Stellus Capital Investment Corporation (NYSE:SCM) Q4 2022 Earnings Call Transcript

Stellus Capital Investment Corporation (NYSE:SCM) Q4 2022 Earnings Call Transcript March 1, 2023

Operator: Good morning, ladies and gentlemen, and thank you for standing by. At this time, I would like to welcome everyone to the Stellus Capital Investment Corporation’s Conference Call to Report Financial Results for its Fourth Fiscal Quarter ended December 31, 2022. This conference is being recorded today, March 1, 2023. It is now my pleasure to turn the call over to Mr. Robert Ladd, Chief Executive Officer of Stellus Capital Investment Corporation. Mr. Ladd, you may begin the conference.

Robert Ladd: Thank you, Ali, and good morning, everyone, and thank you for joining the call. Welcome to our conference call covering the quarter and year ended December 31, 2022. Joining me this morning is Todd Huskinson, our Chief Financial Officer, who will cover important information about forward-looking statements as well as an overview of our financial information.

Todd Huskinson: Thank you, Rob. I’d like to remind everyone that today’s call is being recorded. Please note that this call is the property of Stellus Capital Investment Corporation and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone number and PIN provided in our press release announcing this call. I’d also like to call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information. Today’s conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filing with the SEC for important factors that could cause actual results to differ materially from these projections.

We will not update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.stelluscapital.com under the Public Investors link or call us at (713) 292-5400. At this time, I’d like to turn the call back over to our Chief Executive Officer, Rob Ladd.

Robert Ladd: Thank you, Todd. We’ll begin by discussing our operating results followed by a review of the portfolio, including asset quality and then the outlook. Todd will cover our operating results now.

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Todd Huskinson: Thank you, Rob. As interest rates have continued to rise in recent quarters, we continue to benefit from our favorable asset liability mix in which 97% of our loans are floating and only 32% of our liabilities are floating. As a result, we had solid results in the fourth quarter and for fiscal year 2022. First, I’ll cover our annual results. For fiscal year 2022, we more than covered the dividend of $1.30 per share with realized income of $1.65 per share which included $3.7 million of net realized gains or $0.19 per share. Core net investment income was $1.38 per share and GAAP net investment income was $1.46 per share. As a reminder, core net investment income excludes the reversal of $2.8 million of capital gains incentive fees accrued on realized and unrealized gains, which are not included in net investment income and $1.2 million of estimated income taxes.

Net asset value decreased by $9.3 million, primarily — or $0.59 per share year-over-year, primarily due to portfolio company specific issues, offset by realized earnings in excess of our dividends. Turning to the fourth quarter. Our total distributions of $0.34 per share were covered through core net investment income of $0.44 per share and GAAP net investment income of $0.50 per share. And with that, I’ll turn the call back over to Rob.

Robert Ladd : Okay. Thank you, Todd. I’d like to now cover the following areas: life-to-date review, portfolio and asset quality, dividends and then outlook. So life-to-date review. Since our IPO in November of 2012, we’ve invested approximately $2.2 billion in over 175 companies and have received approximately $1.4 billion of repayments while maintaining stable asset quality. We have paid over $207 million of dividends to our investors, which represents $13.35 per share to an investor in our IPO in November of 2012. Now turning to the portfolio. We ended the year with an investment portfolio at fair value of $845 million across 85 portfolio companies. This is up from $773 million across 73 companies as of December 31, 2021.

During 2022, we invested $211 million in 22 new and 28 existing portfolio companies and received $90 million of repayments for net portfolio growth of $90.8 million for the year. With respect to the fourth quarter, we’ve invested $30 million in 4 new and 2 existing portfolio companies and have received repayments of $48 million. At December 31, 99% of our loans were secured and 97% were priced at floating rates. We continue to move toward first lien loans, which were 87% of our loan portfolio at year-end. This is up from 84% at the end of 2021. We are always focused on diversification. The average loan per company is $10.8 million and the largest overall investment is $21.1 million, both expressed at fair value. And 83 of the 85 portfolio companies are backed by a private equity firm.

