolio return to be around 11.3-11.5% by the end of the second quarter of 2023.

ORCC portfolio performance

Presentation of Q3 2022 quarterly results

At the same time, this growth in yields also increases the NII. Based on Q4 interest rate increases and portfolio yield growth, I expect an NII of $0.39 to $0.40 for Q4 and around 0. $4 to $0.41 NII during the first half of 2023. The downside of rapid increases in interest rates is loan origination. New investment financings and the number of new portfolio companies in which ORCC invests decreased significantly compared to previous quarters. Year-over-year, new investment financing has fallen by 85% and I expect this trend to continue as long as interest rates continue to rise. The number of new portfolio companies also declined slowly (-41% YoY and down 19% QoQ).

Due to the large number of holding companies and the relatively large market capitalization of BDCs, the main risk is not that holding companies go bankrupt. There is a 2% unsecured loan share in the current portfolio, this could cause problems but not a major problem. The risk lies in the management and its dual interests. ORCC is only a part of Blue Owl (OWL), the CEO of ORCC is also a member of the board of OWL. The conflict of interest arises from the fee structure and shareholder interests. OWL shareholders receive a fixed commission on the AUM, the bigger the AUM the better. And the main interest is to grow AUMs regardless of performance. However, the priority of ORCC shareholders is to minimize costs, maintain share price and net asset value, and receive a stable dividend. It hasn’t caused any problems yet, but in the future there may be problems due to this conflict of interest.

Valuation of ORCC shares

The company is slightly undervalued based on traditional valuation measures. It is trading at around 13% below its book value. It is below its average since the IPO, the average price-to-book ratio is around 0.95x. Its earnings multiple is 10% lower than its 3-year average. This is no surprise as earnings have been rising over the past quarter, but the price has been declining since April and only started to recover last month.

Valuation of ORCC shares
Data by YCharts

The company trades at a dividend yield of 9.83%. However, if we also include the additional dividends, the dividend yield is over 11%. It’s in the top 10% of dividend yields over the past 3 years, so it could be an ideal opportunity for income investors.

Summary

Due to the new dividend policy and interest rate increases, ORCC could be a great choice for income investors who want exposure only to large-cap BDCs. The dividend yield above 11% is attractive, management has delivered on its dividend promises and the investment portfolio is well diversified. The only problem is the conflict of interest which worries me a bit. However, the NII will most likely increase over the next 6-9 months and I expect the company to perform well. What do you think?