OFS Credit's Q2 Earnings Surprise: Cash Flow Triumph or Value Mirage?

OFS Credit (NASDAQ: OCCI) reported its Q2 2025 earnings with a stark contrast between its GAAP and non-GAAP metrics, raising critical questions about the sustainability of its business model. While the company's Core Net Investment Income (Core NII) surged 23% quarter-over-quarter to $0.37 per share—a figure management highlights as a key measure of distributable cash flow—its GAAP NII remained flat at $0.21 per share. This divergence underscores a deeper tension between OFS Credit's short-term liquidity and long-term value, particularly amid volatile credit markets and geopolitical risks.

The Core NII Surge: A Triumph of Structure or Timing?

The jump in Core NII stems from higher recurring waterfall payments from CLO equity investments, which rose to $13.0 million from $10.9 million in Q1. These payments reflect the structure of collateralized loan obligations (CLOs), where subordinated equity tranches receive residual cash flows after senior investors are paid. The timing of these distributions, however, often lags behind GAAP income recognition. This creates a gap: Core NII adjusts for this discrepancy by including cash received but not yet recognized under GAAP.

The company's strategy of focusing on CLO equity—a niche asset class with high yield and structural protections—has long been its cornerstone. Yet the surge in Q2 payments may also reflect a one-time acceleration of cash flows from newly invested CLOs, as noted in the press release. Investors must determine whether this trend is sustainable or a temporary artifact of the investment lifecycle.

The GAAP NII Stagnation: A Warning Signal?

While Core NII captures cash flow, GAAP NII—the metric tied to the company's financial statements—remains flat. The per-share decline from $0.23 to $0.21 reflects a narrowing net interest spread, driven by a drop in the interest income yield of the investment portfolio to 14.04% from 14.68% in Q1. This compression likely stems from rising borrowing costs, as OFS Credit raised $24.3 million in 8.00% Series G preferred stock during the quarter, increasing its interest expense.

The stagnation in GAAP NII also highlights a structural challenge: the company's reliance on CLO equity's volatile cash flows to prop up distributions. A decline in CLO performance or a slowdown in waterfall payments could quickly reverse the Core NII gains.

NAV Decline: The Elephant in the Room

The most troubling metric is the 26% drop in net asset value (NAV) per share to $6.17, driven by unrealized losses of $0.71 per share on CLO equity holdings. Widening debt spreads and falling collateral loan prices—likely tied to broader market uncertainty over the Russia-Ukraine war and U.S. monetary policy—have hit the fair value of these investments.

This creates a paradox: while Core NII suggests ample distributable cash, the NAV's decline implies the underlying assets are losing value. Over time, this could pressure the company to reduce dividends or raise capital at unfavorable terms, as it did with the Series G preferred stock issuance.

Strategic Implications: Betting on CLOs in a Bear Market

OFS Credit's bet on CLOs hinges on two assumptions:
1. CLO equity will continue to generate high cash flows, even as interest rates and default risks rise.
2. Market volatility will subside, allowing CLO valuations to rebound.

The first assumption is plausible in the near term, given CLOs' structural subordination and the lag in GAAP income recognition. However, if credit spreads remain elevated or default rates rise, CLO equity could underperform. The second assumption is riskier: geopolitical tensions and Federal Reserve policy uncertainty are unlikely to abate soon.

What Does This Mean for Investors?

The earnings report presents a bifurcated picture:
- Short-term optimists will focus on the Core NII surge, which supports the company's $0.115 monthly dividend (20.7% annualized yield at current prices).
- Long-term skeptics will worry about the NAV decline, rising interest expenses, and the concentration risk of a CLO-heavy portfolio.

The Bottom Line

OFS Credit's Q2 results are a mixed bag. The Core NII growth validates its ability to generate cash flow from CLOs, but the NAV decline and narrowing net interest spread highlight vulnerabilities. Investors must weigh whether the dividend is sustainable against the risks of a prolonged credit market downturn.

For now, the stock's valuation—trading at a 23% discount to its April NAV of $6.67—suggests some skepticism is already priced in. However, with geopolitical risks and interest rate uncertainty high, the long-term value hinges on whether CLO cash flows can outpace asset devaluation.

Investment Advice:
- Hold if: You believe OFS Credit can sustain Core NII growth and that broader credit markets stabilize.
- Avoid if: You foresee prolonged weakness in CLO valuations or a sharp rise in defaults.
- Wait and see: Monitor the company's Q3 results for signs of whether the Core NII surge was a one-off or a trend.

Historical data shows that a strategy of buying OCCI following Q2 earnings announcements and holding for 20 trading days has underperformed significantly, with an average total return of -69.71% and a maximum drawdown of -72.32% between 2020 and 2025. This underscores the risks of short-term trading on earnings catalysts in volatile markets.

Backtest the performance of OFS Credit (OCCI) when 'buy condition' is triggered by Q2 earnings announcements and 'holding for 20 trading days', from 2020 to 2025.

In a market where uncertainty reigns, OFS Credit's earnings serve as a reminder: high yield often comes with high risk, and the gap between cash flow and value can widen faster than expected.