I've covered a ton of different Business Development Companies over the last quarter and I've noticed that many share similar weaknesses at the moment. When I previously covered OFS Capital (NASDAQ:), I issued a sell rating due to the insufficient net investment income and skepticism around its valuation. Since my last coverage, the price has slightly declined but has remained within a tight trading range. OFS recently reported its first quarterly earnings report for 2025, so I wanted to revisit this BDC to provide some updated insights into its current value proposition and outlook going forward. Looking at the performance over the last year, we can see that OFS's price has fallen by more than 14.4%. Even when we include all of the distributions that were paid out over the last twelve months, OFS's total return is still in negative territory. The main appeal of holding a position in a BDC like OFS is the generous starting dividend yield of 16.4%. However, the latest earnings makes me a bit cautious about the overall sustainability of the distributions going forward. If net investment income levels aren't improved, we may see the distribution get reduced. Data by While OFS has demonstrated some improvements, there are always some areas of its performance that has weakened. For instance, the rate of non-accruals have improved, but the underlying levels of net investment income has declined. I fail to see any meaningful catalyst that can reverse OFS's performance for the better. While I do like the fundamentals of the portfolio strategy, the primary focus to Manufacturing businesses may be impacted by tariffs. So let's start by taking a look at the underlying portfolio strategy that OFS implements to generate its earnings. Portfolio Strategy According to the most recent , OFS has investments at fair value of $400M, that is spread across approximately 45 different portfolio companies. OFS prides itself on the limited exposure to cyclical sectors, such as no direct holdings to oil or gas investments. The portfolio does put a large emphasis on Manufacturing investments however, which now accounts for 38.1% of the portfolio. This is followed by exposure to Health Care and Administrative investments, making up 20.3% and 6.4% of assets respectively. The combination of these three sectors makes up nearly 65% of the portfolio's total assets, so we can assume that these will have the greatest impact on OFS's daily price movement and total return potential. OFS Presentation Additionally, 90% of the portfolio of debt investments are structured on a floating rate basis. This means that OFS should have been able to capitalize on this higher interest rate environment that we remain in. A higher interest rate directly leads to a higher cost of debt for borrowers. Therefore, OFS should have been able to collect a higher amount of interest income from its portfolio. However, it seems like a solid portion of the borrowers are being negatively impacted by these higher interest rates, which can weigh down on operating margins and make it a lot more difficult to remain profitable. OFS's portfolio primarily has exposure to senior secured loans that make up 54% of the portfolio. Senior secured loans sit at the top of the corporate capital structure and have the highest priority for repayment. This can act as a defensive mechanism to protect against losses, since it reduces the probability that OFS loses all invested capital in a bad transaction. If a borrower is underperforming and needs to liquidate assets to pay down their loan, OFS would be entitled for repayment before other forms of debt. OFS also has a 27% exposure to equity based investments, which are on the bottom of the capital structure and have the lowest priority for repayment. Equity investments may not produce the most consistent levels of cash flow but they can provide OFS the opportunity to participate in some capital appreciation when the valuation of underlying borrowers grow. Updated Valuation &amp; Risk Profile Following the continuous price decline, OFS now trades at a sizeable of about 30.8%. The discount has widened and OFS now trades above its three-year average discount to NAV of 23.2%. Even though Wall Street analysts have an of $9 per share, I struggle to see a catalyst that can take the price higher. There are a lot of uncertainties regarding the resilience of OFS's portfolio at the moment, such as the impact of tariffs and a scenario where no interest rate cuts happen for the remainder of the year. CEF Data Even though higher interest rates can help boost net investment income levels, prolonged elevated rates can certainly be a source of stress as well. The Fed has decided to keep interest rates in their latest meeting as they continue to observe economic data. Inflation rates still remain higher than anticipated and if tariffs have a significant impact on costs, this can take inflation rates higher. I like to measure the non-accrual rate of a BDC every quarter because it provides a glimpse into the overall health of the portfolio of investments. Non-accruals represent the rate of borrowers that are materially underperforming and cannot keep up with their required debt maintenance. The shifts in non-accrual rate can give a bit of context into management's underwriting abilities and the portfolio's resilience to economic headwinds. When a borrower is put on non-accrual status, they aren't actively contributing towards a BDC's earnings and it reduces the quality of the entire portfolio. The latest released confirms that non-accruals now amount to 4.2% at fair portfolio value. While this is a significant improvement over the non-accrual rate of 9.3% at the time of my last coverage, OFS's non-accrual rate is still on the higher end compared to some peers. Just for reference, here are the non-accrual rates for some notable peers