Overall, our asset quality is stable at a 2 on our investment rating system or on plan. 17% of our portfolio is rated a 1 or ahead of plan, 17% of the portfolio is marked at an investment category of 3 or below plan. In total, we have 3 loans on nonaccrual, which comprised 2.3% of fair value of the total loan portfolio. Now turning to dividends. We’ve increased our regular dividend 43% from $0.28 per share per quarter in the first quarter of 2022 to now $0.40 per share per quarter beginning in the first quarter of 2023. This is payable, as you know, in monthly increments. This increase in our dividend reflects the greater earnings that we are generating in this higher interest rate environment in which our loan portfolio is over 97% floating and our liability structure is over 65% — pardon me, over 65% fixed rate.

As a reminder, part of our strategy has been to invest in the equity of our portfolio companies in a modest way in order to generate realized gains sufficient to offset losses over time. As our business has matured over the last 10-plus years, we’ve begun to see somewhat regular realized gains from our portfolio. And during 2022, we generated $3.7 million of net realized gains. And now turning to outlook. As a reminder, across our platform of Stellus Capital Management, our total assets under management is approximately $2.8 billion. This additional capital allows us to invest in larger transactions, remain active in the market when SCIC has limited capital and helps us build our portfolios in a diversified way. Since year-end, we funded $25.5 million at par in 2 new and 1 existing portfolio companies and have received no repayments.

This brings our portfolio to approximately $870 million today, which is where we would expect it will finish the quarter at the end of March. Finally, repayments and equity realizations seem to be slowing, but we expect to be able to maintain our investment portfolio between $850 million and $900 million throughout the year of 2023. And with that, we’ll open it up for questions. Thank you. And Ali, would you please start the Q&A session?

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Q&A Session

Operator: Our first question is coming from Erik Zwick with Hovde Group.

Erik Zwick : First, I just wanted to kind of get your thoughts a little bit on the new dividend level at $0.40 a share. I’m just curious. Certainly, the interest rate environment continues to go up, and that will be likely additive to earnings but at some point, a couple of years out, could normalize. So just wondering if you could kind of frame your confidence in having the dividend at this level relative to the outlook for longer-term earnings at this point.

Robert Ladd: Yes. Sure. So in setting the dividend for this year, certainly the first quarter, we expect for the year to earn more than that level of $1.60 or $0.40 a quarter. So we’re keeping in mind that rates could certainly moderate in the future. And if you look at the forward curve, we should be able to maintain this level of dividend based on earnings for at least a couple of years, if not longer.

Erik Zwick : And switching gears to credit. As you pointed out, nonaccrual is still very, very minimal at this point. There’s obviously a lot of concern that the economy may be dipping into a more kind of stressful environment, which could impact some lenders and some businesses. So just curious, one, are you seeing any signs of that the business activity weakening for any of your borrowers? And also are you experiencing any increase in amendment request at this point?

Robert Ladd: Yes. So in terms of any stress, not a material amount. I think what’s been true for us historically is given our underwriting that if we have concerns, it’s more company specific than kind of a broad-based impact. So I’d say that the portfolio has held up relatively well. We’ll always have company-specific issues. And I’m sorry, the second part of your question?

Erik Zwick : Just if you’ve seen any increase in amendment requests from any portfolio companies.

Robert Ladd: We have not. Now one thing I’ll share is that as rates continue to increase, you certainly reach a level where you could have some more stress on portfolio companies, but we think we’ve got a good ways to run before that will — higher rates will be impactful.

Erik Zwick : And then last 1 for me, and I’ll step aside. Just curious if you could update me on the value of spillover income at this point? And how you think about that either as supporting that dividend or a potential for maybe a special dividend at some point?

Robert Ladd: Yes. So I’ll turn that over to Todd.

Todd Huskinson: Yes. Sure, Erik. So our current spillover level from last year into this year is a little over $28 million. And our dividend at the current level in the current number of shares is about $31 million of dividends. So for this current year, our regular $1.60 a share will a little bit more than pay out the spillover and then will pay out a little bit of the current year earnings as well. All other things being equal and kind of what we would expect from this year’s earnings going into the following year, if we continue with $1.60 dividend then there might need to be a special dividend at the end of that year just because we expect to out earn $1.60 dividend. But the way I think about it is, we want to earn our dividend from realized income, which we always have. And then we also have a substantial amount of spillover that’s available to support that dividend as well.

Robert Ladd: Maybe just to add to that. So as we look forward, there could be a need next year for a special dividend, but we’re a good ways off from that.

Operator: Our next question is coming from Robert Dodd with Raymond James.

Robert Dodd : Congrats on the quarter. And back to that point — I mean, to your point, Todd and Rob, you’ve talked in the past about earning the dividend from realized income, and you can earn it from pure NII in the near term. You said, Rob, that I think equity gains are likely to slow this year. I mean in — that’s probably part of the cycle. Do you hypothetically expect them to be slow for the year? Or have you tapped — is there an age vintage component in that in terms of like they’re going to be slow for more than a year and then come back sometime down the road? Any color you can give on that? And then also, I’ll lap it all up for you —

Robert Ladd: Sure. Yes. No, no, it’s a good clarifying question, Robert. So this is just to share as we tried each quarter kind of the cadence of activity — level of activity that we’re experiencing and whereas in previous quarters, we could tell, and there were things on the horizon. And just at this point, there’s nothing on the horizon. But we’ve learned over time that will change. But it’s not a vintage issue, I think it’s just probably a state overall of the M&A market and just expect it to be slower. And I would couple that with what maybe more importantly is that repayment seemed to have slowed for the moment. But again, I wouldn’t call this a long-term phenomenon, and it may could very well pick up as we get into the middle of the year.

Robert Dodd : Got it. And on kind of just conceptually long term, what would you — this is a qualitative than quantitative question probably, how much of your total realized earnings would you expect to come from NII versus realized gains on average ?

Robert Ladd: And sorry, Robert, on average and over what period of time?

Robert Dodd : Going forward, just long term, how much should we expect to roughly to come from NII versus the realized gains. Obviously, they both generate value, and they both contribute for dividend funding, but I’m just trying to —

Robert Ladd: Sure. I’d say for the foreseeable future, again, based on the forward curve, which has now risen up that we would expect to have robust NII out into the future and not need realized gains to support the dividend, which I know is not exactly what you’ve asked, but just to clarify that. And then with respect to realized gains, as a percentage, it probably could be something like 10-ish percent or so of our earnings. As a nominal percentage, it’s typically 5% of the portfolio. But because of the magnitude of what it can generate could be outsized. But we would still expect it to be a modest percentage but overall meaningful. And then in a conservative way that we look at it is that it would cover realized potential losses and credit losses. But in any event, we would expect to be positive and put it in the 10% range, I think.

Todd Huskinson: Yes. Robert, I just might add that’s historically been the case. We’ve effectively covered our dividends through NII throughout our history. I mean there have been times when the realized gains have come in handy. But for the most part, it’s been coming from NII.

Robert Dodd : Understood. And to that point, I mean, over time, your realized gains have been greater than your realized losses, which goes to dividend funding on that front as well. So what are you seeing in the environment right now? I mean you said you expect the portfolio to be, what was it, $850 million to $900 million this year, kind of stable in the first quarter. Is this just — is this year of rotation, a few repayments, a few additions? Or do you expect larger scale rotation in the second half? Or can you give us any color about how that — how you think the year might play out in terms of activity level.

Robert Ladd: Sure, sure. So a few thoughts. One, because of our capital base, we kind of reach a top portfolio around $900 million or so. So we’re operating within the range. We have liquidity right now to get us to that point. So that’s about where we tap out. So I think in terms of activity that we’re seeing and continue to see a number of opportunities throughout the country, that’s why we’d be comfortable being in that range. And then what of course is helpful that as we get repayments, we’ll get the benefit of the fee acceleration. And so repayments are helpful to us as we stay in the range. In terms of activity, a little bit slower in the first quarter as a platform, certainly expect it to pick up in the second and then short of a significant recession in the country likely to be picking up more in the third and fourth quarters. The real point I wanted to make though is that it doesn’t take a lot of activity for our investment portfolio to be full here.