and their respective total returns: * Fidus Investment (): 0.8% non-accrual rate at fair value. * Hercules Capital (): 1.8% non-accrual rate at fair value. * Kayne Anderson BDC (): 1.6% non-accrual rate at fair value. Data by However, I believe that a bigger risk for OFS can be its focus on the Manufacturing industries. Markets are still trying to determine what the ripple effects of President Trump's tariff proposals will be and how it will impact different sectors. The manufacturing sector is anticipated to be one of the most heavily impacted sectors and the rising cost of goods can cause operating margins to become a lot more challenging for businesses. I do believe that this can lead to a scenario of higher non-accruals by the end of 2025, which would undoubtedly cause OFS's net investment income to shrink over time. Therefore, I remain cautious and will continue to monitor over the remainder of the year. Management even confirmed this questionable outlook in their . They reassured investors that they are staying diligent and optimistic about the stability of the portfolio, but I would still advise caution here. &gt; In our view, the overall economic outlook remains uncertain, given the potential impact of global tariffs and the related fallout. It is too early to estimate, how this rapidly changing global economic environment will affect our portfolio. However, we believe that the chances of a slowdown in economic activity have increased, which could lead to earnings pressure on our portfolio companies, and in return on the earnings of the BDC. **- Bilal Rashid, Chairman and CEO** Q1 Earnings OFS reported its at the beginning of May and the results continue to be a bit underwhelming. Most notably, net investment income landed at $0.26 per share, which was a decrease from the prior quarter's net investment income of $0.30 per share. This was attributed to a drop in non-recurring dividend and fee income and a decline in interest income from the portfolio. The portfolio experienced a net realized loss of $0.19 per share and was accompanied by another $0.61 per share worth of net unrealized depreciation from investments. Total investment income amounted to $10.2M, which was a sizeable year over year decline from the prior amount of $14.2M. As a result, OFS's NAV has declined once more, falling to $11.97 per share. The declining NAV is one of the clearest indications of the portfolio's weakness. OFS Presentation OFS had $13.8M in unfunded commitments for the quarter, but management didn't really dive into the specifics of how they are prioritizing new investment activity going forward. The 10-Q form indicates they allocated $10.4M towards portfolio investments, but this was offset by sales and repayments of approximately $10M. So growth during the quarter was very limited and doesn't really drive the needle forward for OFS. This leaves me a bit concerned about the earnings potential and NAV decline. If no new portfolio companies are added, there's a good chance that OFS's net investment income will continue to decline over the next few quarters. Lastly, OFS saw its cash and equivalent total decrease down to $4M, from the prior quarter's total of $6M. Revolving lines of credit remains unchanged at $68M and the total liabilities have slightly decreased down to $251M, from the prior quarter's total liabilities of $255M. Dividend Sustainability As of the latest quarterly distribution of $0.34 per share, the current dividend yield sits around 16.3%. As previously mentioned, net investment income only amounted to $0.26 per share for the quarter. This indicates that the underlying earnings still do not support the current distribution level. There was no mention of any sort of undistributed spillover income in any of the latest earnings documents. Therefore, I have to suspect that management will have to reduce the distribution at some point. While the distribution has remained fairly consistent for more than a year now, I believe the time has come for a cut. The NAV will continue to deteriorate over time due to the larger payouts and OFS isn't allocating enough capital towards new investment activity to really drive earnings higher over time. If the portfolio is impacted by tariffs and the higher interest rate environment, any increase in non-accruals or slowdown in portfolio performance will also take net investment income levels lower. Seeking Alpha Therefore, I would not recommend this BDC for any investor that is looking for a stable and secure source of dividend income. If a BDC's distribution is under threat of being reduced, it defeats the purpose of maintaining a position at all, in my opinion. It's also worth mentioning that the distributions received from OFS are classified as ordinary dividends, which have the heaviest tax burden that investors must consider. Takeaway In conclusion, I maintain my sell rating on OFS due to the NAV deterioration, weaker net investment income, and failure to support the distribution over the last quarter. I believe that OFS's portfolio may be severely impacted by tariffs at some point so even though it trades at a larger discount than usual, this still isn't an attractive time for entry. I also suspect that the distribution will be reduced at some point before the end of 2025 as net investment income levels continue to decrease and OFS isn't allocating enough capital towards new investment activity to offset these declines.

OFS Capital: The Dividend Needs To Be Reduced (NASDAQ:OFS)

The article analyzes OFS Capital's financial performance, highlighting declining net investment income, a reduced dividend yield, and concerns about potential distribution cuts due to economic factors like tariffs and interest rate environments. The analyst maintains a sell rating, citing weak portfolio performance and risks from global economic uncertainties.