Operator: Our next question is coming from Ryan Lynch with KBW.

Ryan Lynch: First one I had was just what percentage of your portfolio is sponsor backed versus nonsponsored?

Robert Ladd: Yes. So the — in terms of number of companies, as I said earlier, is at 83 out of 85. So 95% plus.

Ryan Lynch: Okay. Sorry, I missed that if you said that earlier.

Robert Ladd: No worries.

Ryan Lynch: Yes. The other question I had was, obviously, there was a very big jump in NII quarter-over-quarter, which was expected given you guys positioning for rising rates. I’m just curious as we turn the page and look at Q1, I’m trying to get a sense of should we expect a similar jump in NII from Q4 to Q1 or a lesser jump. Or there’s a couple of different ways to also think about it, have you guys run what fourth quarter NII would have been if base rates at 12/31 were in fact that whole quarter and/or could you provide the average base rate that your portfolio had for the duration of the fourth quarter. There’s a couple of different questions in there, but I’m just trying to get a sense of the potential growth in Q1. I think there’s just a couple of different ways to think or look at it or disclose it.

Robert Ladd: Sure. So let me take a shot at it first and see if Todd wants to add. So the fourth quarter was a little bit unusual in that we had some fee acceleration. And then also, if you look at just NII, it was affected by, as Todd said earlier, the reversal of some capital gains incentive fee. So I’d say that we would expect in the first quarter to be less than the $0.50 of GAAP NII, but still a number that would exceed the dividend. And then in terms of core NII, likely we will be up over the quarter, reflecting the higher rate. So if it’s helpful, yes, we expect kind of as all things being equal to have greater earnings in the first quarter frankly and in the second quarter more because rates have moved up again. And then in terms of rates to think about, we ended the fourth quarter where LIBOR was about 3.75.

We ended the first quarter where LIBOR was closer to 4.75. And we’re likely to enter the second quarter where LIBOR is over 5. So think of it as — and then we have repricing during the quarter because some are on monthly pay and reprice monthly. But again, you kind of have to take out some quarter-over-quarter changes in other items. But I’ll just start over again to say that we expect earnings to be higher, all things being equal in the first over the fourth and the second over the first.

Ryan Lynch: What was the level of accelerate — so maybe what was the level of accelerated fees in the fourth quarter versus what you guys have timed. I know it’s lumpy but sort of an average run rate that you guys would expect to experience.

Robert Ladd: Todd will pull it up, but I want to say roughly $0.5 million or more in the fourth quarter than we’re expecting in the first.

Todd Huskinson: Yes, that’s right.

Ryan Lynch: Okay. And then just my last question, and I know you talked about kind of portfolio growth expectations for Q1 as well as where you guys expect to operate kind of throughout 2023. But I was just curious as kind of a thought process. You guys are one of the more highly leveraged BDCs on a total leverage basis, not from a regulatory leverage but a total leverage basis. Rising base rates have really significantly benefited your portfolio and allowed significant growth in NII as well as your operating ROEs. Has there been any consideration to lowering the total leverage level, which obviously would reduce ROEs. But since ROEs are so high today given rising base rates, you could still generate a very strong operating ROE. Has there been any consideration to using this higher base rate environment to reduce overall total leverage on the balance sheet?

Robert Ladd: So Ryan, we really haven’t focused on it. And I think the reason is that if you think about the leverage that allows us to go from the low 1s to the low 2s. It’s the SBIC debentures. And so those — so this is, of course, our shareholders are benefiting from our 2 licenses with the SBA and the lower cost of funding that we’ve effectively been locking in now for some time. So if it were non-SBA leverage that had different terms and different maturities, shorter maturities that would certainly be something to consider. But we think this is the right leverage. So think of it, as you say, is 1:1, excluding the debentures; a little over 2:1, including the debentures we think this is the right way to operate and really reward our shareholders for being with us so many years and now benefiting from this interest rate environment.

Ryan Lynch: Okay. Yes, I understand that. I was €“ because I kind of think there’s maybe 2 ways to think about it. One is we want to generate x minimum level of ROE and to the extent that we get significantly above that we can toggle back risk by decreasing leverage on the balance sheet and still generate a healthy ROE. The other one is we’re going to put a certain amount of leverage on these assets that we think are appropriate and the ROE will toggle depending on various factors, including right now, base rates being €“ have a influence. So it sounds like you’re more in that latter camp.

Robert Ladd: I think that’s right. And then if you go back 2 years when we had a different rate environment, we thought this was the right leverage to operate at. So this wouldn’t change our opinion. Now if we felt that macro factors were much riskier and we had great concerns about other matters, then we’d be prudent, Ryan, to look at reducing €“ and in that case, the leverage we’d reduce would be our regular way leverage, like under a bank facility. But we currently operate that facility. It’s borrowings in the low $200 million and it has commitments up to $260 million. So we’ve got capacity there. So I think that’s part of our calculus is that a fair amount of regular way leverage that’s unused and is there for unfunded commitments, et cetera.

So I think we’re at the right spot. But it’s a good point to raise, and we’ll certainly consider over time, but we think our overall view of the economy and our portfolio would indicate that this is still an appropriate leverage level.

Operator: Our next question is coming from Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan : Rob, could you expand on Ryan’s question a little bit? What is your broader economic view right now that guide your investment decisions?

Robert Ladd: So I’d say, overall, we think the economy is certainly headwinds, but not materially — has not materially changed the overall economy. Certainly inflation is of concern and has popped back up at least on a monthly basis. So we would be cautious but we don’t see any significant downturn in the foreseeable future. The one thing that will impact the economy and all of our portfolios is if you have higher and higher interest rates. And so as an example, if you went from a SOFR level today, which is in the high 4s to the high 6s or 7s that would be impactful. But at the current level, our portfolio can withstand higher rates certainly within the 100 to 200 basis points level. So I’d say cautious. But if it’s helpful, again, our overall business is to support private equity firms acquiring new businesses, professionalizing them, creating great value for their investors and therefore, for ours.

So the M&A activity is still very good in the country, and we think it’s a very good place to be investing. So I’d say we’re cautious, but positive and we expect to be quite active during this year.

Christopher Nolan : Also, given the changing interest rate environment where you now have an inverted yield curve, would there be any scenario where you guys would actually start trying to become more liability sensitive or do you actually — you start seeing the top of the interest rate tightening cycle, and you expect an easing cycle to start. Would you take appropriate measures whether through hedges or anything to try to protect your margins through a declining interest rate environment?

Robert Ladd: It’s a good thought, Chris. We’ve taken the approach over time that just kind of float, if you will, with the market. And so one approach one could take would be, though, if — could you lock in some of our loans at fixed rates at higher rates with borrowers. That would be one approach one could take. Whether that would be interesting to our borrowers is another matter. But I think that we like the approach of just having the market rights that we get. And then we certainly would look at it, but I think — I would think of us not as a firm that would be hedging interest rates.

Christopher Nolan : Another question is, how many quarters of expanding investment spreads do you anticipate?

Robert Ladd: So it looks like based on the curve that the expansion of rates will end this year. So that would be our — we’ve learned to go with the forward curve. So I recall, Todd, it expands into the third — kind of starts coming back or flattening in the third or fourth quarter of this year?

Todd Huskinson: Yes.

Robert Ladd: So we don’t expect more than that, although certainly, there’s some talk that it is going to go higher, but we would just go with the forward market curve.

Operator: Thank you. There are no further questions in queue. At this time, I would like to turn the call back to Mr. Ladd for any closing comments.

Robert Ladd : Okay. Great. Thank you very much, Ali, and thank you, everyone, for your support on being on the call. And then we’ll report, of course, the first quarter in early May and look forward to speaking with you then.

Operator: Thank you. Ladies and gentlemen, this does conclude today’s conference call. You may disconnect your lines at this time, and have a wonderful day, and we thank you for your participation.